The rhetoric was hot and the drama significant as the Group of 20 leaders gathered in London.
Theoutcome: a long declaration on climate change, workforce fairness, trade, economic stimulus, regulatory reform, accounting, International Monetary Fund authorities and funding.
Chief executives and senior leadership teams face significant challenges when interpreting this declaration. Productive economic activity requires two basic components: systemic stability (predictability in how government and economic actors function) and vision (the foundation for innovation and economic growth). Vision provides parameters for allocating resources, managing risk and, ultimately, signing individual names to audited financial statements. Today's corporate leaders must minimise non-quantifiable risks that their decisions could become fodder for tabloid sales, government inquiry, regulatory action and possibly litigation in addition to doing their day job of creating value-added for shareholders and customers and fostering economic growth.
The declaration by itself yields few clues for corporate decisions. Clarity comes instead from related puzzle pieces, including Financial Stability Forum (FSF) and G-20 Working Group reports (released on the same day as the summit), among others. This article focuses on four key directional indicators based on those puzzle pieces.
Leverage and procyclicality
Few people oppose correcting the excesses of recent years. However, financial firms exist to provide leverage so that companies can grow. Decreased leverage in the financial system therefore implies serious adjustments to the intermediation model. Decreased sensitivity to the economic cycle suggests that banks must provide steadier funding to the economy over time. All the announced initiatives taken together suggest that the rush towards cash-collateralised lending (especially through clearing house arrangements) will accelerate as policy seeks to constrain credit risk everywhere. Finally, policy will encourage reliance on deposits to mitigate liquidity risk and decreasing leverage in the system as a whole. Welcome back to the world of asset and liability management.
Strategic vision will be found on the liability side of the balance sheet, in how firms approach deposit relationships and how governments approach intermediaries' use of deposit-like instruments such as money market funds to support credit businesses. Bank regulation frameworks will be stretched to their limits if they apply asset-based standards to business strategies focused on liabilities. In addition, corporates shut out of the commercial paper market will likely rely more on banks and less on capital markets.
Increased attention (not clarity) regarding 'systemic stability'
The rush to create 'macro-prudential' or 'systemic stability' regulatory entities is now on. Regardless of the structure, global firms will not be able to opt out of this new oversight. The better question is how such regulators will approach other firms providing intermediation using different time horizons, holding periods and execution tools. Private equity, venture capital and the treasury functions of major corporations (in addition to hedge funds) could count as 'systemic' under certain circumstances. Level playing field considerations may require a broad focus. Clarity in the regulatory approach should also address whether 'stability' (insulation from volatility) or 'resilience' is the key objective. These are fundamentally different policy objectives.
Accounting still
The G-20 endorsed development of one global accounting framework. Yet within 36 hours, policy makers were moving in the opposite direction. In a richly ironic set of developments, the Financial Accounting Standards Board bowed to domestic political pressure and moved away from fair value while International Accounting Standards Board rejected EU politicians' pleas to converge with the US. Completing crisis resolution and architecture construction requires consensus on valuation for traded credit instruments. At its most basic, the debate reflects deep ambivalence regarding the consequences of providing credit through trading tools. Banks cannot have it both ways. They cannot offer traded credit products as lending or hedging solutions but seek shelter from the trading arena when liquidity dries up. The outcome of this debate will determine how credit is intermediated in the future.
Risk Management and Compliance
Risk managers must make more assessments based on risk factors that fall outside the realm of economicmodelling. The temptation exists to merge risk management and compliance functions. This should be resisted. Compliance focuses on ensuring that the firm remains on the right side of the law. Risk management focuses on ensuring that the firm delivers shareholder value without taking on excessive risk and now increasingly anticipating political and regulatory risks. The evolution of risk management after the spectacular failure of quantitative finance is a topic for another day. It is sufficient to say that compliance and risk management serve two different and complementary strategic functions whose outputs should not be muddied by merging them.
Barbara C Matthews is managing director of BCM International Regulatory Analytics LLC and a former US Treasury Attache to the EU.
