Europe’s Two Priorities for the G20

Europe’s Two Priorities for the G20

By Daniel Gros

Daniel Gros is Director of the Centre for European Policy Studies. This Commentary was
previously published in What the G20 should do on November 15th to fix the financial
system, Barry Eichengreen and Richard Baldwin (eds), a VoxEU.org Publication, November
2008.
CEPS Commentaries offer concise, policy-oriented insights into topical issues in European
affairs. The views expressed are attributable only to the authors in a personal capacity and
not to any institution with which they are associated


Generals often fight the last war. Regulators try to prevent the last crisis. There is thus
a tendency to concentrate attention right now on securitization and rating agencies.
However, since the securitization market has broken down and all ratings are now
regarded with a healthy dose of skepticism, these two areas should not figure high on
the agenda for the reform of the global monetary system.
The current crisis had a number of causes, some of which cannot be addressed, maybe
not even prevented, by even the best designed global monetary system. For example,
the under-pricing of risk in almost all financial markets until 2007 was a global
phenomenon which regulators could not have prevented. But something could have
been done. It is now clear that monetary policy should have reacted earlier to the
boom in house prices and regulators should have forced banks to accumulate larger
reserves for the tougher times that had to come sooner or later.
The root causes for these two macroscopic failures need to be understood properly
before trying to create a new Breton Woods.

The unwillingness of central banks to react to bubbles on their way up was not due to
the design of the global monetary system. It represented the dominant ideology over
the last decade, which held that bubbles could be diagnosed only once the boom had
turned into a bust and that all central banks could do at that point was to try to
minimise the impact on the real economy by lowering interest rates. This approach is
now totally discredited and, in any event, it is unlikely that we will see another bubble
emerging soon. It is also clear, however, that some time into the future the global
monetary system will need a strong ‘whistleblower’, i.e. an organisation that has the
expertise to diagnose a bubble and the clout to make its voice heard.
The Bank for International Settlements – the bank for central banks based in Basel –
repeatedly warned about the build-up of risk in financial markets, but its warnings
went unheeded. The International Monetary Fund would be much better placed to
look at the macroeconomic dangers resulting from an excessive accumulation of
leverage, but this would require the IMF to be sufficiently independent from its
political masters (its larger members, in primis the US) to perform this function. A
first item on the agenda for reform of the G20 should thus be not only an extended
remit for the IMF to look at financial market stability, but also a much higher degree
of independence so that it can actually warn of dangers even if this is politically
inconvenient for its major shareholders. To choose the next Managing Director of the
IMF on a competitive basis (as called for in the text of the French EU Presidency)
would be a first step in the right direction. The creation of the unified IMF
representation for the euro area might have been a further important step into this
direction because it would have broken the veto of the US concerning any criticism of
US policy-making.

The second macroscopic failure mentioned above (lax supervision of banks) stems
mainly from the fact that supervision remained national while the larger banks
operated increasingly on a transnational level. The problem is particularly severe in
Europe where a dozen complex international banking groups have emerged, which are
all too large to fail, but some of which are also too large to be saved by their home
country alone. National supervisors allowed this to happen because they perceived
their mission as mainly to help their own national champions. This perceived
competition among national supervisors meant that they did not focus on their main
mission, namely to control risk-taking and it also meant that there was no exchange of
the crucial confidential information among national supervisors that would have
allowed them to see the systemic risk that arises when all banks are following the
same strategy. National supervisors were confident that the situation was under
control because they administered many stress tests. But none of these tests could
reveal the consequences of problems arising simultaneously in more than one market
because no national regulator had access to information from other countries and there
was no European-level institution to look at the stability of the European banking
system as whole.

The conclusion is clear: an internationally integrated banking market is not
compatible with exclusively national competence for banking supervision.
Unfortunately, however, European policy-makers have refused to recognize this. The
latest proposal by the French Presidency concerning the EU position for the G20
mentions only the creation of so-called ‘colleges’ of supervisors. This will not be
enough. At a minimum, national supervisors will have to follow the same (European)
rulebook (to avoid competition in laxity) and must regularly exchange all information
concerning large systemically important institutions (so that systemic risk can be
recognized early).

The same degree of cooperation among supervisors would of course be needed for the
(smaller number) of banks that are systemically important at the global level. It is
unlikely, however, that this can be organized at the global level if it does not happen
first within Europe.

Europe could have been the major driving force for a reformed global monetary
system. But as long as the EU is not able reform its own internal organization, its
contribution will remain minor. Given that the United States has no strong interest in
changing the status quo, it is thus likely that little will change.