Previous critiques of the FSF have described its performance as disappointing, in view of the goals envisioned for it.6 Apt though such assessments may be, the evidence supporting them has been paltry, commensurate with the meagre amount of information disseminated to the public. The material presented herein lays bare, with far greater specificity and authority than has been possible to date, how slow the FSF was at discerning the financial system’s fragility and at directing preventive and preparatory action.
6 One leading example is the discussion of the FSF in Howard Davies and David Green (2008), Global Financial Regulation: The Essential Guide, Malden, MA: Polity.
This does not mean that FSF members were blind to, or blasé about, the forces building inside financial markets and institutions that would eventually menace global prosperity. Records of their meetings show that they spotted, tracked and discussed a number of these factors. But, for a variety of reasons, which will become clearer as the narrative unfolds, they spent a great deal of time on issues that turned out not to matter much and failed to respond with sufficient alacrity to ones that turned out to matter a great deal.
Moreover, once markets manifested early symptoms of the crisis, the FSF was again sluggish at grasping its severity — as evinced by documentary material revealing how the “worst-case scenarios” that members privately discussed became progressively more pessimistic. The FSF has generally drawn much higher marks for how it performed after the crisis was fully underway, thanks to a report it issued in the spring of 2008 that helped set the agenda for much of the G20’s subsequent action. But this perception that the FSF rose to the occasion during the crisis fails to take into account an embarrassing episode that came two weeks after the Lehman bankruptcy, and which was not reported either at the time or afterward. The group had to effectively abort a meeting for lack of attendees, despite the hopes of its chairman that it would assume a new role in coordinating countries’ crisis responses. This episode was emblematic of the breakdowns in international cooperation that plagued this period and exacerbated the turmoil.
Where the FSF failed, perhaps the FSB will succeed. The stated presumption among policy makers is that the new body offers much better promise of recognizing where the financial system is in greatest need of shoring up, and that it has better tools to ensure that its views are acted upon. Without a doubt, the FSB differs substantially from the FSF. In addition to its much broader membership, there are also major enhancements over the preceding arrangement. Policy makers extol the FSB’s more systematized method of detecting vulnerabilities, its “peer reviews” of member countries, the “Early Warning Exercise” it conducts jointly with the IMF and the clout the group wields by dint of its close links with the G20.
Yet aspirations for the FSF were also lofty, and its ties to major powers formidable, at the time of its emergence. As noted in chapter 3, it was a creature of the G7, with each of the seven industrial powers represented by three high-ranking officials — from their finance ministries, central banks and regulatory agencies — who sat alongside representatives of international institutions (such as the Basel Committee) that the G7 dominated. Moreover, the draft proposal for the FSF’s creation, written by Hans Tietmeyer, president of the Deutsche Bundesbank, was based on the concern that no other body had “the breadth of information or the capacity to formulate a complete assessment of evolving risks.” Filling that void was a laudable, if daunting, objective.
The Good, the Bad and the Ugly
On the day of the FSF’s inaugural meeting, which took place in Washington on April 14, 1999, an op-ed published in the Financial Times reflected hopes for the body’s success at surveilling the financial system. “We need to look for trouble more systematically than before,” stated the op-ed, written by Howard Davies, who as executive chairman of Britain’s Financial Services Authority (FSA) was a prominent FSF member. “It is easy to forget the dramatic market volatility of 1997, and the near-meltdown of last September [the collapse of the Long-Term Capital Management hedge fund]. So now, before the memories fade, is precisely the time to begin planning our response to the next crisis.”7
7 Howard Davies (1999), “A Forum for Stability,” Financial Times, April 14.
Andrew Crockett, the FSF’s chairman, was especially determined that the body would become more than just an international talk shop. Crockett, who was also BIS general manager, was a skilled, likeable veteran of financial diplomacy, and he exercised his prerogative of the chair at that first meeting to present a proposal. He suggested the creation of three working groups to study and offer recommendations concerning specific problems that were sources of worry. One working group would study hedge funds, another would examine capital flows and a third would focus on offshore financial centres.
The work of the first two groups proved of little consequence. But the working group on offshore financial centres did have an impact, and is worth brief discussion for what it reveals about international governance and how global bodies can change countries’ behaviour. The FSF’s powers, it will be recalled, were based on soft law rather than an international treaty or formal agreement. But that didn’t mean it had no capacity to enforce its will or issue credible threats. In the case of the offshore financial centres, the fact that many were tiny island countries in the Caribbean, Mediterranean and Pacific — and were thus susceptible to being pushed around — was crucial to the outcome.
The working group on offshore centres, chaired by John Palmer, Canada’s superintendent of financial institutions, lumped the centres into categories labelled Group I, Group II and Group III,8 jokingly dubbed “the good, the bad and the ugly.” At issue was the quality of the centres’ financial supervisory and regulatory authorities; the ones that failed to adhere to international standards “constitute weak links in the supervision of an increasingly integrated financial system”9 by enabling market participants to engage in activities that wouldn’t be allowed elsewhere, the group’s report concluded. (Other problems often associated with offshore centres — tax evasion and money laundering — did not fall under the FSF’s purview, so those issues were left to other bodies.) The 25 “ugly” jurisdictions in Group III, which included the Bahamas, the Cayman Islands, Gibraltar, Macau and Panama, faced the prospect of grave sanctions if they continued doing business as usual. “In extreme cases,” the report warned, the world’s richest countries “could restrict or even prohibit financial transactions with counterparties located in problematic”10 centres (emphasis in original). Since the FSF didn’t have the staff to monitor the centres’ conduct, that job went to the IMF.
8 Group I jurisdictions were “generally viewed as co-operative, with a high quality of supervision, which largely adhere to international standards.” Group II jurisdictions “were generally seen as having procedures for supervision and cooperation in place, but where actual performance falls below international standards, and there is substantial room for improvement.” Group III jurisdictions were “generally seen as having a low quality of supervision, and/or being non-co-operative with onshore supervisors, and with little or no attempt being made to adhere to international standards.” FSF (2000), “Report of the Working Group on Offshore Centers,” April 5, available at: www.financialstabilityboard.org/publications/r_0004b.pdf. These assessments were based mainly on a survey of supervisors in major financial centres.
9 Ibid.
10 Ibid.
Some FSF members voiced skepticism about whether this issue merited so much effort. Offshore centres had not been implicated in creating systemic financial problems, as the working group’s report acknowledged, so the whole issue struck some policy makers as a distraction. “Is it really a threat?” queried Larry Meyer, a Fed governor, according to notes of one early FSF meeting. European representatives, however, were adamant in pressing for a full-scale review and disclosure of the worst offenders when the lists were drawn up. “There are some hard-nosed sinners who need harsh treatment,” said Jochen Sanio, Germany’s
chief bank regulator, a sentiment echoed by Jean Lemierre, the director of the French Treasury, who told his fellow FSF members that the list of non-complying jurisdictions “should be published immediately. Waiting and watching is a compromise, and possibly a dangerous one.”
Despite resentment and fury over having been named, shamed and threatened, many of the targeted jurisdictions hastened to clean up their acts. The Bahamas, for example, retained highly regarded former US and UK officials to help improve Bahamian regulatory policies and operations. The overall improvement was marked enough that the FSF withdrew its list of the good, the bad and the ugly in 2005. Whether or not this made a major difference to the safety and soundness of the global financial system, it clearly showed the FSF’s capacity for exercising clout over individual countries when it could brandish sanctions. Even though the FSF had no formal enforcement power of its own, the group’s wealthy and powerful members could use its findings to justify taking collective action against certain countries that were deemed “hard-nosed sinners.”
This power proved effective when the “sinners” in question were relatively small and weak. It was not so easy with bigger ones.
“Upgrading” Emerging Economies
“Our challenge is to get the systemically important developing countries to ‘upgrade,’” Tim Geithner, the Treasury undersecretary for international affairs, said at an FSF meeting in September 2000, according to notes of the session. “Otherwise we are vulnerable to another crisis.”
The subject Geithner was addressing was, in essence, the FSF’s main raison d’être at that point — inducing changes in the policies of emerging-market nations. The formerly high-flying economies of East and Southeast Asia, many of which were recuperating from crises and recession, still had a long way to go in opening up and revamping their relationship-based, often corrupt financial systems. Countries in Latin America and other emerging regions were grappling with similar issues. With the US economy in the midst of the aforementioned boom, Washington believed it was in the position to be a role model.
To further the goal of “upgrading” emerging economies, an FSF task force had combed through the various standards issued by international bodies and selected a dozen that it deemed to be of the highest priority. The implicit message from the FSF to the developing world was: transform your domestic systems in accord
with these principles, and you can be rich like us. Promulgated in April 2000 as the “Twelve Key Standards for Sound Financial Systems,” they included IMF principles on transparency in monetary and fiscal policies, the Basel Committee’s core rules on banking supervision, IOSCO’s standards on securities regulation and others on issues ranging from accounting to bankruptcy.
It was far from clear, though, how much success the FSF would have in getting governments in developing regions to embrace these principles. After all, the FSF hadn’t accorded those countries any say over the content, and it had no practical way of coercing them; in this case, FSF members had no stomach for using the threat of blocking access to their financial markets as they had done with the offshore financial centres. The FSF’s soft-law power was enhanced in one important respect — by the use of monitoring to see whether countries were adhering to the standards or not. With the backing of the G7, this task was assigned to the IMF and World Bank, which would send teams of financial specialists every few years to each member country under new initiatives, the Financial Sector Assessment Program (FSAP) and Reports on the Observance of Standards and Codes (ROSCs), to prepare lengthy reports aimed at evaluating the strength of banking systems as well as their regulatory and supervisory structures. But there was no penalty for failing to comply — indeed, participation in FSAPs and ROSCs was voluntary, and even if a country submitted to monitoring it could bar publication of the results, in whole or in part. The developing countries, using their clout on the IMF and World Bank boards, had made sure of that.
This was the context in which Geithner made his comments in September 2000. If the FSF standards were to be taken seriously, “enforcement” would probably have to depend on financial markets — that is, investors would bid up the securities of countries that complied, and sell off the securities of those that didn’t. “The problem is, markets are not paying attention to the standards,” Geithner groused. “It’s difficult to impose IMF conditionality ex ante.” (In other words, there is no way to make a country conform to the policies the Fund would require if, hypothetically speaking, the country was receiving an emergency loan.)
The ultimate effectiveness of the Twelve Key Standards exercise is difficult to assess. In the end, it may have been the FSF’s most important accomplishment, because, in some cases at least, emerging market countries took the standards to heart when IMF and World Bank teams came to conduct FSAPs and ROSCs.11 Some observers even credit this factor as the main reason emerging markets weathered the crisis better than advanced countries.12
11 The IMF’s Independent Evaluation Office, in a mixed evaluation of FSAPs, said it had “identified a wide range of cases in which significant changes did take place subsequent to the FSAP and in which there is some evidence that the FSAP was at least a contributory factor...The most commonly identified value-added of the FSAP was as an independent, expert ‘second opinion’ on the financial system and reform plans. In a number of cases, this contribution increased the credibility of reform initiatives.” But the report also noted the existence of “‘missed opportunities’ where the FSAP did not, for various reasons, lead to timely changes to forestall problems. The most dramatic example was in the Dominican Republic where a banking crisis broke out less than a year after the FSAP.” See IMF Independent Evaluation Office (2006), “Report on the Evaluation of the Financial Sector Assessment Program,” IMF Independent Evaluation Office, January 5, available at: www.ieo-imf.org/ieo/pages/CompletedEvaluation115.aspx.
12 See C. Fred Bergsten (2009), “A Blueprint for Global Leadership in the 21st Century,” speech to the Global Human Resources Forum, Seoul, November 4.
But there are grounds for skepticism about this claim, notably a scholarly study that analyzed the process of reform in several Southeast Asian countries and found much evidence of “mock compliance” with the standards.13 A judgment about which of these views is right is beyond the scope of this book.
13 See Andrew Walter (2008), Governing Finance: East Asia’s Adoption of International Standards, Ithaca, NY: Cornell University Press.
This much is certain: the United States made sure it would not be subjected to the kind of monitoring and direction from abroad that it wanted other countries to accept. Until after the global crisis hit, Washington refused to undergo an FSAP;14 Federal Reserve Board Chairman Alan Greenspan, by all accounts, was the one most adamantly opposed, on the grounds that it would be pointless and burdensome to spend a lot of time with an IMF team looking at well-known shortcomings of the US regulatory system such as the confusing array of agencies at the federal and state level. (Several other major countries, including China, Indonesia and Argentina, likewise declined.)
14 Edwin M. Truman, who was assistant secretary of the Treasury for international affairs in the Clinton administration, contends that the United States initially agreed to an FSAP but later changed its mind when President George W. Bush came to office. See Edwin M. Truman (2009), “The International Monetary Fund and Regulatory Changes,” Working Paper WP 09-16, Peterson Institute for International Economics, December.
Furthermore, especially after President George W. Bush came to power, US representatives on the FSF took a dim view of Crockett’s effort to turn the FSF into more of an action-oriented body. Largely for that reason, the FSF formed no new working groups after the three mentioned above finished their reports. The Bush administration was not eager to empower the FSF — partly because the forum was a Clinton-era creation, but more importantly because Bush officials wanted to avoid any semblance of giving influence over US financial policy to an international group. Thus, entreaties from
Europeans for the FSF to consider more international monitoring and possibly even regulation of hedge funds, credit-rating agencies and insurance companies came to naught. Randal Quarles, who as assistant secretary of the Treasury for international affairs participated in a number of FSF meetings, said in an interview that he personally would have preferred giving the FSF “more of an athletic role,” but he explained:
It was generally the US view that as much as possible, [the FSF] should be a communications forum, so it wouldn’t take steps that might limit our freedom of action, where we might have to say to some constituency in the United States, “Well, we promised the Indonesians” — or worse, the French. It would be counterproductive if Congress thought there was somebody out there who had obtained commitments or claims on the US government. So for all those reasons, it was part of the relatively conscious, if not loudly articulated, view of the United States that these should be bodies principally for communication, as opposed to decisions. Better to have a discussion, see what people want, and see if we can achieve it, rather than bind to doing things.
So the FSF was to be little more than a talk shop after all, at least during the period leading up to the crisis. What, then, does the record show about the quality of the group’s discourse?
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