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Dutch report on the future of global finance may well give clue to the current split within G20

Posted: October 11, 2010   By: Pierre Habbard Category: Alternative assets & derivatives, G20 & G8, Taxation,

The roles of “good guys” and “bad guys” seem interchangeable in the G20 which is supposed to give new impetus to international financial regulation. To simplify (a lot) there are two ways to consider financial regulation:

  • regulating financial institutions themselves; that is the case, for example, of the new prudential framework for banks, Basel III, published in September this year;
  • regulating markets and market transactions, as seen in the on-going discussions on bringing OTC derivative trading within the scope of organised exchanges or in the current debates and campaign for the creation of financial transaction tax (FTT).

Regarding regulation of banking institutions the role of the “bad guy” is held by Germany - and perhaps also by Japan. Both countries have – it seems – spent a lot of time and effort to curb and limit the negotiations on the new Basel III, while the US and the UK have been fairly relaxed about it. The roles appear reversed when it comes to regulating hedge funds: support by the continental Europeans, heavy opposition by the British and the Americans (as well as the Swedish by the way). The roles are reversed as well when it comes to the derivative markets. The French and Germans (but also the Austrian) have made known their views on the need for tightening the rules as well as for the creation of an FTT – something that will happen over the dead body of the US Treasury it appears. It is rather difficult to apply such “good vs. bad guy” distribution of roles in the case of emerging countries that participate in the G20 though. It may well be that financial regulation & supervision do not rank on top of their to do list, at least compared with other G20 issues such as reforming the IMF & World Bank.

Much has been said about this distribution of roles and differences of position between members of the G20. The Dutch Centraal Planbureau (literally the “Board of Centralised Planning”, a body that does not centralise or plan things anymore but one that does speak with authority within the Dutch political scene) published a prospective report in September on the future of global finance and the political and regulatory challenges ahead. In a two-dimension world (1. level of concentration of banking, 2. level of market disintermediation) the report identifies four scenarios for the future global finance:

  • A world made of “isolated islands” in which financial institutions are local and specialised and in which financial information (and hence credit default risk) is managed through banks mainly (leaving little room for derivative markets and securitisation). This is the old-style banking model which according to the authors is best exemplified by the current German system.
  • A world made of “big banks” with the same characteristics as the island-scenario (strong domestic base, heavy intermediation by banks) but in which banking institutions cumulate several business lines (they are not specialised), featuring a high degree of concentration of the sector. Japan – we are told – is the closest to that model.
  • A world dominated by “competing conglomerates” with the same level of concentration of the industry as the above but in which financial information and credit risks are channelled through markets (hence heavy reliance on securitisation and derivatives) and with a high degree of internationalisation of banking groups. Most European countries fall under that category according to the report;
  • Last but not least, a world of “flat finance” in which financial disintermediation (ie. greater role given to markets and derivatives) and internationalisation are pushed in the extreme but banks would remained specialised by activity (hence a very large and yet diluted financial sector) – best example is given by Wall Street, say the authors.

This Dutch report surely will not be the first nor the last one to be produced on that topic. On the negative side, one will regret the narrow approach of the report which excludes alternative financial services (cooperative banking, mutual insurance, public financial services). The paper nevertheless has the merit of simplicity and clarity, especially when the authors take the perspective of the regulator. Basically, the message is that the further we get away from the traditional “isolated islands” scenario the more challenging it becomes for regulatory authorities and policymakers. Weak political authority and commitment to reform in the face of heavy financial lobbies will be especially problematic in the “competing conglomerates” and the “flat finance” scenarios compared with “big banks” and “isolated islands”. Tightening banking regulation will be more controversial and therefore subject to greater resistance by financial lobbies under “competing conglomerates” than in the “flat finance”. Conversely, derivatives’ market regulation will be more difficult to achieve – and yet so much needed – under “flat finance” than under “competing conglomerates.”

If these scenarios are valid ones and indeed if they match national contexts within the G20, then it is (almost) no wonder why Germany (= isolated islands) and Europe in general (=competing conglomerates) are not too comfortable with the current negotiations on the regulation of banks, but have no problem lashing out at derivatives or discussing the creation of an FTT openly. Conversely, it would come (almost) as no surprise that the U.S. (= flat finance) belong to the “good guys” on Basel III but have a problem when the conversation leads to derivative regulation, not to speak of the creation of an FTT.

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