Our new paper for the European Parliament highlights how old approaches to international governance are increasingly out of date in the day and age of increasing globalization. We now live in a world that is highly interconnected, is full of externalities and is increasingly fast paced. (Available for download in our publications section)

The ever faster and larger cross-border flows of commerce, people, and information technologies has reduced the idiosyncratic risks by allowing us access to an increasing array of options for example for investments or suppliers. At the same time, the higher degree of interconnectedness that this has brought about means that the risk of system wide failure – the dominoes all falling together - has increased significantly as demonstrated by the recent world wide collapse in cross border finance and trade.

Existing international governance structures to pursue shared global goals and manage externalities were designed at a time when systemic risk, externalities and the pace of change was much slower. These institutions and their approach to global governance now look increasingly out of touch. There is an urgent need to plug this governance gap that grows by the day.  

Financial Transaction Taxes: Tools for Progressive Taxation and Improving Market Behaviour. The discussion on financial transaction taxes is reaching a climax. There have been several suggestions for the form such a tax should take and many estimates for how much revenue levying such taxes would generate often running into hundreds of billions of dollars. 

Proponents of the financial transaction taxes (FTT) are happy that the tax is in the news again. However they can’t help but wonder if it is just another false dawn. It is not.

The financial crisis, the biggest in living memory, has massively titled the political and financial landscape in a direction that makes such taxes not just more desirable also much easier to implement.

Keynes was an early proponent of FTTs and the idea got a new lease of life when James Tobin extended it to currency markets. The Asian crisis helped revive the discussion and after falling off the agenda yet again the idea was brought back to life as a potential source of revenue for funding development. Each time it died a slow death. The opponents of FTTs won those battles but are about to lose the war. Here is why.

Risk taking is central to the functioning of any financial system but the current crisis was brought on by excessive risk taking and a simultaneous decline in the risk absorption capacity of the financial system. Financial institutions have needed of billions of dollars of taxpayer funded public support because they did not have sufficient capital of their own.

Regulators allowed Capital, which acts as a shock absorber by absorbing losses, has been allowed to deteriorate over time both in quantity and quality. Even the discredited credit rating agencies have been using a more conservative definition of capital than lax regulators.

Under the current capital adequacy regime, regulatory capital requirements have been designed to converge towards the financial institutors’ own definition of capital adequacy based on dubious assumptions of institution self interest and market discipline. Since capital is costly, this regulatory complacence has driven a race to the bottom in capital holding by financial institutions.

Almost by definition, it is impossible to use market mechanisms to guard against market failure. Regulators need to make banks do something different to what they would do anyway; otherwise why regulate.

This erosion of capital is the other side of excessive leverage in the financial system which has the effect of amplifying both profits and losses and is responsible for the current fragility of the financial system and the speed of its collapse.

A parallel development has been the steady chipping away of mandatory liquidity requirements such as Statutory Liquidity ratios, which are still an integral part of the regulations in emerging markets such as India and have helped them withstand the worst impact of the crisis.

Because banks borrow short term and lend long term they are particularly susceptible to liquidity drying up. In this crisis, which arose out of excess liquidity in the financial system, liquidity disappeared both on the funding side as well as the asset side. That is why liquidity funding cushions and more conservative asset liquidity assumptions are part of the solution.