Why the governance rules of the Financial Stability Board will not satisfy any true democrat

By Michael Prowse, Senior Visiting Fellow

Plato would have supported the Financial Stability Board (FSB) because he believed in rule by benevolent “Guardians”. He rejected democracy partly on the grounds that only an elite of knowledgeable experts can be trusted to make the “right” decisions for the rest of us.

If ever there was a sphere in which Plato’s principles might seem to apply, it would be financial markets. During the recent financial meltdown, we learned that boards of directors did not understand the derivatives and other complex products their traders were selling. In fact, it transpired that most of the traders did not understand them either.

Should we, then, leave the task of regulating global financial markets to a body such as the FSB - a self-appointed committee of “experts” from leading financial centres – or should we place our faith instead in democratic principles and argue that all those affected by its decisions (the poorest as well as the richest nations) deserve representation at its table?

The answer matters: after the G20 itself, the FSB is the most significant innovation in global financial governance in decades. For the first time, the largest financial powers have a permanent mechanism for researching, debating and designing a regulatory structure for financial markets around the world.

There is no doubt that a global economy needs common financial rules. If capital, people, and firms are free to move anywhere, different regulatory regimes imply “regulatory arbitrage”. Competition will be anything but fair and efficient because profit seeking firms locate subsidiaries wherever regulation is lightest (London grew rapidly as a financial centre in the 1970s as US banks moved offshore to escape onerous domestic regulations). The FSB’s attempt to take a global rather than national perspective thus makes a great deal of sense.

The FSB’s members are the central banks, finance ministries and financial market regulators (where these exist and matter) of the G 20 nations plus those of Switzerland, Hong Kong, Singapore, Spain and the Netherlands. Other members are trans-national institutions with financial responsibilities, including the IMF, World Bank, Bank for International Settlements (which houses the FSB), Basel Committee on Banking Supervision, and the European Commission.

The G 20 established the FSB last year as a successor body to the Financial Stability Forum. Its mandate is to assess the vulnerabilities affecting the global financial system and to identify the regulatory actions needed to address them. According to its charter, its primary goal is to promote financial stability and a level playing field for financial institutions. To this end it hopes to coordinate policy actions across different jurisdictions and sectors.

This bringing together of top regulatory minds is much to be applauded. Yet if the FSB is intended as a permanent addition to the global financial infrastructure, its governance and goals leave much to be desired.

The first question to ask is whether such a body is sufficiently representative of a diverse global economy. Some will say the number of participants must be limited or serious debate will be impossible. In practice, the G 20 plus five extra nations provides sufficient breadth to ensure that the interests of all nations are taken into account. Moreover, in a sphere as complex as global finance, democratic niceties are irrelevant: what matters is whether the reforms are coherent and improve the functioning of financial markets.

And to clinch this argument the FSB’s backers will remind critics that it is only an advisory body. Having no legal standing or powers of enforcement, its role is merely to make recommendations to the G 20 and other international bodies.

At Toronto, for instance, the FSB submitted an interim report on the regulation of systemically important financial institutions – firms such as Goldman Sachs and J P Morgan. It sought the G20’s approval of the general thrust of its work programme. The FSB, therefore, can tell those worrying about democratic deficits that it is answerable to a higher authority: the G 20. If there are any worries about democratic deficits they should be addressed to the G 20, rather than to a group of experts charged with doing its spade work.

The thrust of this argument is that so long as nation states are democracies, their citizens can overturn the decisions of unrepresentative international bodies. Lack of democracy at the trans-national level does not necessarily impair democracy at lower levels.

This is a seductive but false argument. Nations cannot opt out of the global economy. If a group of the most powerful nations agrees on certain financial rules and institutions, smaller nations will have little choice but to accept them. If the smaller, poorer nations are to exert any influence, they need a voice at an earlier stage – when the proposed new rules and structures are being debated and designed. In the financial context that means they need a place at the FSB’s table.

To say that the G 20 plus an extra five nations is sufficiently representative will not do. Few, for instance, would deny that Greece has an interest in financial stability. Yet it has no voice in FSB proceedings. Nor do nations as diverse as Poland, Ireland, Venezuela and Nigeria, let alone scores of poorer nations.

The FSB’s charter calmly asserts that its “Plenary” (at which its members take decisions) will decide whether or not to admit other jurisdictions. Is it acceptable that a self-appointed club of nations can decide unilaterally whether any other jurisdictions can have a say in financial decisions which will affect the entire global economy?

Regrettably, we do not today have any widely shared sound principles of global economic governance. We do not agree how to represent different national interests. For instance, there is no agreement on what weight to allocate to population, or to gross domestic product or to a range of other factors. The G 20 is itself an unrepresentative and self-appointed group of nations.

The IMF’s governance structure is far from ideal but it at least attempts coherently to represent the interests of 182 nations. Through the quota system (now under review) nations have decision-making power that is loosely linked to various economic criteria. In order to avoid the problem of having too many seats at the table for serious debate, many of its 24 executive directors represent groups of smaller nations. At the very least the FSB should adopt a governance structure as representative as the IMF’s.

A further unresolved problem has to do with the goals of international financial institutions. Bankers and regulators believe the FSB should have the narrow mandate of promoting financial stability, and doubtless support the nature of the demands placed on its members: that they commit themselves to financial transparency, acceptance of international regulatory standards and periodic peer review. Bodies such as the World Bank, they will argue, can be left to pursue other laudable goals such as economic development and poverty relief.

Yet since financial markets have so powerful an influence on economic growth and the distribution of its rewards, there is a case for widening the goals of a body such as the FSB. Financial stability alone is barely credible as a goal. Stability for what? Stability can be consistent with all manner of inefficient and unjust economic structures.

The FSB should be charged with promoting financial stability but subject to a proviso – that in creating new rules and regulatory standards for financial markets it must also seek to promote sustainable growth and a more equitable global economy. It needs to focus on ethical ends as well as technocratic means.