On the evening of June 10, Josef Ackermann, the CEO of Deutsche Bank and chairman of the Institute of International Finance, and his wife were enjoying a performance of the famed Lipizzaner horses at the Spanish Riding School in Vienna. He was smiling and cracking jokes, acting every bit the amiable Herr Ackermann.
During the day, however, Mr. Ackermann had exhibited a different side of his personality. The presentation he had given at a conference of his institute could easily have been interpreted as a threat to the world's leaders. Ackermann said that if the stricter regulations for banks that are currently under discussion became reality, the euro zone, the United States and Japan would create 9.7 million fewer new jobs by 2015.
The argument Germany's most powerful banker was using -- the threat of fewer jobs in the future -- could easily have come from the operator of a waste incineration plant who has been told to expect stricter environmental regulations: he said future jobs were at stake. Although Ackermann wasn't saying that new banking regulations would jeopardize existing jobs, his statement that they could translate into about 10 million new jobs not being created was strong enough.
The tone of the debate is becoming more strident, and the fight that has been going on for the last year and a half is turning serious. The bankruptcy of investment bank Lehman Brothers on Sept. 15, 2008 led to a near-collapse of the global financial system. More recently, entire nations, like Greece, have threatened to collapse under the burden of their debts. The controversy over regulation pits bankers, hedge fund managers, lawyers and lobbyists against the world's most powerful politicians.
The key question revolves around how many new regulations lawmakers can impose on financial institutions to avoid a repeat of the disasters seen in recent years. At their meeting in Toronto later this week, the representatives of the leading industrialized nations and emerging economies, the so-called G-20 nations, will resume their efforts to tackle the supremacy of high finance. It will likely be their last attempt, and if they fail yet again, they will have missed a historic opportunity.
Until now, the politicians' victories in this duel have been nothing but a triumph of words. "Never again will the American taxpayer be held hostage by a bank that is 'too big to fail,'", US President Barack Obama thundered.
"We can no longer accept a capitalist system without rules, without order and without norms," French President Nicolas Sarkozy fumed. "A system in which most of the money is earned through speculation instead of production -- that is not the kind of system in which I want to live."
These are grand words. But virtually nothing has happened to diminish the business of speculating in stocks and currencies, in the ups and downs of financial markets, the banks' practice of gambling with the minimum possible stake.
There have been plenty of summit meetings since the Lehman Brothers bankruptcy. The G-20 governments have met in Washington, London and Pittsburgh. All of their meetings have ended with declarations of intent and announcements of their wishes, but no drastic measures have been implemented to date.
And when a single country does decide to press ahead on its own, as Germany recently did when it imposed a ban on especially speculative transactions, its efforts, as well-intentioned as they are, can have little effect given the global interconnectedness of markets. Speculators simply take their business elsewhere. Instead of betting against a bank or a government from an office in Frankfurt, they do so from London or New York.
In fact, such international solo efforts are nothing but helpless attempts to conceal the failures of politicians at the international level.
"In our hour of need, we decided that each financial product, every player and every financial center must be regulated in the future," German Chancellor Angela Merkel said recently. "That was the promise we made to people." Nevertheless, she admitted, it is a promise "we have yet to keep."
Investment Banks Setting up a new Casino
It is high time for something to be done about the problem. The markets are growing and thriving as if the near-collapse of the global financial system had never happened. In the first three months of this year alone, three major financial institutions, Goldman Sachs, JPMorgan Chase and Deutsche Bank, raked in $13.5 billion in profits. Soon afterwards, Europe had to set up a fund in the triple-digit billions to bail out cash-strapped member nations. And the investment banks are already in the process of opening a new casino in the commodities trading business.
They continue to benefit from a financial system characterized by few rules and many loopholes. Hedge funds are subject to scant regulation, even though they are the ones that engage in particularly risky transactions. Banks are not required to maintained sufficient capital reserves to cover the risks they are taking. Finally, rating agencies continue to do business with banks whose products they then assign top marks to.
Things are going the way they have been going for years. The big wheel is still turning as if nothing had happened. In fact, it is even being lubricated with the cheap money central banks pumped into the markets to minimize the consequences of the financial crisis. As a result, those who helped create the crisis are now benefiting from government efforts to resolve it.
If there is one lesson banks, investors and hedge funds have learned from the crisis, it is that nothing can happen to them, because governments are shouldering the risks.
Governments are approving one rescue package after another. The bailouts of struggling banks were followed by bailouts of beleaguered nations. This can't go on, because in the end the saviors themselves will go bankrupt.
This is why it is important to draw the right lessons from the crisis, to learn from past mistakes to safeguard the future. Financial markets were only able to develop their dangerous habits because they were largely freed from regulatory constraints. That is why it is clear how the monster that was created can be tamed.
Five Commandments for Taming the Monster:
Control the Banks!
A government has reorganized the banking sector once before in reaction to a financial crisis. The Glass-Steagall Act, named after its two Democratic sponsors in the US House of Representatives and the Senate, was enacted in 1933 under then US President Franklin D. Roosevelt.
This law forced financial institutions to make a decision: Either they could be normal commercial banks involved in classic banking activities, that is, managing customer deposits and lending money, or they could concentrate entirely on the securities business and thus call themselves investment banks.
This strict separation of business was the government's response to the prior turmoil in financial markets. In the Great Depression after 1929, about 5,000 banks collapsed and millions of savers lost their assets. When a Senate commission led by Ferdinand Pecora, a former assistant district attorney in New York, investigated the causes of the disaster, it discovered that bankers had sometimes deceived their customers. Lawsuits were brought against some of the major Wall Street firms.
The outrage these revelations triggered paved the way for the Glass-Steagall Act, which then reestablished confidence in the banking sector. The separation was preserved for more than six decades, until the late 1990s, when the markets were intoxicated by the zeitgeist of the "New Economy" and the distinctions between commercial and investment banks began to erode.
Commercial banks began trading in securities once again, and some even merged with investment banks. For example, Citicorp, the world's second-largest bank, merged with Travelers. In November 1999, during the administration of then President Bill Clinton, the Glass-Steagall Act was completely repealed and replaced with financial reforms that liberated the industry from inconvenient restrictions. "This legislation is truly history," Clinton said triumphantly at the time, "we have done right by the American people."
But it was a historic mistake, as has become clear today. Countries began competing to jettison as many financial regulations as possible. Their goal was to attract banks and hedge funds by improving business conditions in their markets. The German government at the time, a center-left coalition of Social Democratics and Greens, also jumped on the deregulation bandwagon.
Now the financial crisis has prompted calls in the US for a return to separating bank business. Presidential advisor Paul Volcker, a former chairman of the Federal Reserve Bank and a major influence on US financial policy, is calling for a new division in the banking world: into institutions that engage in speculative transactions for their own account, and banks that can draw on savings deposits and central bank loans and engage in classic banking activities. Although the latter group of institutions could still conduct significant parts of their investment banking business on behalf of their customers, they would no longer be allowed to engage in highly speculative deals. The banks would either have to abandon these activities or spin them off into separate companies.
In the United States, this change would merely represent a return to what was once the status quo -- and to the consequences that were drawn once before from a global economic crisis.
Naturally, the banks are fighting such curbs on their activities. Nevertheless, as the experiences in the United States prior to 1999 showed, the proposal would hardly hurt economic activity. When the separation was in place, the United States experienced more growth than many other countries.
2. More Equity Capital!
A bank is required to maintain capital reserves for any loan it issues -- as security in case the borrower is unable to repay the loan.
In the European Union, the core capital ratio is supposed to be at least four percent. But banks are not required to maintain the same level of reserves for all of their loans. For those loans that are considered safe, the mandatory reserves are lower. This waters down the principle.
Besides, banks can outsource risks by investing in hedge funds or establishing so-called special purpose vehicles (SPVs), for which very low capital reserves are required and that do not appear on the banks' balance sheets. This loophole should be closed. Most of all, however, the capital regulations should be tightened. "This is the key strategy for bringing about a recovery of the banking sector," says Hans-Werner Sinn, president of the Ifo Institute, one of Germany's leading economic institutes.
Banks object that this would restrict their ability to lend money. This is correct, but it's also necessary, because the bubble that triggered the financial crisis when it burst could only develop as a result of excessive levels of debt. In the United States, people with relatively low incomes were able to buy real estate that they couldn't really afford, and banks lent more and more money for increasingly shaky investments, thereby creating a boom fueled by credit.
Such unhealthy growth will cease to exist if the banks are forced to establish a bigger cushion against risk. Because the system will be more crisis-proof, growth will be more sustainable. A bank will no longer be threatened when a few of its debtors are in hot water. It will simply write off the loans.
3. Quality Controls for Financial Products!
Every tricycle has to be approved before it can be sold, but complex financial products often require no certification whatsoever. In some cases, they are not even sold on exchanges, where changes in pricing are transparent, but in direct transactions between banks. Both of these deficits have to be corrected.
A certification process for financial products can only be based on whether they serve as insurance for real business transactions. Only then do they make sense.
For example, a bank can insure the Greek government bonds it holds against the possibility that the creditor is unable to repay the debt. But the exclusive trade in credit default swaps, or CDS, by banks that don't hold the bonds should be banned. The practice is done purely for speculative reasons and can make it dramatically more difficult for a country to obtain credit.
Hugh Hendry, 41, had made a lot of money with these kinds of transactions. The London hedge fund manager predicted Europe's crisis well before it happened. In December 2008, Hendry was issuing warnings about the so-called PIIGS nations, Portugal, Italy, Ireland, Greece and Spain. He bet against Portugal, he says, because he thought it was impossible "for such a stupid country, without a monetary policy of its own, to receive a higher credit rating that Great Britain."
Hendry bought Portuguese CDSs, a sort of credit insurance against the default of Portuguese borrowers. The worse off the Portuguese are, the more valuable the CDSs become. That's because the value of an insurance policy against default, or a CDS, rises as the risk of the Portuguese not being able to repay their debt grows.
However, rising CDS prices also mean that the Portuguese government must pay investors a higher interest rate if it hopes to borrow new funds. This exacerbates Portugal's difficulties, which in turns leads to higher CDS prices. In other words, speculators expand the problem on which they are betting by investing in CDS.
CDS already played a harmful role in the first financial crisis, which led to the Lehman collapse. But because politicians did nothing, CDS have now been able to exert their destructive power in the second financial crisis.
Many economists also believe that so-called short sales should be banned. In these types of transactions, banks sell stocks or foreign currency that they don't even own or have merely borrowed. They are then required to deliver the underlying security or currency on a fixed date, usually in a few weeks or months, at a fixed price. If the price declines by that date, their gamble has panned out. Then they can buy the stocks or currencies at the lower current rate and sell it at the fixed higher price.
The only problem is that by selling large numbers of stocks, banks can sometimes create the price declines that they later profit from. Short sales, says economist Sinn, "helped bring down Lehman Brothers."
4. Monitor the Hedge Funds!
Hedge funds conclude particularly risky transactions. One would think that they would be subject to special monitoring as a result. But precisely the opposite is the case.
Their headquarters often consists of a letterbox address in the Cayman Islands. They invest in Ukrainian wheat producers, are interested in uranium mines in Africa or bet against the euro.
No one knows exactly what they are up to. They openly gamble on the bankruptcies of entire nations. About 7,000 hedge funds have taken in roughly $1.5 trillion from pension funds, insurance companies and universities seeking to boost their return on investments.
No law forces hedge funds to maintain capital reserves. And the banks that invest in them don't even have to show their investments on their balance sheets.
There is no reason why hedge funds shouldn't be subject to the same capital requirements and accounting rules that apply to banks. There should be no special rights for speculators.
5. Control the Ratings Agencies!
The failure of the three largest ratings agencies, Fitch, Standard & Poor's and Moody's, is beyond dispute. They awarded their highest ratings to junk securities and assigned Lehman an A+ credit rating shortly before its bankruptcy.
Ratings agencies are exposed to several conflicts of interest. They help banks structure securities that they subsequently rate. This has to be prohibited!
They are also paid by the same banks that seek to market the securities they rate. Clearly this can cloud their judgment, which is why ratings agencies should be paid by the buyers of financial products in the future.
Besides, a system of competition among the three main agencies should be developed. Peter Bofinger, a member of the German Council of Economic Experts, is calling for a government-run European ratings agency which the EU would have to establish and partially fund, at least at first.
Even this type of agency could be vulnerable to being influenced -- in this case, by politicians seeking to prevent their countries from being downgraded. But a European ratings agency would be only one voice among the ratings agencies. It could act as a counterbalance to its commercial competitors.
The banks are lobbying hard against many of these proposals. The bankers who are fighting back against overly stringent rules for their industry argue that they would weaken banks, slow growth and prevent job creation.
But politicians should not allow themselves to be deterred by such arguments. Even the chief economist of the Bank for International Settlements, Stephen Ceccheti, characterizes such doomsday scenarios as blatant exaggeration.
According to Ceccheti, the banks' dire warnings are based on the assumption that the maximum impact of the biggest possible change in the rules will coincide with the smallest possible change in the banks' behavior -- a worst-worst-worst-case scenario, in other words. In fact, says Ceccheti, the effects of the proposed reforms on worldwide growth would be "negligible."
Nevertheless, the G-20 summit is likely to produce minor advances at best. Jörg Asmussen, state secretary in the finance ministry, will be Germany's chief negotiator at the summit. He has a special history when it comes to financial market reforms. In a former job as senior official under former Finance Minister Hans Eichel, a Social Democrat, Asmussen was in favor of Germany emulating the Anglo-Saxon model and permitting hedge funds.
Asmussen does not deny that he supported the zeitgeist of the moment, which paid homage to market liberalization. Today, as a state secretary under Christian Democratic Finance Minister Wolfgang Schäuble, he takes a different view of the world. His change of thinking began after the Lehman bankruptcy, and now Asmussen strongly supports better regulation. But he is not overly optimistic.
His skepticism stems from the fact that there are too many competing interests. The emerging economies, which make up half of the G-20 group, see the financial crisis as a problem for the Northern Hemisphere. But even the established economic powers are not all on the same page. On the one side are the continental Europeans, who want to see tighter regulation of hedge funds. But Great Britain, seeking to protect London as a financial center, opposes such regulation.
The Americans, most of all, are determined to impose stricter regulations and a banking tax on their financial institutions in the future. Australia and Canada, whose financial systems have survived the financial crisis virtually unscathed, come down on the other side of the regulation debate. Why should they burden their banks now, they argue?
All signs point to the Toronto closing communiqué being as vague as usual. One of the concrete efforts being proposed so far is to prohibit the providers of high-risk financial derivatives, like banks, from trading directly with customers, like hedge funds. Instead, the trade in such securities would take place through exchanges, the goal being to increase transparency. A bank tax to pay for the burdens of financial crises seems as unlikely to succeed as an international tax on financial transactions.
US economist Nouriel Roubini, who predicted the financial crisis, warns of the consequences of inadequate reforms. If the international community does not intervene now, says Roubini, even bigger and more dangerous speculative bubbles could develop. "If that happens, what we are experiencing now would only be a taste of what is to come."