Trimming the sails of global finance?

Across the world the liberalisation of financial markets is either stalling or in retreat as regulators at last get to grips with global finance

Randall GermainWith the recent announcement that the EU will push ahead to establish some form of pay cap for bankers, are we at long last – over four years after the onset of the worst financial crisis of the modern era – at the point where the sails of global finance are finally being trimmed by public authorities?  I think we are, and here’s three reasons why.

First, the EU is chipping away at some of the central support struts for unbridled finance.  Establishing limits for bonus pay is one such element, as it removes an important incentive to generate financial transactions.  The recent decision by France and Germany to pursue a financial transaction tax is a further blow to the scale of rewards delivered to traders and firms.

Together with the continuing circulation of proposals in the European Parliament to restrict when and under what circumstances credit rating agencies can rate sovereign debt, we are seeing a firming of political will across Europe to establish a clearer and stronger public footprint upon its financial system.

This trajectory is of course complicated by the wildcard that is now the UK – both in terms of being outside the Eurozone and being prickly about all EU governance initiatives.  Nevertheless, with or without the UK, the determination of the EU authorities to begin to rein in global finance is increasingly impressive.

Second, the UK itself is no longer the leading cheerleader for unfettered finance that it once was.  The coalition government and its City allies may be critical of some EU regulatory developments, but on other fronts the UK is hauling in the rope in ways that are equally impressive.  The UK – along with Switzerland – is demanding that its banks hold even more regulatory capital than required by either Basel 3 or the new EU capital directive.  At nearly 10% of Tier 1 capital, British banks will in this scenario be among the best-capitalised banks in the world.

But highly capitalised banks are not usually particularly profitable banks.  So in its own way the UK is making a full contribution to trimming the sails of global finance, at least in relation to British-based elements.  If we add to this the Vickers Commission’s recommendation – picked up by the coalition government – to ring-fence domestic retail operations, we see yet another way that public authorities are tacking into the wind to constrain global finance.

Third, and perhaps most critically, the US has been busy trying to constrain global finance through the implementation of the Dodd-Frank Act.  There are many facets to this legislation, but the most important part is the so-called Volcker Rule, which will affect all kinds of banking activities.  Although the details are not yet finalised, its outlines are clear:  it will restrict the ability of banks to undertake their own proprietary trading and set strict limits on how much capital they can invest in off-balance-sheet vehicles.

In other words, the effect of this rule will be to restrict an important set of activities that financial institutions once undertook with gusto, as well as to prescribe more tightly how much financial support they can provide to specialised vehicles and other kinds of funds.

Additionally, a December 2012 agreement between the US and UK authorities – on how to wind up insolvent financial institutions that are systemically significant to the global financial system – will demand that such firms hold higher levels of Tier 1 capital separately in their UK and US operations than currently required.

The net result, almost across the board in the core countries, is that financial institutions are trimming staff, closing lines of business no longer profitable under the new rules and generally undertaking less financial activity.

Some readers might think that I’m overstating the importance of these actions and their predicted effects.  This may be fair: the final shape of many of these initiatives is not yet settled, and there is a long history of global financial institutions evading regulations designed to contain their activities.  And, of course, it may be that these lower levels of financial transactions are the result primarily of economic recession and turmoil in many parts of Europe and North America.  Perhaps…

But I am more impressed by the global determination among regulators to reduce the vulnerability of their economies to financial distress.  When senior officials such as the Bank of England’s Mervyn King and former US Treasury Secretary Hank Paulson can agree that global finance got out-of-hand prior to 2008, I see a formidable depth of intent to fashion a wider and deeper public footprint upon the world’s financial system.

The final result might be watered down from initial aspirations, but, even if so, we should not confuse politics and negotiation for weakness, ineptitude or regulatory capture.

What is more, if we look beyond the heartland of financial globalisation towards the so-called ‘emerging markets’, which are today the fastest growing bits of the global economy, we see that financial liberalisation has halted almost completely.  Nowhere do we find financial markets being opened up to foreign competition, or new markets for derivatives or bonds – other than Sukuk bonds – being developed (with the possible exception of Chinese efforts to increase the international use of the renminbi).

Instead, what we see are capital controls making a comeback, and state control over finance undiminished.  In short, wherever we look, we are left with a global financial order where liberalisation is either stalled or in retreat.

To me, this is a strong argument that the sails of global finance are at long last finally being trimmed.