Sessions with titles like “Reconfiguring the Global Financial Regulatory Architecture” are not always the most difficult to get into at Davos. This year is different. As the second G20 summit approaches there is a sense that decisions may be made which could significantly alter the environment within which financial firms work. So the topic seizes the attention here, especially of those who worry they may be brought into the net, like hedge funds and private equity firms. The private sector is not, however, defending the status quo. There is a widespread recognition that the system, especially in the US, but also in the EU, has not done what it says on the tin. And I detect an emerging consensus around three points.
First, we need to revisit the question of regulatory scope- in other words which firms should be subject to enhanced oversight, especially from a capital perspective. The test should be whether a firm is “systemic”, in other words whether its failure could generate costs to innocent bystanders, and especially to the taxpayer.
That test needs to be revisited from time to time, as one can imagine a hedge fund achieving that status in the future, especially if its business model implies some form of maturity transformation. That in turn implies that regulators need to know more about currently unregulated firms, on a routine basis. In London hedge funds are registered with the Financial Services Authority. In the US many have no relationship with the Securities and Exchange Commission. That needs to change.
Second, there must be more effective global co-ordination, involving a wider group of countries. Easy to say, but where, and which countries?
The option increasingly favoured for the co-ordinating role is the Financial Stability Forum, originally a Gordon Brown creation after the Asian financial crisis, to his credit. The International Monetary Fund must focus on macroeconomic surveillance, and there needs to be a structured relationship between the two, but the FSF, with its mixed membership, including the key regulators, looks best placed to oversee the reform of capital rules which is clearly required now.
A year ago, the acronym FSF would barely have rung a bell with the hedgies and the PE folk. Now they and others see it as sitting at the centre of the complex web of bodies which oversee the system. I doubt if this reform will be sufficient, and favour a wholesale cull of other bodies and committees, but it is a start.
As for membership, well China of course, and Wen Jiabao signalled a willingness to play on the team yesterday. But the whole of the G20? Including Argentina, with a financial sector almost entirely cut off from the rest of the world? Doesn’t make much sense, but choosing the G20 as the summit vehicle makes it hard to leave them out.
Third, there is a near universal recognition that the US system must be changed. Regulation based on institutional or functional lines has had its day, if indeed there ever was a day when that approach made sense. But which alternative model is to be preferred?
The two contenders of choice are the FSA-style single regulator, or the Australian “twin peaks” variant, with one prudential regulator across the financial sector, and a separate conduct of business regulator for transparency and consumer protection. Both have their advocates.
The reputational damage suffered by the UK system around the Northern Rock failure has not affected the fundamental attractiveness of the model to those who believe the regulators must be able quickly to adapt to changing structures.
But while the Australian cricket team is clearly past its best, the Aussie regulatory model is coming up on the inside as a model for others to adopt, especially in the EU, where there are national central banks , with little to do, who can pick up the prudential role. This debate will continue, but more widespread adoption of either, or both models would greatly simplify the task of international co-ordination.
This may seem like a Titanic and deck chair exercise. Everyone acknowledges that fire-fighting is today’s priority. But architectural change only tends to happen in a crisis, so it is worth seizing this rare opportunity for fundamental reform.
Sir Howard Davies is director of the London School of Economics and Political Science