Many national leaders, such as those at the G20 meetings, are advocating global regulation of the financial services industry. I am not convinced.

Much of the buildup to the current crisis happened in plain view – housing bubbles in the US, UK and Spain, mortgage lending insanity like 125%mortgages, soaring volumes in complex derivatives with immeasurable counterparty risk and credit ratings that were pouring petrol on the flames instead of restraining the actors.

So why think international regulation would do any better?

Carmen Reinhart and Kenneth Rogoff offer one reason – global regulators are less likely to be captured by local interest groups. Rather than argue for a fundamental reform of the American money-political influence regime (probably a realistic hesitation) they say:

“We recognise that international financial institutions are far from perfect. Nevertheless, a well-endowed, professionally staffed international financial regulator – operating without layers of political hacks – would offer a badly needed counterweight to the powerful domestic financial service sector lobbies …

“The fact that financial regulatory policy deals with specific companies and markets makes it difficult for a domestic regulator to stand up to focused political lobbying and interference.”

They contend that less leverage would be a good place for global regulators to focus – hard to argue with that
“… both domestic and international regulators should look for ways to make policy less cyclical.

In addition to imposing stricter capital requirements than envisioned by Basel II, they should dig up other rusty tools to combat leverage, such as margin requirements and reserve requirements.”

A different approach comes from Benn Steil at the Council on Foreign Relations who advocates a fail-safe approach which relies on market mechanisms, such as central clearing, rather than the wisdom and discretion of regulators. (A much wiser approach, I think.)

Writing in the FT he proposes that derivatives should have to move to central clearing and settlement once they reach a specified volume.

“Compare the 2006 collapse of hedge fund Amaranth, whose derivatives exposures were on-exchange, with the 2008 collapses of Lehman Brothers and AIG, both of which had large exposures in non-cleared, over-the-counter CDSs. Amaranth’s derivative defaults had trivial systemic ripples, while those of Lehman and AIG created major shockwaves. AIG invisibly built up huge under-collateralised sell positions on the back of a faulty credit rating.”

A leaked memo from Morgan Stanley indicates the big banks are moving toward central clearing of derivatives as a way to reduce risk, especially the risk that regulators will insist on running derivatives through exchanges, which would reduce the fat margins that bankers so dearly love.

Steil is co-author of Money, Markets and Sovereignty (Yale University Press, forthcoming.) Sounds like it will be worth a look.

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