The Hindu Business Line : Global oversight of the financial sector

There is an urgent need for global supervision, which needs to be based on some globally agreed upon standards. It was widely thought that was the IMF’s job, and they may still be brought in to implement a new framework.

C. Gopinath

The IMF bailed out Iceland. Now why is that unusual? Two reasons make us want to take note of this event. This is the first time that the IMF has had to bail out a developed nation. This country was one that had reached high per capita income levels in recent times and the IMF is normally riding in with a bunch of conditionalities to save developing nations from their own past bad policies. The interlinkages between nations in the area of finance is such that no country is free from the consequences of bad policies, their own or someone else’s. The second reason is that we are finally seeing the IMF in action.

Iceland, a tiny country of 3,20,000, rode the boom-and-bust cycle within one person’s lifetime. The country is highly dependent on the fishing industry, which caters to 70 per cent of the exports and employs about 8 per cent of the population. They fiercely protect their fishing rights, even sparring with neighbours to do so. (Another distinctive feature of this country, which does not have anything to do with the rest of our argument, is that it does not have a military, perhaps because no one in their right mind would want to invade or occupy the frozen landscape!)

Iceland made the mistake of moving from its idyllic existence of fishing in a frozen environment when it built up its banking industry, fuelling a decade-long expansion aggressively overseas and significantly helping to raise domestic prosperity.

However, even as the rumblings of the global financial crisis spread and credit tightened, and the value of their krona fell, Icelanders were unable to finance their debts. They had taken loans in foreign currency that they could not repay, spreading the gloom domestically (similar to what happened to Thailand in 1997). Britain felt necessary to freeze Iceland bank holdings in the UK to protect British interests.

And Iceland did not have the resources to help its banks. The assets of the three biggest banks were 10 times the country’s economic output. After trying to get help from elsewhere, the country finally had to knock on IMF’s doors for $2 billion (Rs. 9,400 crore).

Both global and local

The financial services industry reveals peculiar characteristics of being a global and a domestic industry at the same time. It is domestic in the sense that each nation stipulates a set of regulations for its financial firms to follow, and closely monitors them. But it is global in the sense that the same firms operate across all the major economies, offering the same kind of services and deriving global scale economies, and their clients are also global. There is lots of space between these two contexts for virus to take root and spread.

In such an environment, one would have expected the IMF to have been more active when nations began to suffer in the current crisis. After all, the primary purpose of the IMF is ‘To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.’

If the IMF did not rush in to rescue the US financial system, that can be explained. It did not have the $700 billion (Rs 32,90,000 crore) the US was looking for.

Moreover, with the US, one of its big shareholders with de facto veto power, in the role of the prime suspect, one could not expect the institution to take much of an initiative. Hence it laid low, engaging in research, and putting out reports in case anyone wanted to read them. But now that the world leaders are in a mood for coordination and France’s Nicolas Sarkozy has been calling for action, the time is ripe for the IMF to take the leadership.

Superpower status still

However, it is the US administration that has invited global leaders to Washington to talk about the current situation. The White House says that ‘the leaders will review progress being made to address the current financial crisis, advance a common understanding of its causes, … and agree on a common set of principles for reform of the regulatory and institutional regimes ..’ The timing is unfortunate; they will meet 11 days after the new president has been chosen. So, it will probably be an opportunity for President Bush to privately apologise to the world leaders for having allowed its financial system to run riot, and introduce president-elect Barack Obama to them. It is a sign of the US’ superpower status that it can still call for such a meeting with a straight face and be taken seriously. After all, shouldn’t the IMF be calling such a meeting that should be held at the IMF headquarters?

Never mind. If something good comes out of this meeting, that’s all that matters. One can expect a lot of talk and posturing. The Europeans want greater international oversight of financial markets, while the US wants to avoid that and instead argue for continued national regulation. The two positions can co-exist. One outcome that we should all hope for is for some agency to have responsibility for supervision of the industry, while leaving regulation at the national level. If the horrible supervision of one country can so easily affect other countries and with such severity, it is not an industry that can survive with only local oversight.

There is an urgent need for global supervision, which needs to be based on some globally agreed upon standards. We all thought that was the IMF’s job, and they may still be brought in to implement a new framework.

Supervision of ratings practice

There are other important issues pending resolution. For one, it should no more be possible for the existing credit rating agencies (namely, Moody’s, Standard & Poor’s, and Fitch) to function without supervision of their ratings practice.

These ratings are not infallible, (for example, see the ratings they were giving Enron till a short while before that company declared bankruptcy). Ratings need to be highly reliable and the credibility of these firms has been called into question.

It should also no more be possible for some parts of the industry to be regulated (stocks and bonds) and other parts to be left totally free (derivatives, or credit default swaps), especially when the same firm operates in the various segments. This is akin to telling a toothpaste company that the paste you package in plastic tubes will be inspected but not the ones you sell in glass bottles.

The Prime Minister, Dr Manmohan Singh, in remarks made during his visit to Beijing, called for a “global monitoring authority to promote global supervision” of cross-border investment, trade and banking. He should get the weight of the developing world to push for this.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. blfeedback@thehindu.co.in)

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