The reform of the international financial regulatory architecture: Addressing legitimacy issues

Abstract

International financial standard setting process has almost always sprung from real-politik. Now, the world is witnessing a shift of economic power and thereby political influence from traditional western ‘empires’ towards the emerging economies clustering around Asia and in Latin America. The most important variable at work in this transition is ‘capital’. The power mechanics at work during the classical and neo-classical era were military manifestations of power but now this base on economic might which has shifted to and rests with the emerging markets, led by China. This is a great paradox that liberal flows of capital, trade, currency which came as the result of western powers’ national interest choices have in fact brought this paradigm shift in economic power and political influence from west to the East.

Under the system of Gold Standards and later under the Bretton Woods system, it was predominantly European powers that kept controlled movement of capital across jurisdictions. After Bretton woods especially as the cold war era ended, market capitalism and de-regulation of the international financial markets became the prevalent economic philosophy and financial liberalization turned out to be a slogan for decades to come.

The gaps and lacunas in the trade and monetary policies pursued by the western capitalist countries and repercussions those policies brought, highlighted distortions that were threatening developed economies themselves. Imbalances were increasing in trade, in saving ratios, in reserves, in capital accumulations between the Asian production hubs and the western consumption cauldrons. The FSF was established as the crisis hit Russia and the US (in a limited sense as crisis hit LTCM), yet the prime causes of instability were almost conveniently bypassed. The 2008 crisis however, has established beyond doubt that market forces, market capitalism and the dominance of only G-5 over the standard setting-and-adoption process is not sufficient to ensure stability of global financial system and thereby economic development and growth.

It is true that with the beginning of the 21st century regulatory standards-setting-bodies (SSB) - on realizing significance of emerging economies - started to enlarge their memberships. The process, however, was adopted only sparingly and at much slower pace than the speed at which emerging economies were asserting their influence in the globalised financial markets. Interestingly most of the popular literature on the 2008 crisis termed it as “Global Financial Crisis”, because the west (US and Europe) equivocates to globe in terms of its economic might and influence and therefore, the literature called it ‘global’ crisis. Secondly, the fact that it is the ‘rest of the world’ (i.e. the periphery states) which have never been made part of the decision-making process as far as the formation of global standards has been concerned. It was the first time that these emerging economies were taken into consideration, naturally, the pace of this amalgamation and absorption had to be slow and only sparing at its best. The establishment of the FSB and its enlarged membership was a mega step forward in the direction. The IMF governance reform, quota re-allocations are also part of the same move to enhance legitimacy, broader representation and accountability of the financial architecture.

Tim Geithner called the ‘FSB as the fourth pillar’ of the financial standards setting process. Other regulatory bodies including IOSCO, IAIS, BCBS, Joint Forum are in expansion process albeit gradually and slowly. The theme of this paper is to analyse this transition. This article is going to highlight issues which demand special attention in the international financial standard setting process and demand accountability and legitimacy of these rule-making bodies.

However, the critical factor is to identify the mechanism i.e. how to accommodate and incorporate changed priorities almost for the first time in the history of financial markets. Merely enlarging upon the membership numbers of some regulatory bodies would not mean imparting enhanced legitimacy. There are as many issues as changing and formalizing the role of the IMF, the status of US dollar as the global reserve currency, the regional initiatives and collaborations particularly that happened during the early years of the 21st century including but not limited to European Stability Mechanism treaty, or on the Asian side, proposals for an AMF (Asian Monetary Fund), or Chiang Mai Initiative (CMIM). These regional initiatives like the AMF in fact represent a practical manifestation of the resentment against the ‘imperialistic’ IMF policies, not to forget, protests in Greece and Ireland and Spain against austerity measures followed in consequence to IMF’s recent bail-outs.

This article follows a historic-cum-analytical approach and shall assess lessons from the decade of financial disruptions in Latin America and Asia during the late 1990’s and shall compare recent steps taken by various regulatory forums focussing particularly on the FSB. The issues include enhanced membership, more representation, and vigilant compliance under ROSCs, FSAPs, and the Peer Review initiatives under the IMF. Again the ‘key’ shall be “enhanced cooperation” and “faith on the government’s commitment to a policy” that shall derive the process of standard setting in the international financial regulatory architecture.