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Global Governance and Risks: Strengthening the International System through Multidimensional Cooperation

Interactive Session on Economic Governance: Instability and Systemic Risk 24 March 2011, 13.30 - 15.30 At the Stiftung Wissenschaft und Politik (SWP), Berlin, Germany
Session Description How can a well-functioning governance structure be established to deal with systemic risks and instability? The following dimensions were addressed: • Lessons learned from the financial crisis • The challenge of effective quantity and quality of risk management • The level of risk management and how the international financial architecture should be structured Key Points • • • • • Crises are always the same in the sense that they are about too much liquidity in the market and overleveraging by financial institutions. The instability of the market was a result of market failure, especially with regard to the risk models used, in relation to a government failure (pro-cyclical regulations and a lack of macro-prudential supervision). Even though there had been some reforms, e.g. Dodd-Frank Act, European system of financial supervision and Basel III, the problem of “too-big-to-fail” was not solved. To develop better risk management systems, there is a need for international cooperation, because risk management is a multistakeholder and multidimensional process. The G20 might be the right forum to establish a financial governance structure, because it is backed by the most important countries of the world.

Synopsis Already in 2004, financial experts saw strong indicators of an approaching massive crisis. Thus, it is surprising that, since the breakout of the crisis after the insolvency of Lehman Brothers in September 2008, there is still talk about how to overcome the crisis and how to implement new risk management systems in the market as well as on a supranational level to prevent a crisis or to manage the next one. The lessons learned from the crisis are that there was a failure by the market but also by governments and the governance structure. The risk models of the private financial institutions had worked badly. They relied on insufficient data (small number bias) and were too simplistic. In the end, they were not able to depict the interconnectedness of different financial sectors and thus the endogenous nature of risks. This meant that actors from different financial sectors (e.g. banking vs insurance) were hit by the same shock. Beyond that, the incentive structures within corporations fostered excessive risk-taking behaviour by traders and managers. The financial risk of higher order due to insufficiently controlled markets, e.g. dark pools, is another problem that needs to be solved. These flaws on the side of business intermingled with serious failures by governments. It was not that there were too few regulations, but rather, they worked insufficiently and had been incorrectly designed. Governments and their agencies had been too much focused on micro-prudential and too little on macroprudential supervision. The effect was pro-cyclical working regulations, e.g. Basel II and an overlooking of systemic risks. The aim of governments and financial players now is to arrive at a system of risk management that works better, but at acceptable prices. There is still no mechanism for risk management to deal with the high

volatility in a globally changing world. The actual governance structures are only a result of the crisis. Even though they are working relatively well, the question remains as to how and where a body that is capable of preventing or at least managing the next crisis should be institutionalized. Besides the G20, the Financial Stability Board is the institution that is operationally and intellectually able to deal with the future problems. A potential solution to arrive at a better risk management structure should be international cooperation by different actors from the market and the public, because risk management is a multistakeholder and multidimensional process. The fact that there are different perceptions, objectives and preferences of how risk management should be structured, is and always will be problematic for the process. Current solutions are not ideal. But due to the complexity of the market and other influential factors, an ideal solution is not possible. Experts stress that, in such a situation with high market-pressure, the fact that there is a strong will to find a common solution is a positive sign. Basel III in this respect is an important step in the right direction to stabilize the financial system. It has the potential to reduce the risk that a crisis is triggered by a scarcity of liquidity, because it defines quantitative minimum standards and in particular reduces the pro-cyclical effect that was inherent in Basel II. Also, the Dodd-Frank Act in the US and the new financial supervision architecture in the European Union that takes the macro-prudential supervision more seriously than before the crisis are viewed positively. On the other hand, there are questions which remain unanswered. The solutions and mechanisms that have been found until now do not suffice. There is as yet no solution to how to deal with important financial institutions. Thus, “too-big-to-fail” remains a significant problem. Risk models used in regulation by the financial actors still rely on past data. The crisis triggered a process of rethinking how to integrate the problem of a model switch into risk management. Even though the problem of models relying on past data will not be overcome, the risk managements have the possibility of scenario and qualitative analysis; thereby, the risk management has a broader approach. But in the end, all the discussions about the stability of the financial system are not worth much if there is no change in business ethics and culture. It is not enough to only point to the problem and then say what cannot be implemented. Constructive criticism is needed. One useful idea is to reward actors if they identify a potential systemic risk. Regarding the initial question of how a well-functioning governance structure should be constructed, participants concluded that there are too many institutions involved in designing the new international financial architecture and that these institutions, e.g. the World Bank, IMF, Financial Stability Board and Bank for International Settlements, have different approaches. Because there is no new structure without the will of governments, the G20 in cooperation with the Financial Stability Board seems to be the right institution for answering the question.

Participants Discussion Leaders Volker Deville, Executive Vice-President, Government Public-Policy, Allianz, Germany; Insurance & Asset Management Industry Agenda Council Wolfgang Hartmann, Chairman of the Executive Committee, Frankfurt Institute for Risk Management and Regulation, Germany Hans-Helmut Kotz, Senior Fellow, Center for Financial Studies, Germany Moderated by Daniela Schwarzer, Head Division EU Integration, German Institute for International and Security Affairs (SWP), Berlin Rapporteur to the Plenary Stormy-Annika Mildner, Senior Fellow in the Directing Staff, German Institute for International and Security Affairs (SWP), Berlin Disclosures This summary was prepared by Ralf Schlindwein. The views expressed are those of certain participants in the discussion and do not necessarily reflect the views of all participants or of the World Economic Forum, the German Institute for International and Security Studies or the German Federal Foreign Office. 2

Copyright 2011 World Economic Forum No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of the World Economic Forum. Keywords: risk, macroeconomic policy, financial instability If you want to know more about this event, please contact Matthias Catón, Associate Director, by e-mail at matthias.caton@weforum.org, or telephone at +41 (0)22 8691311.

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