Global Policy Forum

WEED statement on the report of the Financial Stability Forum

By Peter Wahl & Peter Waldow

GPF Note: The three reports of the Financial Stability Forum (April 5, 2000) can be downloaded:
1. Report of the Working Group on Capital Flows;
2. Report of the Working Group on Offshore Financial Centres;
3. Report of the Working Group on Highly Leveraged Institutions;

On April 5th, 2000, the Financial Stability Forum (FSF) presented its final report. Against the background of numerous financial crises with devastating social consequences, especially in South East Asia, and due to the experience with the (near)-collapses of highly speculative funds, the FSF was established in February 1999 on the suggestion by the G7 to develop proposals for a reform of the international financial system. The members of the FSF are finance ministers, heads of central banks, representatives of the OECD and representatives of supervisory authorities and international financial institutions such as IMF, BIS and WB. The FSF was chaired by Andrew Crockett, the president of the Bank for International Settlement (BIS).

The Forum dealt with three issues: capital flow, offshore centres and highly speculative funds ("highly leveraged institutions"). The recommendations will be presented at the spring meeting of the IMF and in two years their implementation is going to be evaluated.

Useful diagnosis...

The main asset of the report is that it rather openly names the flaws, problems and risks of the sectors analysed. It underlines the criticism – from NGOs and others - geared towards the uncontrolled liberalisation and deregulation of international financial flows. The report also implicitly admits that the IMF has made mistakes and misjudgements in the past. It does no longer maintain the theory that the crash in South East Asia was solely due to internal problems ("crony capitalism") in the respective countries. Instead it concedes that the financial markets pose systemic risks to small and medium-sized national economies. The report also acknowledges the dangerous effects of offshore centres and their criminal practices (money laundering), of highly speculative hedge funds and some derivates. All in all, the report does not leave any doubt about the obvious need for a reform of the international financial system and its institutions.

...wrong therapy.

However, considering the extent and the complexity of the problems, the reform proposals of the FSF are more than insufficient. The recommendations referring to capital flows are restricted to the most obvious: increased transparency of all actors, incl. IMF, improved monitoring, provision of reliable and timely statistics, risk management based on international standards and improved supervision. Of course, all of this makes sense, especially for the financial systems of development countries and emerging markets. However, it is not sufficient to eliminate the inherent risks of the system as demonstrated by the involvement of numerous banks from OECD countries in the crisis despite their elaborate control systems. The same is true for highly speculative funds.

Only the recommendations referring to the offshore centres might be helpful to reduce the risks of this questionable product of the capital markets – provided the political will to do so. The inclusion of the private sector in the prevention and management of crises ("bail in") is not mentioned any longer in the proposals. That makes the report fall way behind what has been discussed after the Asian crisis. Even the harmless proposal of a credit list, as presented by the German government before the G7 summit in Cologne, is missing. The principle "privatisation of profits, socialisation of losses" is not questioned.

The report warns against instruments such as capital account controls because their costs would be too high, although they have been successfully applied in Malaysia during the Asian crisis. Further reaching measures such as a tax on capital transfers (Tobin Tax) to reduce the extent, the speed and the volatility of international capital flows are not mentioned at all.

The report clearly focuses on developing countries and emerging markets. The effects of liberalised financial markets on the industrial countries are completely ignored. There is no discussion about private pension funds and their dependence on the international financial markets. The report does not comment on the fact that by threatening to withdraw their capital ("exit option"), the financial markets exert a great influence on the finance, economic, budget, social and labour politics even of most of the G7 countries. It does not mention the democratic deficit caused by this, either. Therefore, the report can only be considered a lead-in to the discussion about a truly substantial reform of the financial markets.

Report Of The Working Group On Capital Flows

The analytical part of the report states that the international mobilisation of capital is necessary but bears potential risks and costs. Especially short term portfolio investments are identified as risks. Above all abrupt portfolio "adjustments" – e.g. the withdrawal of capital -can cause severe problems. Especially countries with high short term debts are in danger. Incentives for short term portfolio investments by international banks are recognised as risk factors which increase the volatility of capital movements. In this respect the report bids farewell to the illusion of an ideal world of globalisation.

The most important recommendations of the report are:

improved monitoring of capital transfers and economic development on a national level,

improved risk management of the public and the private bank sectors, especially a careful debt and liquidity management,

strengthen supervisory institutions and procedures, especially introduction of rules for adequate minimum deposits for banks and introduction of limits for the borrowing in foreign currency,

scepticism towards capital account controls; only in exceptional cases inflow controls through market instruments as practised in Chile, are considered useful and practicable without causing too many costs,

extend the issuance of long term government bonds in order to attract long term investments,

transparency of national authorities, provision of reliable statistics, adoption of accounting standards by companies – if necessary via corporate law.

All proposals have in common that they shift the responsibility to the national level. That is the place where the FSF wants to build the dams and safeguards against the negative effects of the floods of global capital. However, the FSF does not want to influence the extent, speed and direction of the flood. The core problem of the 1.5 trillion US-Dollars that are transferred freely every day, is not touched. An international tax on capital transfers (Tobin Tax) remains taboo for the FSF.

With that, the proposals for an improvement of the risk management – if implemented at all – will lose much of their effect. They will not be sufficient to prevent a speculative attack, because due to an unrestricted growth of international capital flows, actors prepared to take high risks will get greater opportunities. The race between supervisory authorities and speculators will always be won by the latter if speculation as such stays attractive. As long as one can earn money much faster and easier with short term investments, arbitrage and speculation than with real investments, the international financial system will be prone to crises.

Report of the Working Group on Offshore Centres

The report on Offshore Centres (OFC) is based on the scarce literature on this issue and on surveys conducted by the Working Group. In contrast to previous publications that focussed on the bank sector and specific OFC, the FSF working group presents a more complex and realistic description of the problem.

The following fundamental problems of the international financial system that emerge from the existence of OFCs, are described with suprising clarity:

the lack of adequate regulations and/or effective supervision hinders the introduction of international standards, weakens the efforts to prevent financial crises and creates a potential systemic threat to the international financial system,

the growth in assets and liabilities of institutions based in OFCs together with a growth in risky credit transactions increase the risk of contagion,

the lack of due diligence with which financial institutions can be formed in OFCs facilitates inappropriate structures that impede effective supervision,

the lack of availability of information on ownership of corporations stimulates illegal business activities (e.g. money laundering),

Based on the previous analysis the following recommendations are made:

an assessment process for OFCs should be carried out under the auspices of the IMF in order to introduce the main international standards in the most important OFCs and to establish effective supervisory structures,

creation of incentives by national institutions, e.g. by discrediting ("naming and shaming") companies engaged in OFC (black lists),

extension of financial supervision beyond the bank sector, referring to the responsibility of national insurance supervision and securities and investment supervision,

the OFC should be asked to report their financial activities to the BIS.

These recommendations reach much further than the previous discussions within international financial institutions and the G7. If the recommendations were fully implemented, the OFCs would almost be neutralised. However, the suggestion to restrict the process to the most important OFCs and standards undermines the systemic approach and will lead to a shift of offshore financial activities to either not registered or newly founded loopholes.

Apart from that, it is more than likely that the proposals will be watered down by the IMF and even more diluted by single governments. The decisive flaw of the recommendations is that the responsibility for the regulation of OFCs is delegated to the national level, because for competitive reasons, the governments are not interested in regulating the OFC in a manner leading to their abolition. Therefore, a regulation can only be effective if internationally binding. The discrepancy between analysis and recommendations is highlighted by the way the tax issue is addressed. Whereas the analysis points out that the lack of tax regulations and the possibility of legal tax evasion is one of the main attractions of the OFCs, none of the recommendations addresses these problems. Political consideration for players such as Great Britain resulted in important reform options going by the board.

Report of the Working Group on Highly Leveraged Institutions

Starting point of the analysis of highly speculative funds (Highly Leveraged Institutions – HLI – in the euphemistic terms of the FSF) is the correlation of risk fund activities and the destabilisation of the finance sector of small and medium-sized open economies as well as the threat to the financial system posed by the near-collapse of the US Hedge Fund LTCM in 1998, which was prevented by political intervention in the last minute.

The working group states:

a high degree of leverage in financial markets – i.e. either an extreme disproportion in the debt-to-equity-ratio or the intensive use of derivative instruments that can be bought with only a fraction of their potential profits – pose a potential risk for the global financial system,

the lack of documentation and supervision of risky transactions of HLIs increases the danger of sudden collapses causing international chain reactions,

transactions of HLIs are focussed on unregulated securities and derivatives markets, especially over the counter (OTC) transactions, i.e. transactions circumventing banks and stock exchanges,

the herd instinct of finance market participants – often due to transactions of risk funds - leads to price distortions and liquidity squeezes that can have systemic effects. The increasing concentration of capital in HLIs accelerates this effect,

the insufficient risk management of HLIs and their counter parties poses a permanent threat,

hedge funds are the riskiest and most dangerous types of HLIs. They are mostly unregulated, opaque and located in offshore centres.

Not all of the members of the working group share the views of this analysis. Especially the systemic effects of HLI transactions were a contentious issue. Therefore, the recommendations are less far reaching than expected after the analysis. They include:

improved risk management by HLIs and counter parties,

improved information disclosure of by HLIs and counter parties, via national legislation, enhanced national surveillance of financial market activities, in particularly of foreign exchange and OTC transactions,

introduction of best practice guidelines for financial market participants and their supervision by national authorities.

The creation of an international credit register and the direct regulation of hedge funds were discussed but finally not recommended, upon request of the Anglo-Saxon members. As a result, the HLIs will be able to continue to exert their destabilising effect on the financial system because:

derivates continue to be an opportunity for exorbitant borrowing. Risk funds working with such leverages are not interested in risk management. An improved supervision won't change that, because the fast creation of open positions can only be noticed afterwards.

once more an international (regulation) problem is shifted to the national level. This stimulates a race between countries for the weakest regulation as a competitive advantage.

three quarters of all hedge funds are located in offshore centres that lack the political will to implement the recommendations and improve documentation and supervision. Only a direct regulation of the hedge funds can stop their potential risk.

Conclusion

All in all, the report does not provide any solutions for the core problem – in the meantime also affecting industrialised countries: the influence of financial markets deprive the governments of their sovereignty in macro-economic decisions. "The capital markets start to discipline the ‘political actors' as inadequate political and structural frameworks encourage the mobile capital to look for locations that promise high returns on investments.", explains Josef Ackermann, member of the board of the Deutsche Bank. This, of course, creates a fundamental democratic deficit. Therefore, a reform of the international financial system that does not strive for a democratic control of the financial markets will only be piecemeal.

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