Reshaping World’s Financial System Now a Must

But those expecting a complete overhaul are likely to be disappointed when the process is done.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

October 27, 2008

Is a new global financial system coming? The phrase "Bretton Woods II" has been making the rounds for weeks, but nothing quite that dramatic is in the works. The original Bretton Woods conference in 1944 remade a financial order shattered by the Great Depression and the Second World War. The current predicament, while unnerving, doesn't compare. That said, significant changes are likely to help the world manage future crises. It’s clear to everyone that neither leading economies nor the International Monetary Fund (IMF) as-is can do the job.

A need to compromise will limit the outcome. Satisfying both the Group of Eight (G-8) industrialized nations (the United States, Japan, Germany, the United Kingdom, France, Italy, Canada and Russia) and the big emerging markets is critical to success.

The West knows it can’t set the terms as it has in the past. That’s why the biggest developing nations were invited to join the G-8 in Washington on Nov. 15 for the first in a series of summits that will run well into 2009.

The earliest a new framework is likely to emerge will be next spring. That will give the next president time to get his new economic team in place, which he'll need to do before advocating any major changes to the world's financial architecture. It will also keep negotiators from pushing through changes that would end up aggravating the problems they hope to solve.

"The only thing worse than doing nothing in response to this is to do the wrong thing hastily," says Stuart E. Eizenstat, deputy treasury secretary under President Clinton and currently a partner with the law firm Covington & Burling.

What is the end result likely to be? More nations will help in governing the IMF. The U.S. has long pushed for that, and movement on this front began last year, but European nations have been reluctant to yield any of their authority over the fund to make room for new players. Now Europe has little choice but to accept China, India, Brazil, South Korea and other large emerging markets. An expansion would fill the fund's coffers, which it badly needs, given that Iceland, Belarus, Pakistan, Ukraine and Hungary are threatened with bankruptcy and queuing up to ask for help. Turkey, Estonia, Latvia, Lithuania, Romania and Bulgaria may join them before long.

"Reality suggests that large emerging market economies which have been growing very strongly and which do have the potential to grow robustly in the future -- particularly those that have accumulated a lot of foreign exchange reserves -- should have a more prominent voice in managing the global economy and financial system," says Hung Tran, senior director for capital markets and emerging market policy at the Institute of International Finance.

An expansion would also help restore credibility to the IMF. Many governments, particularly in Latin America, are still smarting with resentment over the fund’s heavy- handed approach to the last round of crises in 1997-2001. Giving more emerging markets a stake in managing the fund would send a message that emerging markets in general have a shared interest in making sure the global economic and financial system is doing well.

Also expect a broadening of the fund's monitoring and advisory functions. It will add several new measures of financial health to the 12 it now checks.

Remaking the G-8 into something closer to the G-20 also appears likely. A large part of the reason the G-8 has been seen as increasingly irrelevant in recent years has been its exclusion of so many of the world's new stars. Most of the economies poised to join the IMF's leadership are each worth $1 trillion or more. Two, China and Brazil, are already larger than some current members. The Group of 20, whose full membership President Bush invited to the Nov. 15 summit, comprises the G-8 countries as well as China, Brazil, India, South Korea, Mexico, Argentina, Australia, Indonesia, Saudi Arabia, South Africa, Turkey and the European Union (EU).

New regulations governing multinational financial institutions will prove harder to sell. The EU can't even agree on a single standard for its own members. EU members and others will likely balk at anything that requires them to cede oversight over their biggest financial services entities. The fallback will be setting mechanisms for better communication and coordination among key regulators. The idea would be to promote closer ties between the supervisor overseeing a financial services firm based in one country and his or her opposite numbers in whatever other countries that multinational operates.

A revisiting of the 2004 agreement on banking laws, known as the Basel II Accord, might be in the cards. Basel II was designed to make sure financial institutions kept adequate reserves on hand. In practice, many such institutions kept far fewer resources on hand than they needed to guard against risk. Odds are the agreement will be retooled to include more visible capital requirements, but doing so will take long and highly technical negotiations among central banks.

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