'Plain wrong' to think financial danger is over

As confidence mounts that the global economy has stabilised, governments' attention is turning to measures to reduce the risk of another financial crisis on the scale of last year's tsunami.

Financial regulation has been high on the agenda of this week's G20 leaders' meeting in Pittsburgh, in part because of a concern that the window of opportunity for substantial reform may start to close as memories of the scary heights of the crisis fade.

"It would be absolutely wrong, plain wrong" to revert to an attitude of business as usual in the financial markets just because they are functioning better, share prices are going up and the worst of the contraction in economic output is behind us, European Central Bank president Jean-Claude Trichet said when announcing the bank's most recent rate decision.

Gross domestic product in the euro area fell just 0.1 per cent in the June quarter, and 0.2 per cent across the European Union as a whole.

But the forecast recovery would be very gradual and remained highly uncertain, Trichet warned. The ECB's forecast for euro area growth next year is in the range of -0.5 to +0.9 per cent, a far cry from a V-shaped rebound.

The central bank not only let its main policy rate unchanged at 1 per cent, it is continuing to make one-year funding available to wholesale markets at that rate too - further evidence that it is not yet ready to remove the plaster cast of supportive monetary policy.

Like their counterparts elsewhere, European economic forecasters are struggling to decide whether the recent improvement in the data heralds a lasting recovery or is only a temporary respite reflecting extraordinary stimulus injected last year and a fillip from the inventory cycle.

"The situation remains very fragile," said Amelia Torres, spokesperson of the European Commission on economic and monetary affairs.

"Since October [2008] the European Central Bank has cut 325 basis while the fiscal stimulus has amounted to about 5 per cent of European Union GDP, some €550 billion [$1.12 trillion]. That included other discretionary measures at the national and EU levels and automatic fiscal stabilisers," she said. "But it is not clear that the economy is capable of sustaining itself without this stimulus."

Unemployment across the EU has risen to 9 per cent from below 7 per cent early last year and is forecast to go above 10 per cent.

Rising unemployment can be expected to weigh on consumer sentiment and spending, though how much is unclear, at the same time that uncertainty and the large amount of excess capacity which has opened up will curtail business investment.

These threats to the sustainability of a recovery in demand carry with them the risk of a negative feedback loop between the real economy and a financial sector which remains fragile.

The crisis laid bare a fundamental problem in the supervision of financial institutions. We have global markets but national regulators. The interconnected-ness of financial markets quickly turned a crash in the US sub-prime mortgage market into a global financial pandemic.

But as long as financial bailouts cost serious amounts of taxpayers' money and national governments continue to control the fiscal purse strings (and that remains true even in Europe), the risk of an unco-ordinated, beggar-thy-neighbour response by national regulators will remain.

The European Commission is recommending the setting up of a systemic risk council to monitor risks to the stability of the financial system as a whole, similar to a body proposed in the United States.

It would be largely made up of the EU's central bank governors, and the idea is that it will provide early warning of systemic risks that may be building up and, where necessary, recommendations for action to deal with these risks.

It will have to rely on moral suasion, however. It will be up to existing authorities to act on these warnings, or if not to say why not, posing at least a political risk for them if they fail to heed what hindsight reveals as sage and timely warnings.

The kind of trend that might elicit the raising of a cautionary flag by a systemic risk council is the large increase in borrowing, especially on mortgages, denominated in euros by borrowers in eastern European countries which are members of the EU but not yet of the euro area.

As their currencies have depreciated the burden of those loans to the borrowers has soared.

Their bankers thought they had no problem with foreign exchange risk as they were raising funds and lending in the same currency. But they ignored the risk that an adverse exchange rate movement would undermine their borrowers' ability to repay them.

Some doubts, however, surround the likely effectiveness of a systemic risk board if it advocates tightening the monetary reins on the grounds of an emerging asset bubble or overheated credit growth, when consumer price inflation outlook is still benign.

Imagine, said one EU official, if three or four years ago the European Central Bank or the Federal Reserve had tightened by 3 or 4 per cent. "There would have been an enormous outcry. It's not impossible. [Former Fed chairman Paul] Volcker did it. But it is painful and requires a lot of guts."

Also on the agenda is the notion of "leaning against the wind" in the sense of a counter-cyclical increase in banks' capital requirements when growth in credit and leverage is particularly strong and asset bubbles may be forming.

As this is unlikely to be something that can be reduced to a mechanical rule, the same issues of judgment and fortitude arise as for conventional tightening by way of interest rates.

The Europeans are also giving some consideration to having tougher capital requirements for those institutions which are deemed to be too big to fail and which therefore pose a greater risk to the taxpayer.

Finally there is the vexed issue of how, and how well, bankers are paid.

Stephen Ceccetti, chief economist of the Bank for International Settlements, put the problem like this: "The ability to sell risk easily and cheaply comes with the ability to accumulate risk in almost arbitrarily large amounts. Combined with compensation schemes in which money managers share the gains but not the losses of their investment strategies, this creates incentives to take on huge amounts of risk. The result is small numbers of people have the potential to jeopardise the entire financial system."

The European Commission has put up a recommendation that bonuses be paid on a deferred basis, in shares not cash, and that it be possible to claim back the money if things go wrong.

It also recommends requiring banking supervisors to look at pay structures to see if they pose a risk that requires banks to hold more capital.

Similar proposals are expected to be recommended by the Financial Stability Board, set up after the G20's April summit to provide a global forum to deliberate on such issues.

The Wall Street Journal reported that it planned to offer proposals on vesting periods for options and clawback mechanisms under which bonuses could be forfeited if performance tumbles or deals fail to deliver.

* Brian Fallow visited Brussels and Frankfurt as a guest of the European Commission.