BY MATT HUTCHINS
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The expansion of international trade and integration of the global financial system have stimulated phenomenal growth around the world, but now that banks and corporations in developed nations are de-leveraging to deal with the crisis at home, export-driven national economies are coming against their greatest challenge in decades. The International Law Journal recently convened a symposium to examine the problems facing the developing world and the solutions needed to address them, and one of the highlights was a panel featuring the General Counsels of the International Monetary Fund and the World Bank along with an expert corporate practitioner, each of whom offered his view of the global financial crisis and its implications for developing nations and multinational financial institutions.
Development in Distress
The experts agreed that the outlook for less developed economies is bleak and that immediate action is needed to avoid the further intensification of the global financial crisis and its cost in human suffering. Sean Hagan, General Counsel for the IMF, warned that the current turmoil is unlike any other crisis because of its simultaneous impact on the economies and financial systems of all the worlds largest economies. “No country is being spared from this crisis.” For developing nations, like those in Eastern Europe, the difficulties thus far are similar to the recent Asian Financial Crisis, says Hagan. Growth was stimulated in these countries by cheap borrowing in foreign currency, fuelled by favorable exchange rates. Export industries promoted growth, but development moved too fast and led to excessive borrowing and reliance on foreign investments. Once exports slackened and the exchange rate became weak, foreign capital began to pull away and put pressure on the exchange rate. With debts denominated in foreign currencies like the Euro, many nations are now suffering because the fall in the value of their domestic currency is making it increasingly difficult to make payments on their loans.
Hagan points to a few key factors that have heightened the severity of this crisis vis-a-vis the Asian crisis. First, the global nature of the current turmoil has caused international trade to dry up rapidly, so devaluation is a somewhat weaker monetary tool for nations with weakening currencies and export-driven economies. Second, the falling global demand for commodities has deprived developing nations of a crucial source of foreign exchange and made it more difficult to make up a current account shortfall. Finally, even healthy developing nations have seen foreign investors withdrawing capital rapidly as they seek to cover wrecked balance sheets in their home country, and so economic hardship is at times meted out fortuitously.
As an organization designed to deal with problems one nation at a time, the IMF finds its power to intervene constrained by an inability to address the needs many troubled nations at once. “The IMF is just too small. We need more money,” says Hagan. Although the IMF has succeeded in raising $100 billion recently through a loan from Japan, it still seeks to obtain an additional $400 billion in capital to help avert the most severe catastrophes which could unfold this year. In addition, says Hagan, the IMF is also working to create new processes to provide assistance, including a pre-qualification system for release of all funds in a single tranche and a preemptive evaluation method for approving funds to countries that are not yet in need, so that foreign investors can be reassured of a nation’s stability.
As international institutions are pushed to the limits of their power to intervene, a comprehensive response to the global crisis will require coordination among national governments and assistance from the private sector. According to Scott White, Acting Vice President and General Counsel for the World Bank Group, a failure to act quickly could have a shocking human cost: 200,000 to 400,000 more infant deaths world wide each year and over 53 million people sinking into extreme poverty. Almost 1.4 million more children could potentially die over the course of a protracted global downturn and recovery. To avoid such an outcome, one key step will be the restructuring of between $1.25 and $2 trillion in developing nation debt, but the economic pressure on developed nations is likely to mean that sources of capital are much more difficult to access and that even healthy nations and businesses face higher costs of borrowing.
Among the multiple strategies being implemented by the World Bank right now to mitigate the human cost of the crisis is the creation of a Vulnerability Fund to help stimulate economic activity in the developing nations that have been hit worst by the first overall drop in global trade in 27 years. The Fund will provide assistance to developing nation safety net programs, create jobs through infrastructure construction, and provide access to microfinance programs that can stimulate private sector growth. To finance these initiatives, the World Bank is asking developed nations to contribute 0.7% of the total amount provided in domestic stimulus as a donation. Other top priorities currently being pursued by the Bank include food safety programs, recapitalizing distressed banks, protecting stressed microfinance institutions, keeping major existing projects on track for completion, providing advice to countries that are not yet in distress, and considering new ways of regulating non-bank financial institutions.
Regulatory Reform
In the midst of ongoing financial turmoil, leaders around the world are turning their attention to the question of how the lessons of the current crisis can help guide reforms that will enable economic recovery that is equitable and sustainable. “It’s extraordinarily difficult to craft a regulatory response for the future while you’re still trying to put out the fire,” says Scott White. When the members of the G20 convene during the first week of April, the agenda will devote substantial time to the development of a new set of principles for the regulation of financial institutions around the world. “Bankers are probably the least respected people right now on a global basis,” says Edward F. Greene ’66, partner at Cleary Gottlieb Steen & Hamilton. According to Greene, who has served as General Counsel of the Securities and Exchange Commission and of Citibank’s Institutional Clients Group, the breakdown of the private banking system has had a devastating effect on the overseas view of American banking. “Europe has lost confidence in the U.S. regulators,”
“What failed were supervisory agencies and regulatory authority,” says Greene. Low interest rates and the lack of regulatory oversight allowed the traditional banking model of long-term lending financed by short-term borrowing to be grafted onto non-bank financial institutions to create a shadow banking system. “We really must expand what we regulate. There was the sense that there was no one at the top with the whole picture. . . there were inconsistent standards of supervision . . . and we may not have had the best regulators in the world.” One problem, according to Greene, is that the structure of the financial system encouraged too much pro-cyclical expansion. GAAP accounting principles, for example, encouraged assets to be marked up during a boom market, but once the bubble burst banks were put in a double bind, forced to deleverage and simultaneously unable to sell their assets. Another example of regulatory failure was the outsourcing of critical market functions to unsupervised entities like rating agencies. Addressing problems like these will be challenging, says Greene, because nations will be forced to consider the adoption of macroprudential regulatory structures while also working to coordinate new regulatory regimes both internally and internationally.
“We have to expand the regulatory perimiter,” says Hagan, agreeing that it will be necessary to create an appa
ratus to oversee the operations of hedge funds, investment banks, and rating agencies. The panelists indicated that the reforms needed include new standards of capital adequacy, principles of regulatory oversight, an examination of accounting rules, methods for coordination between regulators, and mechanisms to encourage adoption of international standards. One possible architecture for macroprudential oversight would be a Twin Peaks model where one regulator would take responsibility for safety and soundness across the financial system while another watched the actions of markets and investors. It may be necessary as part of such an architecture to empower national regulatory agencies to intervene in the affairs of a particular institution to preserve the integrity of the broader financial system. In Europe, the desire to maintain national sovereign authority over financial matters may impede the creation of a powerful central regulator, but it appears likely that some entity will emerge to serve at least the function of an early warning system.
The resistance to limitation of sovereign authority to regulate national financial systems leads Sean Hagan to doubt that the regulatory structure negotiated by the G20 would center around a powerful supranational organization. Rather, it appears that a soft law approach will be adopted whereby the World Bank and IMF encourage compliance with internationally accepted best practices. With the integration of global financial markets, regulators will need to be in constant communication to avoid events such as the collapse of Lehman Brothers, which had devastating effects around the world. The greatest problem though is that while a commitment to openness and cooperation will be likely to lead to greater communication, harmonization will be much more challenging yet critical to avoid the creation of opportunities for regulatory arbitrage.
Although there is currently significant pressure for counter-cyclical policies, Scott White believes that political will power to will evaporate after an economic recovery and that pro-cyclical treatment will return. White also believes that the politics of designing the international financial system are going through significant changes. “This crisis comes at a historic moment in world history, when the weight of global economic production is for the first time shifting from developed nations to developing ones.” Hagan concurred, noting the global financial crash has provided significant economic and moral leverage to LDC’s. “Developing nations are very actively involved and want to shape decisions. This time the G7 will not dominate the design of the regulatory system.”