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The Week That Was

Source: NCB Capital

Between banking reform and a W

The past couple of weeks have seen renewed efforts on the part of policymakers to push through more systematic financial sector reforms. For example, the G20 meeting of finance ministers and central bankers reiterated previous plans and highlighted important new departures. These initiatives build on the assumption that the relative stabilization of the global economy in recent months now permits a shift in focus from economic fire-fighting to policy reform. At the same time, there is mounting concern that a failure to act now might result in an important opportunity being squandered because of a return to ‘business as usual.’ Furthermore, populist pressures generated by bonuses may lead to piecemeal reform stealing the limelight from a systemic overhaul. Nonetheless, it is far from clear that a transition to a new policy regime can be done without significant economic costs. Those costs, however, may prove unavoidable even in the absence of reform.

While the stimulus measures undertaken by governments around the world dominated the recent G20 meeting of finance ministers and central bankers in London, the sense of urgency was considerably diminished compared with previous similar occasions. Indeed, the main focus of the discussion about the economic relief measures was their withdrawal, even though it was agreed that this would be premature at this point.

The improving confidence allowed the meeting to focus on the hitherto frustratingly slow process of reforming the financial sector. Regulatory shortcomings were widely seen as a key contributor to the crisis and a systemic overhaul was expected as a logical corollary. In practice, however, concrete steps in that direction have been minimal to date. While the urgency of anti-crisis measures is the main reason for this, progress has also suffered due to the lack of concerted effort and focus as well as entrenched vested interests. An even greater risk at the moment is inertia in the wake of the recent market stabilization. To the extent that the system can be expected to heal itself, there is less of a perceived urgency to adopt new measures. Yet, it is obvious that a failure to engage in serious regulatory reform will amount to a failure in addressing the fundamental structural vulnerabilities of the system and may pave the way for another crisis. It was these considerations that prompted President Obama in his much-publicized 14 September speech in New York to accuse the financial sector of failing to learn from the crisis and to warn of renewed sectoral and national danger.

The key initiatives discussed at the G20 meeting included a plan to impose more stringent capital requirements for financial institutions as a cushion against losses. An additional recommendation was made for counter-cyclical buffers. Similarly, there was consensus on limiting leverage ratios and off-balance sheet items of banks, both seen as causes of the crisis. Moreover, the discussion highlighted the pre-crisis fallacy of improved distribution of risks through use of derivatives. Not only did this practice enable banks to engage in potentially risky activities on a large scale, but it also caused them to mobilize more of their capital for the purposes of generating profits. In recognition of this, for instance the US government is seeking to enhance the regulation of derivatives markets, among other things by reducing the number of OTC contracts by opting for a centralized counterparty. This would effectively concentrate the main market risks in one regulated market infrastructure institution, thereby significantly curbing the risks of the kind of contagion that manifested itself in the wake of the Lehman collapse. This may, however, not be a real

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