How will G20 leaders deal with the gaps between their ambitions for regulatory reform

G20 leaders gathered in London on 2 April to discuss the effects of the credit crisis. Robert Finney assesses their End-of-Summit Communiqué and follow-on work in the area of financial regulatory reform.

Before the Summit

Before the Summit, world leaders expressed diverging views as to what they thought it would achieve. As the gathering approached, Gordon Brown and Alistair Darling (UK Prime Minister and Chancellor of the Exchequer) sought to lower expectations. From the US, Tim Geithner (Treasury Secretary) maintained there was already broad consensus on the shape of the regulatory response to the financial crisis - the gap between the G20 nations is small. The EU emphasised the need for all its members to speak with one voice.

In fact, there were significant differences in the proposals made by G20 leaders or set out in reports on the crisis produced in the UK, Europe and elsewhere. Did leaders agree at the Summit how to fill the gaps, or were they papered over in the Communiqué and other announcements?

What we expected

Before the Summit, the areas under most lively debate were clear.

Papering over the differences

The split on the appropriate fiscal response to the financial crisis was not manifested in relation to regulatory reform, where there was indeed already broad consensus at a high level. But the devil is in the detail. Most of the real debates will be in other fora (such as the Basel Committee on Banking Supervision (BCBS), the International Organisation of Securities Commissions (IOSCO) and the Organisation for Economic Co-operation and Development (OECD) and the new Financial Stability Board (FSB)).

Fundamental agreement on capital and liquidity

But there are two economic reasons why agreement on issues like capital and liquidity standards, and even remuneration policy, is important to the UK:

  • the City of London’s revival as an international financial centre could be jeopardised if the UK were to impose stricter requirements than elsewhere, particularly in areas of regulation that have a major financial impact on firms or their executives. City institutions claim to have paid much more in taxes in recent years than the Government’s bail-out costs, and could again be an immediate contributor to “UK plc”; and
  • as major exporters of financial services and institutions, the UK and the US in particular have the most to lose if financial regulation becomes a new smokescreen for protectionism in the financial sector.

What was achieved

Lord Turner, chair of the UK Financial Services Authority (FSA), identified eight key areas for reform in his recent review of financial regulation1 for the UK Chancellor of the Exchequer (Treasury/finance minister). Almost all of these have been proposed also in other reports and fora. We look at expectations for the G20 Summit in each of these areas, and what the Summit actually delivered, in each of these areas.

Improving quality, quantity and international consistency of capital and liquidity regulation and accounting standards (particularly reserves)

Changes in this area top the regulatory reform list of priorities for the US, UK and many other countries. There is consensus that the procyclicality of existing rules must be changed, and these matters demand international agreement but:

  • agreements on enhancement of the Basel II framework for bank capital and on rules liquidity management are inevitably very detailed. Although work had started2, Europe and the UK have been trying to set the agenda and move ahead with their own detailed proposals even though finance ministers and central bank governors agree “capital requirements should remain unchanged until recovery is assured”3;
  • Geithner proposed a systemic risk surcharge on systemically important institutions, but this approach is not yet widely accepted;
  • France was expected to use any differences on accounting to press its agenda for a Europeanisation of accounting standards, undermining recent progress towards harmonising US GAAP and IAS4;
  • the Summit agreed that international standards for minimum capital should remain unchanged until economic recovery is assured, but called for a range of prudential regulatory reforms to be implemented thereafter, and agreement on accounting standards reforms by the end of 2009. Leaders are concerned in particular:
    • to improve the quality, quantity and international consistency of capital in the banking system: specifically to prevent excessive leverage and to mitigate procyclicality, for example by requiring banks to build up capital buffers in good times;
    • to ensure accounting standard setters and regulators work together to improve valuation and provisioning standards and to produce a single set of high-quality global accounting standards; and  
    • to promote strong liquidity buffers, within a global framework.

Extension of regulation and oversight to bank-like activities and systemically important financial institutions

In the UK, Lord Turner had recommended (and the Government has accepted) that these must be regulated: Turner has repeatedly stressed his mantra that we need regulation by economic substance not legal form.

  • Hedge funds and certain money market funds are prime targets, but there is little agreement on how to regulate them: the licensing of funds’ onshore managers/advisers generally seems a likely outcome, and this is already the position in some countries, but to what extent should regulation reach beyond this to capture offshore funds themselves, and will this ultimately affect all funds or merely systemically important or bank-like funds? This is also part of the debate on the future of offshore centres (see below).
  • There are also calls for more product and market regulation alongside heightened institutional regulation: most notably this looks likely to manifest itself in the US through new regulation and supervision of OTC markets which could be a major boost for exchange-traded derivatives. But in Europe, too, regulatory changes are likely to favour exchange-traded and/or cleared derivatives over OTC alternatives.
  • At the Summit the G20 agreed that “all systemically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight”, arguably the basis for a far-reaching extension of regulation. In particular, hedge funds (or their managers) must be registered and disclose the information regulators need to assess systemic risk, and funds’ financial institution counterparties must implement effective risk management mechanisms. The new FSB was tasked with producing guidelines on assessment of systemic importance, for the next meeting of G20 finance ministers and central bank governors. The Communiqué acknowledged that funds below a certain size might not require registration.

Extension of regulation to credit ratings agencies (CRAs), compliance with principles for compensation/remuneration, and central counterparty clearing in the credit default swap (CDS) market

The Turner Review grouped these together simply because, while they are important, there are significant limits to what can be achieved by these levers alone. Nevertheless, each of these was addressed in the Summit Communiqué – CRAs and Compensation warranting separate sections:

  • CRAs: The 14 March meeting (see footnote 3) already agreed that CRAs should be registered and comply with the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies,5but the scope of licensing and supervision remains uncertain. The European Commission has already presented proposals to the European Parliament. The Summit Communiqué asked IOSCO to co-ordinate national implementation by the end of 2009 of registration/licensing and oversight regimes consistent with its Code, and the BCSB to take forward its review on the role of external ratings under Basel II;
  • CRAs will need to meet international best practice principles, especially in relation to prevention of unacceptable conflicts of interest;
  • Europe is pushing strongly for a European clearing house for CDSs (and grown impatient with what it sees as inadequate industry response), but the US opposes the development of new market infrastructure in Europe which competes with US offerings. The Communiqué rather downplays this area, although it expresses support for control clearing of credit derivatives subject to effective regulation and supervision, so an extension of regulation seems likely on both sides of the Atlantic, but calls on the industry to develop an action plan on standardisation by the fall of 2009;
  • Compensation/remuneration: the protests in the US against AIG bonuses have exceeded the clamour in the UK about bank bonuses, pensions, “rewards for failure”, etc: but principles for regulating compensation structures and practices in banks had already been agreed by the Financial Stability Forum (FSF - the FSB’s predecessor). At EU level, the Committee of European Banking Supervisors finalised principles for remuneration policies on 20 April. In the UK the FSA is developing these further for UK institutions6, the European Commission is expected to publish proposals soon, but the issue seemed not to be high on the US Treasury’s agenda for the G20 Summit. In the event, the leaders endorsed the FSF’s Principles for Sound Compensation Practices which were published at the same time as the Communiqué.

Macro-prudential supervision

Before the Summit there was wide acceptance of the principle of macro-prudential supervision accompanied by deep scepticism of its practicability:

  • Geithner’s proposal of a single systemic regulator has already met opposition from entrenched interests in the US, and his suggested surcharge on systemically important institutions takes a different tack to that proposed by Turner in the UK; and
  • international standards for macro-prudential supervision seemed unlikely to be accepted for two reasons, not least because the issue is too closely related to economic policy management. The US, UK and others will not accept international supervision of their financial institutions.

At the Summit, G20 leaders agreed a supervisory framework, in particular:

  • to change regulatory systems so regulators identify and take account of macro-prudential risks;
  • • that the FSB should work closely with the International Monetary Fund on early warning mechanisms  risks, to consider actions to address the risks and in countryspecific financial sector assessments.

Supervisory philosophy and approach

The UK, through the FSA, had already begun to adopt a more intensive approach to supervision: more focused on systemic issues and on outcomes rather than principles and processes:

  • the G-20 was expected to reiterate support for strengthened international supervision, through supervisory colleges, crisis management arrangements and further reinforcement of the FSF7;
  • a strengthened FSF in the form of the FSB was indeed a key part of the Summit Communiqué;
    • The FSB is not a standard setter for substantive regulation nor a supervisor; its outputs will be seen in improved transparency and international supervisory cooperation, rather than in new rules for financial firms or intrusion into domestic supervision.
  • 28 supervisory colleges have already been established for significant cross-border firms, the rest are to be established by June 2009.

Governance and risk management within financial institutions

This is another area where reform will be taken forward in various fora, including the FSB and established governance standard setters such as the OECD and the Global Corporate Governance Forum at the World Bank. Beyond the statements on stronger capital and liquidity, and on compensation arrangements, the Communiqué says nothing on this subject.

Proprietary trading

In the UK, the Turner Review proposed actions to ensure that commercial banks do not take excessive proprietary trading risks: this is part of Turner’s alternative to the Geithner systemic surcharge (see above). Turner rejected Glass-Steagall style separation of commercial and investment banking, but there is a broad interest in reducing leverage and investment banking risks, especially in “too-big-to-fail” institutions.

At the Summit:

  • leaders recommended that a “simple, transparent non-risk based measure” should supplement risk-based capital requirements to contain leverage, and that improved incentives (including “quantitative retention requirements”) are needed to manage securitisation risks; and
  • they also emphasised the need for “particularly careful oversight” of systemically important, large and complex financial institutions.

Measures to improve supervision of cross-border banks

The UK has its own agenda here, given that it hosts a very high number of foreign bank branches, to push for a global framework rather than merely a European one, and to shift to host states the balance of supervisory power for bank branches in Europe. The de Larosiere report for the European Commission had also identified this as an area for significant attention. The response of the Summit was to reestablish the FSF as a “Financial Stability Board”, with more powers. The new FSB includes the G20 countries and FSF members, Spain and the European Commission.

Other changes

Beyond this agenda, there were pressures for other changes, especially on:

  • offshore centres: the old “tax haven” label has been revived as G20 governments attach their bank secrecy and resulting breach of tax transparency. With the help of the OECD (see below), the G20 significantly ratcheted up the pressure in this area, also demanded more in relation to regulatory standards and supervision and anti-money laundering and counter-terrorism finance;
  • G20 Leaders agreed to use whatever action necessary, including sanctions, against non-cooperative jurisdictions, including tax havens;
  • bankruptcy laws: developing of agreed standards regarding the segregation of client assets, interaction of different insolvency regimes, and of the bank resolution regimes which various countries have rushed through to deal with failing institutions. Although this is an issue promoted by Geithner, the G20 communiqué did not address it; and
  • the engagement of emerging markets in the regulatory reform and standard setting processes, which was really addressed only in the context of accounting standards – although FSB plenary membership was extended to all G20 countries so now includes Brazil and India for example.


There has been mixed reaction to the G20 Summit Communiqué. Although not very long, some of its proposals were concrete and wide ranging. The European Commission said the results were “much more ambitious than expected”. From a UK perspective, the British Bankers’ Association, a powerful industry body, was pleased at new powers for international bodies to achieve agreed outcomes. IOSCO viewed the results as reinforcing the importance of its current initiatives.

What next?

As described above, many initiatives were already underway, for example, in IOSCO, the BCSB and, in the EU, proposals, on CRAs, hedge funds, and on capital requirements, and international, EU and domestic codes and proposals for remuneration arrangements.

Already, the FSF has been transformed into FSB which is keen to flex its muscles. On the day of the Summit it issued three sets of recommendations and principles and one updated report.

And the OECD spared few blushes in releasing on the day of the Summit Communiqué its lists of tax havens, naming (and in some cases shaming) jurisdictions that have, respectively:

  • substantially implemented the internationally agreed standard on exchange of information for tax purposes;
  • committed to it but not yet implemented it; or
  • (in the case of four jurisdictions) not committed to it.

Among the countries on the second, “grey” list are well respected fund jurisdictions such as Luxembourg, Bermuda and the BVI and Cayman Islands. Reactions to the G20 and OECD action in this area have been a mixture of anger, cynicism and compliance.

We await concrete plans for better regulatory cooperation, specifically on colleges of supervisors both within Europe and globally. At an EU level, a critical aspect addressed in the EU de Larosiere Report and the UK’s Turner Review but not raised in G20 was the failure of the “single passport” to protect consumers outside the country of origin of a financial services provider (specifically, the large numbers of UK-based depositors in failed Icelandic banks).

Inevitably there will now be a period of consolidation, while organisations and regulators look at outstanding proposals in the light of the Summit but perhaps less in the spotlight. Then there will be a flurry of papers when they have assessed what they still need to do. There will be new laws, some much sooner than others. Some changes cannot be implemented immediately (such as the capital, or any other, changes that would cause too much financial pain to already sickly institutions – these must wait until the economic situation improves), while others risk being rushed through and causing problems later (such as regulating systemically important hedge funds in the absence of agreed definitions of the key concepts).


So will the G20 outputs mend the cracks or just paper over them temporarily? It’s too early to tell. Franco-German railing against the “Anglo-Saxon”8 free market model of capitalism was pacified without agreement on economic and social theory, because there was so much agreement on regulatory changes and tax havens. But national differences and preferences will surely emerge in putting the agreed concepts into a workable form to which all subscribe.