Bankers were back in force at this year's World Economic Forum meeting in Davos. Professing to be largely in agreement with regulators and policy-makers, they nonetheless warned of the perils of getting regulation wrong and the need to move on from banker-bashing and to focus on growth

Davos 2010 was characterised by a wintry pessimism. The US was being compared to Japan, and fear about the likelihood of double-dip recessions bubbled under the surface of every economic discussion. Much of the debate focused on what to do with the banking system, but there was a noticeable fall in the number of senior bankers present.

Davos 2011, by contrast, had a palpably more optimistic outlook and saw bankers return in force. And gone were the hair shirts they have worn since 2008; this year, bankers called on policy-makers to end banker-bashing and focus on creating the right environment for growth.

The opening sessions focused on the global economy. Participants largely shrugged off the UK's shock gross domestic product figures published that week and instead pointed to the nascent recovery in the US. Most appeared confident the global economy is on track. Even Professor Nouriel Roubini of Roubini Global Economics, perhaps the world's best-known bear, admitted prospects for the global economy represent “a glass half-full”, with upside and downside risks equally balanced. Unsurprisingly, everyone agreed that the emerging world has most of the 'up' and the developed world most of the 'down'.

Capital controls

At HSBC's annual emerging markets breakfast, chaired by the bank's chief economist, Stephen King, one of the themes looked at how emerging economies are managing the huge capital flows flooding out of the developed world and into the more vibrant economies of Asia and Latin America.

With emerging economies doing so well and strong inflationary pressures present in many countries, China and other developing countries have complained that quantitative easing (QE) in the US is doing little more than depressing the dollar and causing hot money to flow into their economies. The problem, said Mr King, is that with debt levels still so high in the West, developed countries are much less responsive to stimulus than emerging economies, so an unintended consequence of QE in the US, for example, is that it is stimulating more activity in emerging markets, helping to push up commodity prices and drive inflation.

In response to QE in the developed markets, emerging economies have begun experimenting with mechanisms such as capital controls and constraints on credit expansion. Mr King dubbed this response to QE “quantitative tightening”.

The idea of capital controls, for so long a no-go area in the eyes of the international financial community, has gained some – albeit reticent – supporters in recent months, notably the International Monetary Fund. Mr King offered a plausible explanation for this change of heart, pointing out that the current outflow of dollars into emerging markets is reminiscent of the situation before the Mexican and Asian crises.

So what should today's emerging economies do, asked Mr King. “Many have already tightened fiscal policies, tightened domestic borrowing criteria and raised reserve requirements,” he said. “If today presents a similar picture, and we have learned the lesson from previous crises, maybe it is unsurprising that capital controls are no longer seen as completely off limits.”

Eurozone exchange

With fears about the global economy easing, the ranks of European politicians on various panels showed a united front in downplaying eurozone woes and the likelihood of any further major shocks. The Franco-German axis stood firm: their finance ministers spoke of how the danger had passed. French finance minister Christine Lagarde said: “I think the eurozone has turned the corner.” German finance minister Wolfgang Schäuble added: “I think the euro will be stable.” The heads of government, by turn, avowed their support for the euro. French president Nicolas Sarkozy said “never will we turn our backs on the euro”, followed by the German chancellor, Angela Merkel, who added: “Should the euro fail, Europe will fail.”

Not everybody agreed with their confidence that the worst was behind them, with some arguing that the numbers suggested otherwise. Speaking on a panel, economist Carmen Reinhart from Maryland University, who has analysed centuries of sovereign debt crises, said: “It is very difficult for me to look at the debt numbers and say a restructuring is going to be avoided.”

Jean-Claude Trichet, president of the European Central Bank, said it was amazing that in 2004 and 2005, France and Germany had attempted to “blow up” the eurozone’s fiscal rules covering budget deficits and called for “a quantum leap” in European economic governance. While he acknowledged that consolidated eurozone deficit and debt levels were much stronger than those of the US or Japan, he said: “It is no time for complacency and in some cases [the situation] is far from sustainable.” (See our economists' roundtable on the euro in the March issue of The Banker.)

Getting regulation right...

If Davos 2010 was dominated by the question of how to rebuild the world’s banks, this year, bankers, regulators and politicians debated what the consequences of that reconstruction will be. Tensions occasionally flared.

On one panel, Mr Sarkozy and Jamie Dimon, chief executive officer of JPMorgan Chase, openly disagreed when the US bank chief voiced his concerns that “bad policies” could stymie economic recovery. When Mr Dimon said regulators must avoid forging policies “out of anger”, Mr Sarkozy responded: “Don’t be accusatory of us. We will be reasonable, but we will be wise.”

On an earlier panel, Goldman Sachs president Gary Cohn took aim at regulators' focus on traditional institutions. In what many saw as a dig at hedge funds and other non-bank financial entities, Mr Cohn argued that regulators must look at the effect of new rules on the financial system as a whole. “In the next few years, the unregulated sector will grow at an exponential rate,” he said. “Risk is risk. My concern is that risk will move from the regulated, more transparent banking sector to a less regulated, more opaque sector.”

On the same panel, Standard Chartered chief executive Peter Sands also expressed concern about the approach of the regulators. “It is not clear why some regulators who were there before the crisis should believe they now have all the right solutions,” he said. “The current regulatory debate is a bit like discussing having better seat belts on planes. It’s hard to argue against but when the plane crashes, it’s all a bit marginal. The real focus of regulation should be on making the air traffic control system safe.”

Peter Sands, CEO, Standard Chartered

Peter Sands, CEO, Standard Chartered

Discussion about the ramifications of the emerging regulatory regime continued at a lunch hosted by Credit Suisse. The panellists – Jaime Caruana, general manager of the Bank for International Settlements (BIS), Philipp Hildebrand, head of the Swiss National Bank, and Larry Summers, until recently US president Barack Obama's chief economic advisor – were moderated by Gillian Tett of the Financial Times

During the discussion, which took in the merits of macro-prudential regulation and measures to counter pro-cyclicality, Mr Summers urged caution about imposing excessive capital charges on banks. There was a danger, he suggested, that Basel III could make banks too risk-averse to play a useful role in driving economic growth. “The world is more likely to suffer from excessive risk-aversion over the coming years, rather than insufficient risk-aversion,” he said.

...Or getting it wrong

Excessive risk-aversion emerged as a persistent theme at Davos – with bankers arguing that avoiding over-regulation is of critical importance to the outlook for global economic growth. At the lunch, Mr Caruana of BIS, the body that oversaw the drafting of the new global capital standards, argued that the phasing-in of new capital requirements through to 2019 would safeguard against this. “The slow process means [the new rules] will have a low impact on growth,” he said.

There are other regulatory perils along the way. Mr Summers warned that regulators aiming to reduce systemic risk must avoid introducing "Maginot Line risk", invoking the massive system of defences that became famous for failing to stop a German invasion during the Second World War. He said: “That which is being defended is indeed impregnable, but not difficult to circumvent.”

Mr Hildebrand, who heads the Swiss bank regulator that has pushed through one of the world’s most robust responses to the financial crisis, also had something to say on circumnavigation. When asked by Ms Tett how he approaches regulatory complexity, his answer was to keep it simple. That is why Switzerland did not follow the US in implementing something similar to the Volcker Rule – which bans proprietary trading at banks – but instead focused on enforcing adequate capitalisation in a bid to get banks to adequately price risk. “We did not want to micro-manage the system. If you try to ban something, it will take someone a week to find a way round it,” he said.

In the corridors of the congress hall at Davos, many bankers bemoaned the lack of clarity around rules and the emerging divergence between different regulatory packages being put together in various jurisdictions. Mr Hildebrand acknowledged the dangers – both for banks and for investment in the sector. “The uncertainty around an incomplete regulatory project is really what is damaging the rebuilding of confidence,” he said. “Even if the rules are tough, once they are clear and they are clear what they mean to the banks, they will adjust to it.”

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