Radical Reform Recommended for Both EU and U.S. Financial Sectors - Part II

In the past days, more leading stakeholders have added their voices to the chorus arguing for a strategic re-design of global financial markets regulation.

On 9 January, the President of the European Central Bank, Jean-Claude Trichet, spoke at a conference organized by the French Government, which also featured President Nicholas Sarkozy, German Chancellor Angela Merkel, and former British Prime Minister Tony Blair among its speakers. Trichet, speaking on the topic of “A Paradigm Change for the Global Financial System,” provided a scathing assessment of the failures of the financial system, not too dissimilar to that of Willem Buiter. Trichet remarked:

“The current crisis stands out because it is affecting the heart of the global financial system. Its root cause was a widespread undervaluation of risk in the global financial system, especially in the most advanced economies. This included an underestimation of the quantity of risk financial institutions took upon themselves and an under-pricing of the unit of risk. Risk was under-priced because, among other things, financial market participants largely extrapolated ongoing trends and the very low levels of volatility in financial markets and in the real economies going forward. “

Concluding that the rot in the system is deep, Trichet went on to make far-reaching suggestions for new regulation in three areas:

  1. Addressing short-term-ism: There has been an excessive focus on short-term profits to the detriment of longer-term business performance that has resulted in excessive risk-taking and, particularly, an underestimation of low probability risks stemming from excessive leverage and concentration. More balanced and forward-looking incentive frameworks for management compensation and more effective internal risk measurement and control systems that take into account not only near-term profitability, but also sustainability and durable financial strength, are required.
  2. Pro-cyclicality: All aspects of the current regulatory framework need to be fully re-examined to ensure regulation does not contribute to the intrinsic cyclicality of banking, including fair value accounting and leverage, capital requirements and provisioning regimes. Looking forward, new mechanisms should be devised to ensure that banks accumulate resources in good times to cushion the shock when the cycle turns.
  3. Increased transparency: Transparency has not matched the increasing level of sophistication and complexity of financial instruments, creating significant gaps in investor information and financial education. Private equity, hedge funds and special purpose vehicles, and the derivative markets in general were singled out.

Given the interregnum and the preoccupation with its domestic economy, the United States has not taken a clear position relative to Sarkozy’s and Merkel’s strong rhetoric calling for increased global financial regulation. The incoming leadership is taking a softer approach for now. President-elect Obama has said in interviews that he believes “international coordination” is in order and his team will develop a plan in advance of the April G20 summit.

At her Senate confirmation hearing yesterday, U.S. Secretary of State-designate Hillary Clinton cautiously offered the promise of cooperation, stating,

“For too long, we have merely talked about the need to engage emerging powers in global economic governance; the time to take action is upon us. The recent G-20 meeting was a first step, but developing patterns of sustained engagement will take hard work and careful negotiation.”

At the French-sponsored conference, the European leaders said that while they hoped the United States would join them, Europe will move forward regardless and be prepared to advance the EU proposals at the G20.

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