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G20-IMF-FSB Update - March 19, 2010

By Adam S. Hersh

FSB Wants Members to Lead By Example

Part of the FSB's core mission is to monitor how well member countries are adhering to international financial standards and cooperating with international information exchange efforts. As a condition of membership, member countries agree not only to implement international standards, but to undergo periodic review of compliance, including under peer reviews conducted under the FSB, under the IMF-World Bank Financial Sector Assessment Program (FSAP), and in self-assessment Reports on the Observance of Standards and Codes (ROSCs).

The FSB's Standing Committee on Standards Implementation (SCSI), chaired by Tiff Macklem of the Bank of Canada and composed of financial officials from 18 countries, the EU, and international institutions (pdf, pp.13-14), is responsible for conducting these reviews. But work of conducting the evaluations is being delegated to an unspecified "Expert Group" under the committee's supervision.

The SCSI is slated to complete its first thematic review on members' adherence to compensation standards (pdf) by March 2010 (though no public assessment of the review has yet been made) and plans two more thematic reviews and three country reviews in 2010. In addition to the compensation principles, other standards to be assessed by the FSB are:

In February 2010, the SCSI's expert group compiled a target list of countries for the first round of evaluations, though this list has not been made public, nor has the FSB disclosed which three member countries will be first to undergo review in 2010. The FSB has explained its metric for prioritizing jurisdictions to be reviewed based on financial importance--both in terms of the size of national financial systems (relative to the overall economy) and in terms of the importance of national financial systems within the international financial system--as well as current evidence of compliance with standards listed above. If a member country is deemed to be in compliance with the standards in recent evaluations, be it in FSAPs or elsewhere, then they will not be subject to further evaluations. Only countries deemed not to be cooperating with the standards compliance review process will be named by the FSB. Most FSB member countries have not undergone FSAPs since the early part of the decade. The United States is one of only a handful of countries that have never completed an IMF-World Bank FSAP and the United Kingdom--aside from the off-shore tax shelters in the Isle of Man and the Bailiwick of Jersey--has not completed an FSAP since 2003.

FSB-Basel Committee Recommendations for Cross-Border Crisis Resolution

The Basel Committee on Banking Supervision, under the auspices of the FSB's Cross-Border Crisis Management Working Group and as directed by the G-20, released its final report and recommendations (pdf) for policies and legal frameworks to rationalize how countries manage the failure of multinational financial institutions. The ten recommendations are based, in part, on case studies of the failures of Fortis (Belgian-Dutch), Dexia (Belgian-French), Kaupthing (Iceland) and Lehman Brothers (US) amid the current crisis. These examples illustrate the challenges of supervision when financial institutions have complex corporate structures with subsidiaries and branches operating across multiple countries, and/or have substantial cross-border counter party exposures. To date, legal and regulatory provisions are generally national in scope and focused on the domestic components of financial groups (though even within countries, it may be unclear who wields resolution authority over complex financial institutions).

A pre-determined framework for unwinding financial institutions facing insolvency can potentially help curtail moral hazard problems. Clearly specified resolution framework will make explicit which authorities hold responsibility for coordinating resolution of insolvent financial institutions and how the resolution will unfold, particularly when multiple jurisdictions are involved. Not only will well-defined approach aid a speedy and orderly resolution that minimizes disruption to the financial system (as opposed to the ad hoc and haphazard approach we've seen), but also can help limit expectations that excessive financial risks will be back-stopped by governments.

The report's recommendations recognize that often the best defense for crisis resolution is a strong offense. Systemically important cross-border institutions should develop ex ante contingency plans to deal with periods of extreme financial duress, including plans for rapid winding down in the event of insolvency. Recommendations go beyond just pre-determined guidelines for unwinding failing financial institutions to limit the size and complexity of financial institutions in the first place. Recommendation #5 suggests imposing regulatory incentives through capital charges or other prudential requirements to discourage financial institutions from becoming too complex. Recommendation #8 suggests a range of risk-mitigating regulations, including standardizing derivatives contracts and moving them onto regulated exchanges with centralized clearing and settlement counterparties.

While the recommendations call for cross-border cooperation, information sharing, and convergence of national resolution measures, these issues are only the first steps involved in addressing financial institution failures spanning multiple jurisdictions. The seemingly least tractable issue, from which the report steers clear, involves how to distribute the fiscal burdens of resolution. Whose taxpayers will foot the bill when a multinational financial institution faces insolvency (for deposit insurance or extraordinary measures to support failing institutions)? What if national resources are insufficient to meet the costs of resolution? The question of how to distribute costs leaves substantial ambiguity in a system to deal with cross-border resolution and may not carry sufficient credibility to deter moral hazard problems.

In the US, both National Economic Council Larry Summers and Federal Reserve Governor Daniel K. Tarullo endorsed the Basel Committee's recommendations for cross-border crisis resolution.

FSB Raises Issue of Credit-Default Swaps

Financial Stability Board Chairman Mario Draghi signaled that the FSB and the relevant international standard setting bodies are exploring systemic regulation of credit-default swaps. Credit default swaps (CDSs) are derivative instruments that allow hedging the risk of default of an underlying debt asset. While declining to comment on what, when, or how CDSs would face international regulatory standards, Draghi staked out territory for upcoming FSB action on CDSs. Particular attention will be paid to "naked" CDSs, that is swaps wherein parties to the trade are not parties to the underlying debt--in essence speculative bets on the probability of debt default. The Greek debt crisis has pushed sovereign CDSs into the spotlight, but non-sovereign CDSs are wanting for stricter regulation, too, including moving from over-the-counter (OTC) trading onto regulated exchanges with centralized clearing (in the present financial boom-bust cycle financial institutions profited handsomely by issuing securitized assets, and then betting against these same assets with CDSs). Europe is considering banning CDS speculation altogether.

G-20 Resources for the Financial Crisis

The IMF reached a new Stand By Agreement with El Salvador to provide US$790 million. The arrangement is "designed to maintain investor and depositor confidence" in the face of the global financial crisis and limits government social spending to "almost" one percent of GDP.

Canada delivered on commitments to supply the IMF with resources to help global financial crisis-affected low-income countries. The agreement will provide  US$769 million to the IMF's Poverty Reduction and Growth Trust.

Chalk One Up for the Hedge Funds

Last week I wrote of a row brewing over international efforts to implement new oversight on hedge funds, with US Treasury Secretary Tim Geithner, and UK Prime Minister Gordon Brown and UK financial services minister Paul Myners opposing EU efforts to enact governance standards and rules on risk management and conflicts of interest for hedge funds. New rules governing hedge funds are being considered by the Financial Stability Board, and the International Organization of Securities Commissions (IOSCO) recently issued recommendations for hedge funds (pdf) to report systemic risk data to appropriate national regulators. This week, the Brits succeeded in striking the issue from the agenda of the March 16 EU finance ministers’ meeting in Brussels.

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