The process of global regulatory reform started with a lot of momentum, coming out of the recent financial crisis. Will the G20 meeting held in Toronto in June set the stage for continued progress, or will the process fall victim to a combination of too much complexity, too much politics and too few common national interests?

The G20 reform initiative got off to a good start in November 2008. The purposes seemed clear: stabilize financial markets, address regulatory shortcomings across global markets, reduce the risk of a recurrence of crisis conditions and restore investor confidence. There was broad consensus on the origins of the crisis: the disconnect between complex financial products — in particular, securitized financial assets — and the inherent credit, liquidity, modelling and counterparty risks caused by poor transparency, overly complex derivatives instruments and excessive reliance on credit-rating agencies. This disconnect was compounded by inadequate capital and liquidity rules, which contributed to overleveraged institutional balance sheets.

There was also broad consensus on the components of reform: higher capital, leverage and liquidity standards; improved transparency and clearinghouses for over-the-counter securities — notably, derivative securities — to achieve greater standardization, lower counterparty risk and improved clearing efficiencies; the adoption of international financial accounting standards; regulation of credit-rating agencies; and better market oversight and co-ordination among domestic and international regulators.

The G20 also has established a framework for reform, including setting up the Financial Stability Board. There’s been progress, in the form of an agreement on the need for greater transparency and clearinghouses for OTC securities and for adoption of international financial reporting standards. Nonetheless, efforts over the past couple of years show diminishing returns. Why?

First, the reform agenda was complex. Different views on the appropriate balance between the financial system’s safety and its ability to function competitively make it difficult to achieve comprehensive agreements in a number of areas, including: appropriate capital; leverage and liquidity requirements for cash and derivative securities and derivatives for clearinghouses; and international linkages of OTC derivatives securities. The recent G20 meetings have signalled that the deadline for capital and liquidity rules will be pushed out to accommodate more consultation on these complex issues.

MANY CHALLENGES

Second, finding consensus to address global systemic risk is inherently difficult. In the U.S., a key weakness was the absence of authority to seize control of failing institutions, deal with obligations to maintain continuity and properly arrange for orderly liquidation. The new coalition government in Britain, on the other hand, is focused on establishing an independent commission to examine the merits of separating retail and investment banking. In Canada, the federal government and many provinces recognize the need for a single securities regulator.

Third, while the crisis was global, there were stark national differences in how financial institutions weathered it. Countries whose institutions withstood the crisis relatively well, such as Canada, are understandably inclined to more modest capital adjustments under the Basel II accord. As former U.S. Federal Reserve Board chairman Paul Volcker recently said, the effort of the G10 Basel Committee on Banking Supervision to co-ordinate the Basel II capital requirements was 10 years in the making — and just in time to be rendered moot by the financial crisis.

Fourth, national and regional priorities are bound to get in the way of global consensus. For example, while the Europeans emphasize compensation and institutional and capital market taxes, countries that did not have to bail out their banks — such as Canada, Japan and Brazil — object to imposing tax measures to compensate the national treasuries of countries that did. Meanwhile, the U.S. is focusing on systemic risk from institutional failures and on prohibiting commercial banks from proprietary trading and from owning hedge funds and private-equity funds.

Fifth, yesterday’s crisis can take a back seat to today’s. The reform effort has been overtaken by escalating deficits and debt in many industrial countries. The need for continued stimulus spending vs the risk of escalating debt burdens dominated the G20 debate in June, resulting in a G20 commitment for longer-term deficit and debt reduction.

Finally, regulators have been distracted by the need to ensure market efficiency in light of dramatic structural changes in global equity markets, driven by rapid technologi-cal change. This includes a substantial shift in secondary trading from stock exchanges to electronic trading platforms, escalation in high-frequency trading activity through “black box” computer trading algorithms and the evolution of “dark pool” trading.

Despite the frustrations of reaching global consensus, the multilateral process — through institutions such as the Financial Stability Board, the International Organization of Securities Commissions, and the Basel Committee on Banking Supervision — is critical to the reform process. While the global reform process may take longer than was anticipated almost two years ago, it will make an important contribution to the efficient and better integrated markets that are essential for global prosperity. IE

Ian Russell is president and CEO of the Investment Industry Association of Canada.