We live in a global economy, and if improvements in financial regulation are not coordinated among the governments of the major economies, they will be less effective than they could be. But the way things are going, changes will be made piecemeal, with each nation refusing to compromise on any issue that might offend some important domestic political constituency or reduce the perceived global edge of its financial sector. This is a tragic mistake that we will come to regret.
Since less than three years has passed since the first signs of a crisis in the summer of 2007 and only 18 months since the panic that ensued when Lehman Brothers went bust, Congress will beat the responses to financial crises in 1907 and 1929 if it produces legislation yet this year. But speed in this case is the enemy of cooperation with the United Kingdom, with the euro bloc that includes Germany and France, and with Japan.
The way the financial crisis ricocheted across the Atlantic illustrates the need for coordination. European banks and investment funds were nearly bankrupted by the highly rated U.S. mortgage-backed securities they had purchased from Wall Street firms. AIG, a U.S. insurance company, needed a cash injection exceeding $100 billion due to losses from one small unit based in London.
Nearly all the major Wall Street firms tried to move assets off their balance sheets by creating entities called Structured Investment Vehicles to hold complex mortgage-backed bonds.
Many were established in havens from taxes and rules like the Cayman Islands to escape U.S. or EU regulation. Goldman Sachs alone created more than 300 such entities.
On both sides of the Atlantic, governments bailed out financial institutions because of fears their failure would trigger even broader economic problems. Britain intervened to guarantee the deposits in Black Rock, a savings bank deeply invested in U.S. mortgage securities. The Belgians and Dutch put money into Fortis. Germany bailed out its regional savings banks and we put funds into some 20 companies in one way or another.
For the United States, some such money injections, especially into Fannie Mae and Freddie Mac, were driven by the desire to avoid a perceived stiffing of major U.S. Treasury creditors like China, Japan, Korea and Taiwan.
Globally, several issues stand out. We need strict capital standards for all major financial firms, including enforceable limits on leverage. We need a consistent approach to limiting the size and interconnectedness of large companies. We need limits and transparency for credit default swaps and other derivatives. We need to curb how firms can hide liabilities in tiny nations that sell their systems of business law to big financial firms fleeing prudent regulation in their home countries.
Europe needs rules on how deposit insurance applies to cross-border bank deposits and on a nation's liability for claims against banks they have chartered that do business in other nations. We need a system of rating securities less fraught with perverse incentives.
Government officials in the major economies all give lip service to international coordination. But little has been done and little is likely to be done. There are several reasons.
First, each nation has constituencies that benefit from the existing system. And these constituencies, largely financial institutions, spend large amounts of money to keep legislative and regulatory changes from affecting their privileges. Wall Street financial firms are outdone only by the medical-pharmaceutical-insurance establishment in the level of campaign contributions splashed around Washington and London.
The second problem is that every country wants to maintain some competitive edge over other countries. New York, London, Frankfurt and Tokyo are the financial capitals of the world, and companies in these cities employ tens of thousands of people and pay billions in taxes. No one wants to kill their gold-egg-laying goose, and elected and appointed officials are willing to compromise effective regulation to maintain a competitive edge relative to other nations.
There is also a factor of national pride. The French want a larger role in international finance. The British don't want to be dictated to by the Continent. Americans assume that since they have enjoyed a dominant role in forging all international agreements over the past 70 years, they still should have that privilege. China is not going to be pushed around by the wealthy countries.
The United States does have an opportunity to exercise leadership, but we are throwing it away. Officials and the general public still don't realize that the degree to which U.S. regulatory and policy failures contributed to the ongoing debacle have undercut our credibility in multilateral negotiations. Treasury Secretary Tim Geithner airily dismisses European proposals but we no longer have clout to get others to follow our lead.
The upshot is that we are likely to have regulations with many loopholes that afford financial firms ample opportunity to play accounting games between different countries and to play one set of regulators off against another. And that increases the likelihood of other painful fiascoes down the road.