The Global Aspects of the Financial Crisis.


Testimony by Paul N. Goldschmidt, Member of the Thomas More Institute, Director, European Commission (ret.) to the Belgian Federal Parliamentary Commission on “Globalisation” – 16th March 2010.






Chairman, Ladies and Gentleman Members of Parliament, it is an honour to testify in front of you and express my personal views on the global aspects of the Financial crisis. I will endeavour to avoid repetitions, at least on those points on which I share the views of the personalities that have already been heard by this Commission. The analysis that I will share with you is based on my professional experience which lead me, on the one hand, to work on both sides of the Atlantic and, on the other, to share my responsibilities between the private and public sector.


In my presentation, I will analyse the causes of the crisis and endeavour to draw the lessons that should guide the implementation of reforms. The aim is to avoid the recurrence of the excesses that have inexorably lead to the most serious financial and economic crisis since the 1930’s and that in turn it degenerates into a social crisis of similar magnitude.


Following, I will comment on some of the key aspects of the reform of the financial system, based on the proposals emanating from the G20, the American Congress and Administration, the European Union (and secondarily from the Lamfalussy Report on the Reform of the Belgian financial system), which are all still subject to further study, negotiation as well as legislative and regulatory procedures.




The causes of the crisis


The trigger to the financial crisis can be correctly ascribed to the bursting of the “Subprime” bubble in the United States private real estate and financial sectors, in which the doubtful (as well fraudulent) practices of actors played a key role in its spreading, initially within the financial markets at home and abroad and, subsequently, to the economy in general. It would, nevertheless, be a mistake to consider them as solely responsible.


The climate of irrational exuberance which developed, notably after the demise of the Soviet empire, contaminated progressively the entire industrialised world, exacerbating the structural imbalances that the dominating neo-liberal ideology refused to take into account. The latter was evidenced, among other features, by the “Washington consensus” implemented by the IMF, under the pressure of the United States and abetted by the other developed economies, through the blind application of the theories of the Chicago School of Economics inspired by Milton Friedman, advocating a complete liberalisation of markets. Its implementation, without any discrimination, to countries whose structures were unable to tolerate such treatment, lead to great suffering whose victims, as is the case in all crisis, were mainly the weakest elements of society.


These structural disequilibria were evidenced, among other examples, by:


-          Capital flows which exacerbated an already unsustainable deficit in the American external balances, creating enormous countervailing surpluses in China and other emerging nations or producers of basic commodities.

-          The collapse of the private savings rate in the United States and a corresponding increase in private sector indebtedness (to finance real estate investments and consumer spending).

-          The volatility of markets in general, among which those in agricultural commodities lead, in 2008, to several uprisings induced by hunger, reversing the trend to the progressive reduction of world poverty.


The objective of the American monetary authorities was to underpin consumer spending at all costs through an accommodative monetary policy conducted by Alan Greenspan. A blind faith in “the end of economic cycles” served as justification for this attitude. The prevailing ideology kept alive the myth of unlimited wealth creation while simultaneously obfuscating the reality that it was benefitting disproportionately a shrinking number of wealthy individuals. This phenomenon occurred in stages, initially to the detriment of the working classes in industrialised countries, whose income stagnated from the early 1990’s, then regressed in real terms due to the pressures of delocalisations benefitting emerging countries; thereafter, to the detriment of the middle classes which felt the pinch accelerating after the turn of the century.


One should have realised that the architecture of the world economy was fragile, and that if  a single one of its corner stones were removed, the whole edifice would collapse; that is exactly what happened with the so called “Subprime” crisis.


The responsibility for the real estate crisis should be shared in the first place with the American Administration and Congress (without reducing in the slightest the responsibilities of the actors of the financial sector), who encouraged deliberately wanton access to house ownership through the support of Fannie Mae and Freddy Mac. By allowing these institutions, that benefitted from an implicit Government guarantee, to remain notoriously undercapitalised, they were finally forced to take them into conservatorship in August 2008, doubling overnight the outstanding official debt of the United States to USD 12 trillion. This decision was all the more unavoidable that some 25% of these “agencies’” outstanding debt was owned by foreigners, in particular Central Banks and Sovereign Wealth Funds; a default would have immediately leaded to a dollar crisis and the collapse of the world financial system. Within this context, it is hardly appropriate for the American Congress to criticise the financial sector for excessive leverage.


Congress, at the bidding of the Clinton Administration, had also dismantled; back in 1999, the last remnants of the safeguards instituted in the 1930’s separating the activities of commercial and investment banks (Glass Stiegel Act); it also failed to adapt existing prudential legislation to take into account innovations that were inundating, at an ever faster pace, the financial sector. Thus, the Regulators, responsible for supervising markets through a series of independent agencies, were not able to fathom the exponential increase in risks assumed by financial operators. In  particular, the multiplication of “counterparty risk”, deriving from ever more complex structures, was obfuscated, all the more that new instruments such as “Credit Default Swaps” and other “derivative products” were developing outside of any regulatory framework, to reach, on the eve of the crisis, notional amounts estimated at some 600 trillion dollars.


This failure of the Legislator and of the Administration was repeated on these shores of the Atlantic, even if it took different forms. Within the European Union, it is especially the fragmentation of the regulatory system which, despite the creation of the single currency, remained a national prerogative and prevented Regulators to carry out their mission correctly. In addition there was a notable lack of financial resources and of training, which seriously impaired the capacity to oversee and enforce regulation, creating a climate of impunity.


Belgium offers, in this regard, a textbook example: le commitments of the four large financial institutions rescued by the State in the autumn of 2008 were equivalent to 5 times the GNP of the country. The majority of these commitments represented counterparty risks located abroad, that is to say largely outside of the reach of the Belgian Regulator. Despite a concentration of some 80% of EU banking assets in the hands of fewer than 50 institutions operating trans-nationally, there was no “burden sharing” mechanism in place in the event that one of them got into trouble. Therefore, as explained by the Minister of Finance, Belgium was compelled to intervene on its own and to give its guarantee to the ECB to allow the Central Bank to fund Fortis to the tune of € 60 billion to avoid default.


Regulators have, nevertheless, also their share of responsibility in the crisis. They often adopted narrow corporatist positions aiming at protecting their privileged status to the detriment of exercising efficiently their mandate. The structural flaws of the financial systems’ architecture were an ideal excuse; it also made them more vulnerable to pressures exercised by the institutions that they were supposed to supervise.


In addition to the doubtful – if not fraudulent – practices already mentioned both in the United States and in Europe (as evidenced by the law suits against distributors of toxic securities sold in violation of national and European Directives), the main criticism that can be levied against the financial institutions is their flagrant lack of competence, in particular at the level of operating management but also of the Boards of Directors, whose irresponsible behaviour was sustained by insatiable greed. Thus, compensation policies were implemented which acquired an all the more obscene character that they deliberately encouraged taking excessive risks – often not well understood – where profits would accrue to the few while losses, after the bubble burst, had to be absorbed generally by the shareholder, often by lower echelon employees victims of enforced restructuring and ultimately, by the tax payer.


In addition to the Legislator, the Regulator and the financial intermediary, one should not totally exonerate the consumer from his share of responsibility. I am referring to the excessive indebtedness assumed to finance consumer spending as well as speculative risk taking often incompatible with the financial means of the individual; this should not be confused with the setbacks suffered by thousands of prudent – or badly advised – savers and by workers losing their jobs as a direct result of the excesses created by the system.


I shall conclude this first section of my presentation by suggesting that the crisis was essentially due to excessive indebtedness of the private sector where a domino effect took hold following the eminently foreseeable defaults that took place in the subprime sector of the American real estate market. The “securitisation” of mortgage claims had lead to the illusion of a wide dissemination of the risks involved as well as to their gross underestimation. But the opacity of the financial structures, often in pyramidal form, created a feeling of distrust once a large number of house owners proved to be insolvent. Initially this translated into a drying up of the liquidity of mortgage backed securities rendering their valuation meaningless. Banks, including many European ones, who had accumulated large positions largely financed in the money market in order to increase the profitability, found it increasingly difficult to refinance their investments. Monetary authorities were obliged to substitute themselves to the “interbank” market and provide directly the necessary funds, a duty that they performed unfailingly, starting in August 2007.


The taking into conservatorship of Fannie Mae and Freddie Mac in August 2008 followed shortly by the bankruptcy of Lehman Brothers and the rescue of AIG, brought the financial system to the edge of collapse and lead to a recession of an exceptional intensity. To avoid that it would degenerate into a depression through an excessively rapid contraction of credit, governments substituted a significant part of the deleveraging imposed on the private sector (banks and consumers) by increasing public sector borrowings to finance vast economic stimulus plans as well as exploding budget deficits.


This situation means that the global economic system remains today “excessively indebted” and that the necessary adjustments lie still ahead.


If I have not spared the role of either Politicians or Regulators in my evaluation of the root causes of the crisis, it is, nevertheless appropriate to recognise the determination with which monetary authorities and Governments intervened starting August 2007 for the former and in the fall of 2008 for the latter. The rescuing of the banking sector and the implementation of stimulus programs were able to avert the collapse of the financial system. By doing so, the responsible authorities have bought themselves a short respite, in order to put into place a new architecture for a global financial system. This respite will be short lived. To date, the signals given to the market are not particularly encouraging despite the urgency which was underscored by Governor Quaden in the recent annual report of the Belgian National Bank. It is to this subject that I would like to turn in the second part of my presentation.









The reform of the financial system


In the aftermath of the Lehman bankruptcy and its immediate consequences, the European Union, under French Presidency, took a series of energetic initiatives to coordinate the management of the crisis. It lead to the mobilisation of the G20 which, for the first time, invited to the negotiating table emerging market countries whose importance had become too great to ignore. In parallel, coordination within the EU was also initiated and the Commission was mandated to make legislative proposals to reinforce the regulatory framework of the European financial system. The United States, after a delay due to the change of Administration, after the election of President Obama, launched a series of initiatives with similar objectives.


If the initiative of President Sarkosy deserves to be commended, one should, however, deplore that the method he chose had pernicious secondary effects insofar as it reinforced the “intergovernmental” tendencies of European integration to the detriment of its federal character. In so doing, it marginalised the action of the Commission which was nearing the end of its mandate and had remained on the sidelines of the debate. Indeed, each Member State was invited to initiate its own stimulus measures which, even though circumstances differed from one country to another, did not foster progress towards a better coordination of economic policies. Furthermore, at G20 level, the Union was represented by its largest Members acting in their own interests, the Commission representing the other Members collectively. Such a structure was not conducive to reinforce the weight of the Union on the international scene, where the capacity to talk with a single voice is so fundamental.


This “intergovernmental” bias was immediately reflected in the approach contained in the de Larosière Report which presented, as early as February 2009, its recommendations for redesigning the financial system which were immediately endorsed by the European Council and picked up, with only minor changes, by the Commission. As I wrote immediately after its publication, I believed that the Report lacked ambition because:


-          The Report amounts essentially to an in depth updating of the Lamfalussy Framework without reconsidering the fundamental intergovernmental character of its architecture despite the fact that it has been identified as its main weakness. The intricacies of the suggested procedures augur future operational difficulties in a domain where speed of reaction can prove to be of the essence. In this way, the reforms may contain already the seeds of a future crisis.


-          This time around, however, witnessing the inefficiencies of the existing structures, it is hard to invoke the type of excuses used in 2002. The degree of systemic risk created by large participants in financial markets, and the fluidity of transmission mechanisms through the financial system have demonstrated, beyond any possible doubt, the interdependence of national financial markets and their inability to manage a crisis situation in isolation.



-          A fully integrated micro prudential regulatory/supervisory framework (even if operationally decentralised) seems equally called for, at least as far as the Eurozone is concerned. The proposed “European System of Financial Supervision” (ESFS) should benefit from a structural autonomy comparable to the European System of Central Banks. Non Eurozone Members could join the system on a voluntary basis (and would be required to do so when applying for membership). They would nevertheless be bound by minimum standards negotiated at global level and which should be incorporated into the “Acquis Communautaire”. They should also be subject to individual cooperation protocols negotiated with the ESFS to ensure the compatibility of data collection and the rule book between the ESFS and national Frameworks.


-          Such an approach is not only necessary to ensure coherence in the application and interpretation of the rules within the Eurozone, but also to promote an efficient representation of  the “second largest reserve currency” on the world stage, as per the Report’s recommendation n N° 30.”


(See Annexe 1: “The de Larosière Report: preliminary analysis and commentary” dated 1/03/2009 and Annexe 2: « Financial Supervision in Europe: Commentry on the Communication of the European Commission » dated 9/06/2009).


If the Report stopped short of recommending the creation of a single Regulator, even at Eurozone level, it was because it appeared clear that a political agreement on such a step was still out of reach. I believe, however, that, similarly to other important monetary zones (USA – China –Japan – India – Brazil), where a single currency circulates and where a single monetary policy is enforced it is indispensable to have a common regulation and a single Regulator.


It is within this context that I would like to point out some of the inconsistencies between the reform proposals emanating from the European Commission, the Obama Administration, and the G20 as well as from the Lamfalussy Report applicable to Belgium. They concern mainly the articulation of the cooperation between the European authorities, the United States, the IMF and the EU Member States charged with the surveillance of global systemic risks on the one hand and the coordination between the EU national and Union authorities, on the other. It appears indeed that both the competencies and the responsibilities for regulating and supervising markets, both at macro and micro levels are structured differently at each level. (See annexe 3: « High Level Committee on New Financial Architecture – Commentry » dated 30/06/2009).


Another weakness of the de Larosière Report concerns the structure of the proposed “European Systemic Risk Council”. Indeed, it attributes an overwhelming power to representatives of Central Banks (The ECB and its Members would have a statutory inbuilt majority) to the detriment the three new Agencies that constitute the “European System of Financial Supervision” and to the exclusion of any outside expertise. This could prove difficult to swallow by the 27 EU Member States.


Furthermore, in the description of its mandate, no account has been taken of the systemic risk that Sovereign borrowers can present for the financial system. The recent events surrounding Greece, following those involving Ireland and Iceland, have amply demonstrated the interdependence between the credit standing of a State and the solvency of the banking system. This is why a default by Greece is unimaginable because it would put into question the solvency of a number of European banks which collectively own in excess of €200 billion triggering therefore a renewed intervention by the ECB. If, despite the political sensitivity of the subject, the “sovereign” dimension of systemic risk is not integrated into the mandate of ESRC, one will end up creating an expensive structure whose credibility and efficiency will be in doubt from the outset.


Another area which the Report hardly mentions, and which conditions fundamentally the architecture of the future system, concerns the size of financial institutions and their specialisation. This question was recently brought to the fore by President Obama when he suggested reinstating the separation between commercial and investment banking activities; this has become the focus of intense debate. The unilateral approach adopted by the United States in this matter risks to severely complicate the dialogue at G2O level because a global approach is indispensable if one wishes to avoid distortions of competition which lead in turn to a restoration of protectionism. (See Annexe 4: President Obama and the Bankers” dated 17/02/2010).


The stability of the financial system should be considered as a “public asset” whose operation should be strictly regulated. It is therefore unacceptable that high risk activities should be able to compromise the solvency of institutions acting as depositories of current and savings accounts of citizens at large.


It would therefore appear sound to separate the traditional activities of commercial banks from those defined as “investment banking”, all the more because customer deposits benefit from a State guarantee. In this way one would also avoid that “proprietary trading” could benefit from cheap public funding through the mechanism of “fungibility of resources” within a single undertaking.


To ensure the long term viability of commercial banking activities, a framework of coordinated regulatory measures is needed: an adequate ratio of capital to liabilities (Solvency), an appropriate spreading of credit risks (diversification) and an assured access to funding sources (liquidity). These regulatory constraints should also address the questions of the competence of management and adequacy of procedures.


By limiting the activities of institutions that take customer deposits and by framing the type and diversity of allowable risks, one should be able to limit the solvency ratio to a level that insures an adequate return on own funds.


Liquidity played a major part in the spreading of the financial crisis and deserves a special mention: it is imperative for the future to develop a mechanism that secures the interbank market and that in turn makes recourse to Central Bank funding dissuasive. As early as October 2008, I had suggested setting up a “Clearing house” for interbank lending, where the net debit position of each participating institution would be secured by the pledge of eligible collateral. Such a system would considerably reduce the need for recourse to Central Bank funding. The Clearing House could accept “investment banks” as members who would find in such a mechanism an alternative to direct access to Central Bank funding and supervision.


Two additional remarks concerning the safety of markets are in order:


As far as financial institutions are concerned, there does not appear to be sufficient objective reasons to justify limiting their size by law, insofar as the measures mentioned here above are implemented in a coherent manner. The size factor could be taken into account as one of the elements considered in the determination of the solvency ratio as a function of the specific risk profile of the institution and of the economic environment.


The second remark concerns the manner in which governments guarantee deposits and which is at the centre of preoccupations when it comes to insulating the financial system from systemic risk. I refer to one of my earlier suggestions, recommending the instauration of a universal “bank licensing” scheme. It would impose, within the framework of each national legislation, a series of obligations on deposit taking institutions, including the “exchange of information” on accounts benefitting from a public guarantee. This measure is essentially aimed at combating fraud and would be specifically accepted by depositors, in exchange for the guarantee, as part of the procedure for opening an account. This would clearly put the responsibility on the depositors’ shoulders. Banks opting out of the licensing scheme would be clearly at a quasi insurmountable competitive disadvantage, not being able to offer any protection to customer deposits.


A last subject, on which I would like to draw attention, is the controversy that has developed since the inception of the crisis over the excessive remuneration practices within the financial sector. This has lead to some one off severe fiscal measures implemented by the French and British governments and was once again at the core of President Obama’s remarks on the distribution of huge bonuses attributable to banking profits realised last year.


The ire of public opinion, aided and abetted by the media and the populist declarations of politicians, against the obscenity of some compensation packages, is perfectly understandable and largely justified. Indeed the ordinary citizen is still feeling the full weight of the crisis (mainly through increased unemployment and deepening budget deficits which will lead to higher taxes) and finds it difficult to swallow that those who played such a major role in triggering the crisis are getting off so lightly.


However, what I find shocking in the approach of policy makers is the discriminatory measures that designate bankers and traders as scapegoats to an infuriated public opinion, bypassing in the process the equally enormous pay packages (including golden parachutes and pension rights) that are shared by many senior executives in other sectors of the economy. What is needed is a structural approach to the question of executive compensation focussing on achieving greater fairness and social justice.


The aim must be to better align the legitimate interests of the taxpayer, the shareholders and operators to avoid the privatisation of profits and socialisation of losses. Measures that protect the taxpayer against the obligation of rescuing a financial intermediary that would have taken excessive risks and whose failure could jeopardise financial stability, should be promoted.


On this subject, and as a complementary measure to those suggested heretofore, I wish to make a pragmatic proposal that would also contribute significantly to the resources of national budgets:


Considering that remunerations paid by companies that exceed a given amount acquire the characteristics of a “dividend” rather than an “operating expense”, it is justified to limit the amount of compensation that is tax deductible.


For instance, one could implement a generally applicable IFRS rule that would limit tax deductibility to an amount not exceeding 30 times the compensation of the lowest paid full time employee of an undertaking, increased by a discretionary bonus limited to €27,500, to stick with the figure considered acceptable by the French and British lawmakers.


Any cash compensation, be it in the form of bonuses, golden parachutes or retirement benefits that would exceed this amount would have to be paid from after tax earnings. Their disbursement would be subject to shareholders’ approval at the time they vote on the annual allocation of profits between dividends, bonuses and retained earnings. Nothing would prevent keeping the rules relating to the deferral of some payments and their eventual claw back; taxation at the level of the beneficiary would be assessed in the year of disbursement.


This simple measure, easily transposable into national legislations with the necessary flexibility, would be a first step in the direction of a new social and economic environment which everyone recognises is needed but for which few are willing to assume the political responsibility.




A first conclusion is to recognise the extreme complexity of the subject, whether it concerns the analysis of the causes of the crisis or the reforms of the architecture and governance of the global financial system.


It is indeed necessary to reconcile the highly technical aspects, mastered by specialists, with political imperatives which touch on extremely sensitive questions, often relating to national sovereignty. Simultaneously, one has to resist the lobbying by powerful private interest groups which strive to minimise the impact of any constraining legislation or regulation, as well as opposition from corporatist constituencies in the public sector that whish to safeguard their current status.


Two and a half years after the crisis first broke out and eighteen months after Lehman’s failure, one is still very far from a consensus on concrete reforms. The temptation of going it alone is increasing as demonstrated by the American initiatives and the difficulties to reach agreement among EU Member States. As time passes, the tendency to lower expectations will increase, unless a new crisis forces the hand of the negotiators.


A second conclusion is that there is an urgent need to strengthen considerably the training and competence of all actors in the financial markets. In particular the professionalization of the job (art?) of Regulator/Supervisor to be developed in partnership with Business Schools should be a high priority, as well as the creation of an “Order of Regulators” with its distinct rule book and governance principles. Unfortunately, to date, this question has hardly been addressed.


Thirdly, it is of vital importance that any reform provides the necessary measures to ensure enforcement of regulations, including the imposition of credible and dissuasive sanctions. This requirement reinforces significantly the argument for a single regulatory framework at EU level, because it would considerably reduce the opportunities for regulatory arbitrage and would accelerate repressive procedures when needed.


However, the greatest challenge to be faced is the day to day management of the crisis where one can notice growing tensions between the need to sustain economic activity, the mastering of budget expenditures and the preparation of appropriate “exit strategies”. These tensions which breed uncertainty are an important factor in market volatility which in turn impacts the capacity to establish a solid base for sustainable growth.


A premature tightening of monetary conditions (withdrawal of excess liquidity, removal of quantitative easing and higher interest rates) could derail the recovery and risks to push the world economy back into recession. Starting from a significantly weaker budget position compared with 2008, the possibility of having recourse to new stimulus plans appears limited, increasing the chances that such a scenario would degenerate into a depression.


On the other hand, the persistence of accommodative monetary policies, coupled with the inevitable deterioration of budget deficits (due to a lengthening of the period of handing out social benefits and further reductions in tax revenues) cannot fail to rekindle inflationary expectations.


Even if inflation does not appear today as an imminent threat, it is difficult to imagine that it will not be ultimately part of the least painful” solution in instituting a new equilibrium between the value of private assets on the one hand and the indebtedness that was incurred to finance them on the other, as well as in the process of restoring government finances through the depreciation of the accumulated public debt.


It is when it comes to making these unpalatable choices that the risks of important tensions will surface, particularly within the Eurozone, between the monetary policy conducted by the ECB, charged by Treaty with the maintenance of price stability, and economic and fiscal policies that remain the prerogative of the individual Member States. The choice is made even more difficult by the fact that the ECB may be compelled to act on “expectations”, i.e. ahead of any tangible evidence that recovery is underway.


It is therefore urgent to pursue the integration of economic policies in parallel with the reform of the financial system. Despite wide acceptance of this idea on an intellectual level by most Member States, there seems scant political will to implement it.


The EU has at its disposal all the necessary tools to promote its ideals and defend its prosperity on the world stage on the condition that it expresses itself with one voice within the international institutions (UN, IMF, IBRD, WTO, G20 etc.) as well as in bilateral negotiations with its principal partners.


The ratification of the Lisbon Treaty has considerably reinforced its powers. On this score one should applaud the first initiatives of the new Council President, Herman van Rompuy, who is demonstrating his will to create a new climate of cooperation between the Council and the Commission. His weekly lunches with the Commission President and the strong symbolic gesture performed by associating the latter to his first press conference after the recent informal Council meeting constitute promising tokens for the future. One can only deplore the lack of tact of the German Chancellor, Mrs. Merkel and of President Sarkosy, who chose to hold their own press briefing simultaneously, demonstrating the priority they continue to ascribe to an “intergovernmental” Europe. Such an attitude reinforces the position of euro-sceptics advocating a more nationalistic approach which, if it should prevail, would lead Europe inexorably to decadence and a loss of its international influence.


To paraphrase Paul Henri Spaak: “It is not too late, but it is high time”… to convince the European citizen that maintaining his privileged lifestyle and values is conditioned by a deepening of the Union’s integration in the full respect of the rights and the beliefs of each individual. Without such determined effort, in which the body politic has a crucial role to play, any hope of reforming in depth the financial system and minimising the risk of future crisis will remain a dead issue.

10:33 Écrit par Paul N. Goldschmidt 13 Ave. Victoria 1000 Bruxelles dans Général | Lien permanent | Commentaires (0) |  Facebook |

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