The System Worked_How the World Stopped Another Great Depression

by Daniel W. Drezner

  The crisis itself also expanded the audience of parties interested in Basel III. As a result, the affected global governance structures and national regulatory authorities met with sectoral representatives beyond finance.78 For example, the Basel Committee met with International Chamber of Commerce officials for the very first time after the 2008 financial crisis. By interacting with a wider array of interests, regulators evinced less concern about banking preferences in particular.

  Regulators and officials also reacted badly to overly aggressive lobbying. In a speech to IIF members, delivered immediately after the IIF had released its initial impact study, European Central Bank president Jean-Claude Trichet compared the financial crash to the Deepwater Horizon oil spill in the Gulf of Mexico.79 He further argued that the 2008 crisis had “shattered” the idea that self-regulation would work in the financial sector. A year later, at a Financial Services Forum meeting, J. P. Morgan chief executive Jaime Dimon scolded incoming Financial Stability Board chairman Mark Carney about Basel III, calling the proposed rules “cockamamie nonsense.”80 Carney angrily left the room while Dimon was in mid-rant. Other bankers, including Goldman Sachs’s Lloyd Blankfein, tried to smooth things over. This did not stop Carney from telling the IIF attendees, “If some institutions feel pressure today, it’s because they have done too little for too long rather than being asked to do too much too soon.”81

  A final possibility is that the regulatory-capture theory was exaggerated even prior to the Basel III negotiations. As previously noted, much of the international political economy literature simply assumed interest-group dominance in financial regulation, particularly with respect to the Basel Committee. However, Kevin Young has examined the negotiations surrounding the creation of Basel II and found that the financial sector’s influence was more circumscribed. Contrary to the conventional wisdom about Basel II, for example, BCBS regulators pushed back on efforts by the banks to rely solely on their internal risk-management systems to calculate the appropriate level of capital adequacy. He concludes, “There was more scope for public agencies, at least when organized transnationally, to resist and reject private sector demands than has been depicted in the existing IPE literature.”82

  This is not to say that sectoral interests did not affect the Basel Committee’s bargaining. Rather, the effect was muted. There are two ways in which financial interests shaped the Basel III outcome. First, the relative health of a country’s banking sector affected the way national regulators approached Basel III. As Sheila Bair noted in her memoirs, the distribution of preferences among the Basel Committee representatives was clear-cut: “The United States, United Kingdom, Canada, Switzerland, the Netherlands, Sweden, and most other Basel Committee members advocated, or at least were willing to support, higher standards; Germany, France, and Japan would resist.”83 Interviews with BCBS staffers, as well as the contemporaneous news coverage, confirms this basic cleavage.84 When the advanced developing countries from the G20 joined the BCBS, they shared the preference for more-stringent standards. This was because market pressures had long ago forced banks in these countries to hold much higher levels of capital than those in the developed world.85

  One could ascribe the preferences of national regulators from France, Germany, and Japan to push for less-stringent standards as evidence of interest-group capture in those countries. However, there are reasons to view these preferences as equally grounded in national interest. Because the continental European banks had gone the furthest in implementing Basel II, they were the least well capitalized of the globally systemic banks. Japan’s banks had never fully recovered from the country’s recession in the 1990s. As a result, the banks based in these countries were more vulnerable to increases in capital adequacy and liquidity requirements. Furthermore, as coordinated market economies, Germany, France, and Japan relied far more on bank financing than other forms of raising capital than the liberal market economies of the United States and Great Britain did.86 As big as the American banks were, for example, in 2008 the six largest had assets approximately equal to 60 percent of US GDP. In contrast, the top three French banks had assets equal to more than 315 percent of French GDP; the top two German banks held assets equal to 114 percent of German GDP.87 Any regulation that constrained bank lending would have a disproportionate macroeconomic impact on countries that relied more heavily on bank finance than equity markets for financing.

  It should also be noted that lobbying during the Basel III negotiations was not strictly based on material interests either. If short-term interests really dictated national preferences on banking, for example, then US banks would have lobbied for more-stringent standards as a means of improving their competitive position vis-à-vis European banks. This would have been consistent with their behavior during previous rounds of Basel rule writing.88 That did not happen during Basel III, however. The US financial sector continued to loudly resist any ratchet upward of regulatory stringency.89 Indeed, J. P. Morgan Chase CEO Jaime Dimon epitomized the attitude of the US financial sector when he repeatedly blasted the Basel III accord as “blatantly anti-American.”90 Furthermore, the negative US stock market reaction to the Basel announcements suggests that financial markets did not view the shift in global economic governance as beneficial to the US banking sector.91

  The second significant effect of sectoral interests on the Basel III process has been the lobbying to slow down the implementation phase. Any kind of governance reform takes place in three stages: agenda setting, policy formulation, and policy implementation. In the immediate aftermath of the 2008 crisis, the financial sector had minimal influence during the first two stages. As a result, it concentrated its firepower on the implementation stage. As Kevin Young observed, “Rather than arguing that new regulations already on the table should not be pursued, or that the particular details of regulation should be substantially adjusted, post-crisis arguments often take the form of arguing for the postponement of regulatory implementation.”92 Theoretically, interest groups would be expected to exercise more influence at this stage, particularly after the immediate crisis receded. As populist anger against the banks fades, any countervailing pressure against bank lobbying is likely to erode over time, leaving a “quiet politics” more amenable to interest-group capture.93 Indeed, the primary bargaining cleavage during the Basel III negotiations was over the implementation dates. The British and Americans wanted Basel III fully implemented within five years, but a larger constellation of countries with weaker financial sectors preferred a slower process.94 The latter group of countries succeeded in delaying the full implementation dates for Basel III until 2018 and in reducing capital adequacy levels to 7 percent.

  The slowdown on implementation can be seen most clearly in the timetable and rule writing on the liquidity ratio. As the Basel Committee moved toward finalizing the rules and timetable for the liquidity coverage ratio (LCR) in January 2013, banks in the United States and Europe lobbied fiercely for looser standards and a longer timetable.95 On this front, the banks were successful. The revised LCR rules made two significant changes to the draft rules the committee had issued in December 2010. First, they extended the timetable for implementation. Banks will only have to comply with 60 percent of the LCR by 2015; full compliance will not kick in until 2019. Second, the Basel Committee softened the requirements for what banks needed to hold to ensure liquidity. The 2010 draft implied that banks could only apply “Level 1” high-quality liquid assets—cash and government bonds—toward the ratio. In the 2013 revision, banks were permitted to hold up to 40 percent of liquid assets in the “Level 2” form—including commercial bonds, equities, and mortgage-backed securities.96 Stock prices for the major banks rose after the announcement, reflecting the perception that this was a victory for the financial sector. One analyst described the outcome as “a fairly massive softening” of the Basel Committee’s approach.97

  One can argue that sectoral lobbying for slower implementation had an appreciable effect on global economic governa
nce. Insiders like Sheila Bair blamed bank pressure on the dilution of the Basel III standards.98 Outside observers cited the revision as an example of the banks taming the regulators yet again.99 Simon Johnson noted in the New York Times that “these officials caved in, as they did so many times in the period leading to the crisis of 2007–8. As a result, our financial system took a major step toward becoming more dangerous.”100

  While this may appear to be a data point in favor of the regulatory-capture argument, the revisions were equally consistent with the model of regulatory autonomy. In contrast to the ratcheting up of capital adequacy, BCBS officials were far less confident in their calculations on an “appropriate” liquidity ratio. In moving into a new area of regulation, Basel Committee officials were understandably warier about their command of the data and therefore more willing to listen to bank complaints.101 As the Financial Times noted, the LCR was “an experiment, with calculations based on estimated needs rather than solid experience.”102 This was publicly acknowledged by regulators as well. As British banking regulators explained, “The state of macro-prudential policy today has many similarities with the state of monetary policy just after the Second World War. Data is incomplete, theory patchy, policy experience negligible. Monetary policy then was conducted by trial and error. The same will be true of macro-prudential policy now.”103 This is consistent with the hypothesis that the Basel Committee listened to bankers in a discriminate manner, relying on them more when their own data and models rested on shakier ground.104

  A related problem is that key assumptions made by bank regulators were challenged in the interregnum between the draft rules and the final rules. The poor performance of the eurozone made regulators skittish about exacerbating any downturn. In forcing banks to acquire more capital, Basel III encouraged a drying up of cross-border lending in Europe. As the liquidity rules were being debated, the BIS noted that at the end of 2011, quarterly global cross-border lending had dropped to its lowest levels since the Lehman collapse in fall 2008. The decline was “largely driven by banks headquartered in the euro area facing pressures to reduce their leverage,” according to BIS officials.105 Given the fragility in the eurozone economies as the final liquidity rules were being written, regulators were concerned that too onerous a liquidity ratio would worsen the downturn by drying up commercial bank lending.106

  Another macroprudential concern was about how Basel III, combined with the sovereign debt crisis, would affect the market for safe assets. In theory, government bonds were supposed to be the principal means for banks to hold “Level 1,” or high-quality, liquid assets. In practice, the worsening fiscal position of the advanced industrialized states caused a decline in the quality of their sovereign debt. The eurozone crisis and 2011 debt-ceiling deadlock in the United States caused multiple ratings agencies to downgrade significant amounts of sovereign bonds. The Financial Times estimated that the global supply of AAA-rated debt fell by 60 percent in the first five years of the financial crisis, to less than $4 trillion.107 At the same time, as banks started complying with Basel III, BCBS and IMF officials estimated a new demand to acquire between $2 to $4 trillion in safe assets.108

  While some of the downgraded debt would qualify as Level 1, the simultaneous decline in supply and spike in demand had the potential to distort capital markets.109 Not surprisingly, the IMF warned in its 2012 Global Financial Stability Report that “the tightening market for safe assets can have considerable implications for global financial stability.” The fund urged a more relaxed attitude towards the definition of safe assets to “ameliorate pressures” in this market.110 So did British regulators, who had already instituted more stringent liquidity rules within the City of London. Mervyn King, the British central bank head, explained to the New York Times that “nobody set out to make [the liquidity rule] stronger or weaker, but to make it more realistic.”111 Given that the British were by far the most eager of the national regulators to ratchet up standards, their change of mind was significant. It was an indication that interest-group pressure was not the only causal logic at work. In this context, expanding the category of liquid assets to include private commercial paper is less surprising—and less indicative of regulatory capture.

  Even with the relaxed LCR and slower implementation, the evidence suggests that systemically important global banks adjusted considerably to comply with Basel III. One BCBS survey showed that between December 2011 and June 2012 alone, systemically important global banks secured more than $200 billion—or 43 percent of the estimated shortfall in Tier 1 capital—necessary to comply with the capital adequacy standard due to be activated in 2015.112 Parallel surveys by the European Banking Authority in the eurozone and the Clearing House in the United States showed significant increases in liquid assets on hand held by banks.113 The worst-capitalized large European institutions, such as Deutsche Bank, continued to recapitalize in early 2013.114 Further BCBS quantitative research suggests that banks have significantly augmented their capital reserves over the past few years—and, contrary to IIF warnings, did so while increasing lending.115 Even if Basel III did not achieve everything that critics of big banks wanted, its implementation forced systemically important banks to make significant changes to their business model. The financial sector retains significant influence, to be sure. This influence may further increase as memories of the subprime mortgage collapse continue to fade.116 At the same time, improved profits have undercut the banking lobby’s arguments against further regulation.117

  Overall, during the post-crisis response, the Basel Committee responded in a manner that belies the interest-group-capture argument. In expanding capital adequacy and establishing a macroprudential foundation at the outset of Basel III, BCBS regulators took significant steps to retard the probability of regulatory capture in the future. On this issue—where sectoral interests were at their most concentrated, and the tight links between regulators and bankers long-standing—regulatory capture of global economic governance did not take place.

  Conclusion

  This chapter has explored the question of whether material interests can explain how global economic governance functioned during hard times. The major strands of international political economy research would predict that a sufficient constellation of interests had a vested stake in ensuring an open global economy, thus empowering states to act in a cooperative manner. The global supply chain would ostensibly ensure that major importers would still not agitate for protectionism. Similarly, the privileged position of the financial sector in this era of globalization would ensure unfettered capital markets and a light regulatory touch.

  An interest-based explanation goes part of the way in explaining why states did not defect from existing global economic governance structures. Among the G20 economies, there is a moderate correlation between exposure to globalization prior to the crisis and policy adherence to openness after the collapse of Lehman Brothers. Imbricated interests help to explain why countries refrained from trade protectionism. Nevertheless, a closer examination of Basel III reveals two significant flaws in a strictly interest-based explanation of post-crisis global governance: theory and practice.

  Theoretically, the problem with the interest-based explanation is that it presumes a harmony of preferences when one did not exist. Recall the distinction between harmony and cooperation in international relations. In a harmony situation, the salient actors all share the same set of preferences. At best, only minor governance is necessary because there is minimal disagreement among the principal actors about what to do. This covers only a small fraction of possible cooperation problems in world politics, however. Even if a plethora of actors share a similar set of interests on the content of global governance, there are inevitably distributional issues that are zero-sum in nature.118 Who pays for monitoring? Who pays for enforcement? Bargaining is an inevitable feature of global economic governance. In the case of Basel III, the cleavage of interests between coordinated market economies and liberal market economies dem
onstrated the distributional concerns among states affected by of global regulation.

  The empirical problems are more formidable. There are simply too many instances of powerful interests either losing or compromising their positions. The pattern of capital market regulation after 2008 demonstrates the limits of an approach that explains global governance outputs as products of sectoral interests. Regardless of national origin, the financial sector was firmly opposed to the Basel III banking accord. It was a well-organized and well-funded interest group. Despite its opposition, both national regulators and Basel Committee officials crafted a set of regulations that ratcheted up capital adequacy and introduced macroprudential principles to determine liquidity minimums and leverage limits. The empirical evidence suggests that the banking sector exercised limited influence during the drafting of the rules. They did exercise greater influence over the implementation phase—but even here, the evidence points to both national and international regulators exercising autonomy in crafting new rules and regulations.

  Basel III was not the only arena in which banks faced a regulatory setback. They also lost on the question of capital controls. For decades, the IMF had used its influence to pressure countries into liberalizing their capital accounts.119 Some economists went so far as to accuse IMF officials of acting at the behest of the banks in pushing this agenda.120 In the wake of the 2008 financial crisis, however, IMF economists began to change their minds about the wisdom of capital controls. In February 2010, an IMF staff paper concluded that under some circumstances, capital controls could be a legitimate and useful policy tool.121 Dani Rodrik characterized the change in the IMF’s tune as a “stunning reversal” of its previous orthodoxy.122 By November 2012, the staff note had become the IMF’s official position. Now, the fund allows that capital controls can be “useful” in some circumstances, and that “there is … no presumption that full [capital account] liberalization is an appropriate goal for all countries at all times.”123 Brazil even used the logic of macroprudential regulation developed in Basel III to justify the capital controls it imposed.124