2 Perhaps most telling was an episode that came after a first IMF rescue package for South Korea failed to halt the outflow of money from the country. The Korean authorities dispatched an emissary named Kim Ki-hwan to Washington to plead for a second bailout — and rather than spending his time at the IMF, the person Kim went to see was Summers, to whom he pledged that the authorities in Seoul would offer additional reforms as part of a new Fund rescue. See Blustein (2003), The Chastening, chapter 7.
The United States emerged from this series of crises with its economic lustre restored to a level not seen since the 1960s. The Asian “tiger” economies had been cut down to size; so had their model, Japan, which had earlier appeared to pose a serious threat to US economic primacy, but was now struggling to eke out minimal rates of growth following the bursting of its real estate and stock market bubble. The United States, by contrast, was in the midst of a long boom that was widely perceived to prove the superiority of the American way, from its rule of law to its shareholder-oriented corporate governance to its reliance on vibrant securities markets for funding the growth of its industries. Across the Atlantic, Great Britain was enjoying a similar renaissance that likewise seemed to showcase the advantages of neo-liberal economic policies.
At the same time, the crises drove home to the G7 how the fortunes of emerging economies might affect the health of the entire global system. Markets in New York, London, Frankfurt and Tokyo had often demonstrated surprising sensitivity to developments in Seoul, Jakarta, Moscow and Brasilia. Most sobering of all were the events of August and September 1998, when Russia’s debt default led to the collapse of Long-Term Capital Management, the world’s biggest hedge fund, whose supposedly foolproof investment strategies were based on stupendously complex formulas conceived with the help of two Nobel Prize-winning economists. The Russian default was so unanticipated — such a “tail event” in the distribution of probable risks — that markets all over the world moved in ways deemed almost impossibly remote by Long-Term’s battery of Ph.D.s. The resulting losses posed a dire threat to the giant Wall Street banks and securities firms that had lent the hedge fund the sums needed to hold its US$140 billion in assets. The damage was contained thanks to an extraordinary bailout funded by the banks and orchestrated by the New York Fed.
In a world where such things were possible, the “international financial architecture” was, by near-unanimous consent, in need of repair. After much debate about whether this repair should involve transformation or just tinkering, the institutions and groups of the postwar financial order were joined by a couple of new ones.
The FSF and the G20
Renowned for his geniality as well as his competence, Andrew Crockett was the sort of public servant whose elevation to higher status would normally elicit gratification in policy-making circles. The son of a Scottish doctor, with degrees from Cambridge and Yale, Crockett began his career at the Bank of England before rising through the ranks at the IMF to a senior staff position, and in 1994 he was appointed general manager of the BIS, where he won the affection, as well as admiration, of the staff. (“Engagingly unstuffy” is how a laudatory profile in The Banker described him.3) But in 1999, the news that Crockett was gaining heightened responsibilities sparked a confrontation with another titan of international finance — Stanley Fischer, the IMF’s first deputy managing director. When the two men met at a conference in Aspen, Fischer — despite enjoying a similar reputation for amiability — laced into Crockett, taking him by surprise. “It was the most acrimonious conversation I’ve ever had with Stan,” Crockett recalled in an interview.4 “He told me it was unacceptable, that I was behaving badly...He’s a very good friend of mine, and that’s the only friction-filled conversation I’ve ever had with him.”
3 See Melvyn Westlake (1994), “Into Basle’s Inner Sanctum,” The Banker, March 1.
4 Crockett died in September 2012.
Crockett had agreed to become the first chairman of the FSF, which the G7 was in the process of establishing in Basel for the purpose of overseeing and coordinating crisis-prevention policies. Fischer was upset because he felt the FSF’s proposed tasks fell within the IMF’s purview — and his outburst was based on a reasonable question: Why was it necessary to form a separate group? The IMF had a long-standing mandate to conduct surveillance over the global economy, and it had the virtue of legitimacy, with membership that included nearly all of the world’s countries. Moreover, the Fund had led the response to the emerging market crises, and considered itself well positioned to make judgments about what sort of reforms in emerging markets would make the world safer.
But G7 officials, while broadly sharing the view that reform in emerging markets was the key to financial stability, were loath to confer new authority on the IMF. The Fund’s handling of the crises had shown it to be much less savvy about problems in banking systems than it was about tax and budget matters. Another important reason for G7 officials’ chariness of the Fund was the power of its staff and management, which, if enhanced further, might make the institution less amenable to G7 control.
Among the most radical ideas, championed by Gordon Brown, the UK Chancellor of the Exchequer, was the creation of a global regulator with vast new powers over international finance. That idea got little traction elsewhere, least of all the United States. The Clinton administration’s powerful Treasury Department preferred something akin to the Basel Committee — that is, a network of policy makers whose ability to set standards would be based on “soft law,” with moral suasion and force of example used to achieve compliance rather than formal treaties or agreements with enforceable rules. In addition to the Basel Committee, similar soft-law-oriented bodies had been created in the 1980s and 1990s to set standards for financial sectors and issues other than banking; these included the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), and they would be joined in 2001 by the International Accounting Standards Board (IASB).
Still, US officials were keen to bring some coherence to this panoply of international organizations, all of which had been issuing standards in scattershot, disjointed fashion since their creation. The Treasury was also interested in seeing finance ministries gain more input and intelligence regarding international regulatory issues, because the crises of the 1990s had shown the potential for financial turbulence to spread on a global scale. Finance ministries were the ones that would be stuck with the bill — and their political masters would be held to account — if a crisis leapt to their countries’ shores from abroad.
That was the backdrop for the proposal to create the FSF, drafted by Hans Tietmeyer, the outgoing president of the Deutsche Bundesbank, who accepted a request from the G7 in October 1998 to devise a plan. After consulting extensively with fellow policy makers, Tietmeyer proposed a group that would include top officials from 16 international bodies — both standard setters and international financial institutions such as the IMF — plus officials from the finance ministries, central banks and chief regulatory agencies of major countries. Although all of these international bodies and national authorities were constantly gathering data and looking for danger signs in certain segments of the international system, “none has the breadth of information or the capacity to formulate a complete assessment of evolving risks,” Tietmeyer wrote — the implication being that the FSF would assume this formidable task.5
5 Tietmeyer’s report is available on the BIS website at: www.bis.org/review/r990225b.pdf?frames=0.
Also in the incubation stage at around the same time was the G20 — whose future takeover of the G7’s steering-committee role for the global economy was, at that point, unimaginable. The precise details of the G20’s conception are murky. By one account, the initial plan was scribbled on a brown manila envelope at a meeting in the US Treasury between Summers and Canadian Finance Minister Paul Martin.6 By another account, the formative moment came in a transatlantic phone call between Summers’s proteg�
�, Timothy Geithner, and Geithner’s counterpart at the German Finance Ministry, Caio Koch-Weser.7 Although the envelope story may be apocryphal, the driving force behind the G20’s creation was unquestionably Martin, who believed passionately that if the major emerging countries were expected to abide by the rules of the global financial system, they needed a forum where their views on those rules could be aired. Together with Summers, Martin assembled a list of countries they agreed ought to become members. The countries that would be later known as the BRICs (Brazil, Russia, India and China) were obvious invitees, as were a couple of major Islamic countries (Saudi Arabia and Turkey), as well as Argentina (because the pro-market Argentine government at that time was viewed as a poster child for the sort of reforms the G7 favoured).
6 John Ibbotson and Tara Perkins (2010), “Making Both Ends Meet,” The Globe and Mail, June 19. Summers was by then Treasury Secretary.
7 Robert Wade (2009), “From Global Imbalances to Global Reorganisations,” Cambridge Journal of Economics 33, no. 4: 539–562. Geithner was then Treasury undersecretary for international affairs.
But the G20’s status was clearly second fiddle to the G7. Ian Bennett, who was Martin’s deputy, recalled in an interview that the emerging country members of the G20 weren’t even informed in advance about its formation. In what he acknowledged as “the unbridled arrogance of the G7,” Bennett said his role “was to go around to these countries, and welcome them into this new club that they’d never asked to join.”
Tellingly, the national officials on the FSF would be limited to the G7. In a world where the G7 was the supreme club, the FSF was a “club of clubs”8 — of G7 finance ministry officials, G7 central bankers, G7 regulators and officials of international organizations that the G7 controlled. An earlier proposal for such a group had envisioned the inclusion of officials from emerging market countries, and Canada’s Martin fought vigorously to retain that approach. But others in the G7, in particular the United States, wanted to keep the national memberships to themselves, with perhaps a few additional seats for others from similarly advanced jurisdictions.
8 See Daniel W. Drezner (2007), All Politics Is Global: Explaining International Regulatory Policy Regimes, chapter 5, Princeton, NJ: Princeton University Press.
And in another important decision aimed at maintaining a firm G7 grip on policy levers, the FSF Secretariat was limited to a handful of people — at most 7.5 full-time equivalents — with most staffers on temporary secondment from government agencies and international bodies including the IMF and World Bank, except for the Secretary General, a Norwegian named Svein Andresen who had worked for Crockett at the BIS. The G7 did not want to cede control to an independent, IMF-like bureaucracy, and figured that as needs arose for extra staff, the FSF could rely on the brainpower of member countries’ own economic agencies or those of other international institutions. We shall return to the FSF in chapter 6.
In Crockett’s words: “The idea was to get the G7 together. They fondly imagined at that time that crises would only happen in the emerging world, and they would be well-placed to identify and manage risks coming from elsewhere.”
Basel II
William McDonough, president of the Federal Reserve Bank of New York, did not share Paul Volcker’s aversion for travelling to Basel. The silver-maned, bushy-eyebrowed McDonough enjoyed socializing with other central bank chieftains; indeed, he took pride in chairing the BIS’s three-man wine committee, which was devoted to assuring the excellence of the vintages served at the central bankers’ dinners.
In June 1998, McDonough assumed a new responsibility that would increase the amount of time he spent in the Swiss city: he became chairman of the Basel Committee, a post heretofore held, for the most part, by Europeans. Not only that, but shortly after becoming chairman, McDonough made it clear that the committee would pursue an active agenda under his stewardship. In a September 1998 speech, he told a London audience that he wanted the panel to launch discussions aimed at producing a new accord concerning the amount of capital that banks must maintain, replacing the agreement struck 10 years earlier. The overall goal was the same as the previous Basel pact — that is, to foster safety in international banking while also levelling the playing field to the maximum extent possible among banks from different countries. But achieving this goal required new methods and more sophisticated rules, McDonough contended. Seeking to display an appropriate degree of humility about this undertaking, he acknowledged: “Whatever we choose as a direction for future capital requirements is likely to be imperfect, and will eventually need to be replaced, no doubt sooner than we would like.”9
9 See William J. McDonough (1998), “Issues for the Basel Accord,” remarks at the Conference on Credit Risk Modeling and Regulatory Implications, Barbican Centre, London, September 22, available at: www.newyorkfed.org/newsevents/speeches/1998/mcd980922.html.
Prophetic words, those — for this was the opening salvo in what would become known as “Basel II,” which would stand accused of many imperfections and would need to be replaced with almost unseemly haste.10
10 For much of the historical information in this section, see Daniel K. Tarullo (2008), Banking on Basel: The Future of International Financial Regulation, Washington, DC: Peterson Institute for International Economics.
Fuelling McDonough’s determination to draft a new set of rules was the belief that the financial industry was evolving, modernizing and globalizing at such a rapid pace that government regulators could no longer gauge the risks banks were taking as well as bankers could do themselves, so the original Basel Accord was increasingly ill-suited to its purpose. The sums that banks were lending across national borders were growing by leaps and bounds, as was the staggering array of derivative instruments that were enabling them to wring extra profits on their funds while also hedging against adverse developments.
Furthermore, the existing rules were distorting banks’ incentives in undesirable ways. By lumping all loans to private borrowers together in a single category, the rules required a bank to maintain the same US$8 of capital for every US$100 it lent, regardless of the borrower’s size or credit history — the result being extra motivation for making high-interest loans to risky borrowers, and reduced motivation for making low-interest loans to blue-chip borrowers. That was hardly a fitting outcome for rules ostensibly designed to make global banking safer. Nor was another widespread practice that the rules had inadvertently encouraged — moving loans off of banks’ balance sheets, using the now-notorious alphabet soup of entities such as structured investment vehicles (SIVs) and CDOs. Here is how it worked: A bank could maximize the profit it earned on its capital by establishing a SIV, a technically independent shell company of sorts, which would buy some of the bank’s loans, reducing the bank’s capital requirement proportionately (even though the bank would have earned hefty fees in the loan-origination process). Then the bank would use the proceeds of the sale to make new loans, repeating the process; the loan payments going to the SIV, meanwhile, would be sliced and diced into CDOs, which would be sold to investors of varying risk appetites. Such blatant gaming of the Basel rules, together with the rules’ bluntness, suggested to McDonough and his fellow regulators that they needed a better way of matching banks’ capital requirements to the riskiness of their assets.
The banks — or at least the multinational giants — had a ready answer: the traditional scrutiny of loan books by green-eyeshade bank supervisors no longer made sense. Instead, they argued, the Basel Committee’s new rules should make use of the sophisticated models the banks had devised to get a handle on their exposures. In this view, the only way to accurately gauge how much capital a modern bank needed was to use “value at risk” (VaR) models, by which banks themselves calculated the depth of the losses they might conceivably suffer if market forces turned heavily against them. Some Basel Committee members were skeptical of this idea at first, which was being pushed strongly by the Institute for International Finance, the group representing Nor
th American, European and Asian behemoths of the banking, securities and insurance industries. This wariness was warranted; mathematical models, with their supposed precision at predicting movements and correlations among various financial instruments, had been the downfall of the Long-Term Capital Management hedge fund, which had utterly discounted the probability of the tail events that followed Russia’s default. But eventually, the Basel Committee came around, seeing no good alternative in view of the way the biggest financial institutions were working. This approach suited the ideology that predominated at the Federal Reserve, where Chairman Alan Greenspan and many of the most influential staffers believed fervently that market discipline would keep bank executives from allowing their subordinates to gamble recklessly with their firms’ solvency.
Even so, intense wrangling over the details delayed the committee’s progress, exasperating its chairman. McDonough joked often about his “fiery Irish temper,” but his outbursts were none too amusing for those on the receiving end, including fellow Americans. An altercation he had with Jerry Hawke, who was US comptroller of the currency, is still the stuff of legend in Basel. US regulators were profoundly divided over the wisdom of the course the new accord was taking, which only complicated matters further. Banks were also split, depending mostly on their size rather than their nationality. A committee proposal that would allow banks to rely on internal models in determining their capital requirements met with vehement objections from small- and medium-sized bankers, who feared that such an approach would give unfair advantages to their larger competitors. With the negotiations still uncompleted in mid-2003, nearly five years into his chairmanship, McDonough was forced to relinquish the gavel because of his impending retirement from the New York Fed.
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