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Monday, January 28, 2008

International Finance - A systemic weakness?

In my last post, I mentioned that wealth concentration exposed the financial systems to risks. The risk is compounded by inherent weakness of the financial system that  were not designed to accommodate. These systems are weak and plagued by complicated issues.

  • Firstly, these were created as a subset of national governance systems. Consequently the flexibility of these systems are limited by the overall governance infrastructure in each nation.
  • Also, unlike the capital movements, these standalone national regulatory systems are not inter-connected in any meaningful manner. Meaning any response to international financial crises will be subject to foreign-policy-like ambiguities and negotiations and, therefore, delays.
  • The regulations are patchy - unable to control global momentum.

Popular, informed expert opinion is also weighing in on this shortcoming.
You can read Michael J. Panzner

in the modern global financial system, where many participants are either unregulated or are monitored by a patchwork of country or sector-specific regulatory overseers, chances are that a derivatives-related catastrophe will see a similar lack of coordination that will produce a far more devastating outcome than if it was a purely domestic affair.

It is one thing for a central banker to summon the heads of various financial firms into a room to sort out the mess at hedge fund LTCM, as the New York Federal Reserve chief reportedly did in 1998. Despite the fact that the Fed had limited statutory authority in the matter, it is not hard to see why none of those who were asked to attend turned down the "invitation."

However, if a derivatives time-bomb is set off by the failure of a large London-based hedge fund, will a banker in the Cayman Islands, an investor in Japan, an insurer in Germany, and a regulator in France feel similarly inclined to respond, or even to take the lead? That is assuming, of course, that those affected even understand what is going on or why it may be relevant to their own interests. Overall, there appears to be little, if any strategy in place for dealing with cross-border financial upheaval.

And Marshall Jevons linking to Davos

At the World Economic Forum in Davos, Mr Knight said the “major challenge” for regulators was the “the Balkanisation of regulation – fragmented across market segments, across national jurisdictions and yet we want to have a global financial system”.

And Dani Rodrick

How do you deal with capital flows when they are so prone to boom-and-bust cycles and generate (roughly once a decade) financial crashes with painful economic consequences?  The mainstream answer is that you do not regulate capital flows directly--through capital controls such as financial transactions taxes or deposit requirements--but you rely instead on prudential regulation of financial intermediaries. The best way to avoid crashes, this argument goes, is not to "throw sand in the wheels of international finance" (as Tobin famously put it), but to make sure that intermediaries do not take excessive risks.

In Sum...
A system so designed will be prone to momentum effects. The momentum is aggravated by wealth concentration. International finance needs to evolve beyond the free capital movement to counter this risk. A system of seamless regulatory response needs to be developed. Hopefully the thinkers at Davos will lay the first stone of a potent globalized interlinked system.