Tags: Lagarde | cross-border | derivatives | financial

More From IMF's Lagarde — Part II

By    |   Tuesday, 08 October 2013 02:46 PM

In her Oct. 3 speech at George Washington University (GWU), after Christine Lagarde, managing director of the International Monetary Fund (IMF), surveyed the prospects for global growth, she turned to another front in the "transition" of global economic policy that formed the theme of her speech – reform of the financial system.

Lagarde began this portion of her speech by pointing out that the execution of the transition of the global financial system will affect the entire world economy, and she recalled that when she became finance minister of France in June 2007, the financial world was already in a crisis and there would be no August break. (Imagine a perspective that traces the crisis back to the early 1970s, with some of the pivotal events occurring during the August breaks.)

She sought to establish a contrast between the "old model" of the financial system and what the financial system is supposed to look like after the transition.

Under the old model, she correctly observed, "The financial sector took an oversized risk in pursuit of outsized rewards, causing outsized ruin in the last five years."

Admittedly, the transition will be a struggle, because "it's not easy to throw away old blueprints and design new ones." (I would observe that this is especially difficult when for many of the leading players, the old blueprints have worked in the past and are working even better as the government remains engaged in propping up the "too big to fail" banks.)

With a welcome hint of irony, Lagarde chided the halting efforts of the authorities "dealing with the perverse incentives of financial firms and the inability or unwillingness of the authorities to actually act." Therefore, on behalf of the IMF, she pronounced this transition "Mission Not Yet Finished." (A harsher assessment might be "Mission Never Started" or "Mission Bungled.")

However, she asserted that progress is being made, because the leading regulators have "agreed" to stronger standards under the Basel III Capital Accords. She insisted that these are being implemented. However, a Financial Times article cited at a recent Senate Banking Committee quoted bankers as boasting that they can meet the supposedly higher standards without raising any additional capital by shuffling their risky activities among their many affiliates.

She added that new liquidity standards and a leverage ratio should keep excessive risk in check. (A leverage ratio refers to a simple percentage of capital applied to assets, without attempting to apply risk weightings that have failed in the past, because they assumed that, for example, mortgages and sovereign debt were less risky or even risk-free, and this created an incentive for banks to pile into these activities, fueling the mortgage bubble and bringing down Jon Corzine's vehicle for sovereign debt speculation, MF Global.)

The actions by leading regulators to identify systemically important financial institutions among banks and insurance companies is supposed to enable higher standards for both the regulation and resolution of financial companies whose failure could threaten the health of the global financial system.

Viewers will observe that when Lagarde is conveying especially significant ideas, she likes to whisper. At this point, she whispered, "But progress is too slow." In a burst of candor, she added that the progress is being "held back by complexity, but also by delay and divergence."

Warming to the subject, she noted that of all the items that were set forth in the G20 action plan since the first meeting of heads of state in London, with items meant to be ticked off as they are completed, the area that stands out as unfinished is financial reform, "which is interesting." (It certainly is.)

Lagarde then added to her critique the lack of progress on cross-border resolution regulations to enable the unwinding of systemic institutions in an orderly way. She remarked, as the financial regulators often say, that that this is the power the regulators lacked when Lehman Brothers failed in 2008 that they will not have thanks to the Dodd-Frank Act.

She correctly recognized that the collapse of one entity could lead to the collapse of the entire global financial system, as would have occurred in 2008 if the authorities had not bailed out the largest bank and nonbank financial institutions, when uncertainty prevailed among these institutions as to whether their counterparties could pay, and there was a "total lack of transparency" as to the condition of these banks, including the values of their derivatives positions.

She stated hopefully that, "A good cross-border resolution system should deal with that," admitting, "It was a bit late coming." (Late indeed. One wonders how she would react to the warning by former IMF economist, now at MIT, Simon Johnson, that these cross-border arrangements will never be consummated, because each of the major banking countries and their lawyers will continue to defend the interests of their largest banks.)

Taking a closer look at derivatives, bets traders make against the movements of indicators like benchmark interest rates, foreign exchange rates and the S&P 500, Lagarde told her audience that reform here has also been late, but she lauded as progress an agreement between the Commodity Futures Trading Commission (CFTC) in the U.S. and EU regulators to improve transparency in derivatives trading.

But then she dropped this "gee-whiz" number: at the end of 2012, the outstanding derivative positions totaled $633 trillion — with a t — but only a mere $24 trillion were traded on exchanges so that their values could be relied upon.

Incredibly, Lagarde declared that financial markets need "supervision and speedy derivatives reforms" for the various markets. Evidently she doesn't realize that the word "speedy" simply does not compute in the treacherous world of financial regulation.

In fact, now the term of CFTC Chairman Gary Gensler, who pushed for implementation of the reforms against opposition by most of his colleagues on the Commission, expires at the end of the year, and the administration has yet to name a replacement, one who could face a difficult confirmation due to industry opposition to the very cross-border rules she mentioned.

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In her Oct. 3 speech at George Washington University (GWU), after Christine Lagarde, managing director of the International Monetary Fund (IMF), surveyed the prospects for global growth, she turned to another front – reform of the financial system.
Tuesday, 08 October 2013 02:46 PM
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