Welsh Conservatives in the European Parliament
Dr Kay Swinburne MEP

Global Imbalances, International Monetary Policy and Global Governance 10.06.10

One of Dr Kay Swinburne MEP's latest papers which recently received cross-party support;

Thematic Paper: Global Imbalances, International Monetary
Policy and Global Governance – their role in the financial crisis
and impact on future policy framework

It is understood that three of the main contributing factors to the current financial crisis are
global imbalances, regulatory governance and monetary policy. The purpose of this report is
to examine the effects of these factors and propose measures to bolster the financial system
against a future shock of this magnitude.

This is not to suggest that the credit crisis can be attributed to deficiencies in these three
areas alone. Indeed a multitude of other effects and imbalances also impacted on the
situation including: fiscal policies in some countries, bank bonus structures, rating agency
deficiencies and over-reliance on mathematical risk models amongst others. The interplay
between all these factors is highly non-trivial ex-post let alone in any ex-ante analysis that
could have preceded the crisis. Further, it would seem that it is the combination of
deficiencies and asymmetries inherent in the financial and oversight system that drove the
system to failure. For this reason we take the top down approach, examining the three areas
mentioned but remain cognisant that while this is necessary, it is not in itself sufficient.
Globalisation – a key driver of the crisis?

The credit crisis of 2007/9 can be considered to be the first crisis of globalisation, attributed
as such due both to its causes and to the spread of its effects. In this case it is worthwhile
briefly considering the historical perspective from which this problem evolved.

1995 was the year that China joined the WTO and marked a major step forward in
globalisation. Indeed from 1996 onwards China’s current account surplus has increased
every year up to the crisis, with the exception of the 2001/2002 recession, reflecting rapid
export growth and relocation of manufacturing via foreign direct investment (FDI).
By this year, interest rate setting authorities in the most major economies had converged on
the policy of using the overnight target rate as the sole control mechanism to combat
inflation which was typically measured on a basket of goods and services in each economy.
Previous policies, for example in the 1980’s in the US, had targeted monetary aggregates
which reflect credit growth or as in the UK, a target exchange rate. These had proven
inadequate in stabilising inflation, considered necessary for minimising the output gap and
hence optimising economic activity. This policy continued till the dawn of the current crisis
where emergency measures such as quantitative easing were employed. Monetary policy
was therefore a strong contributory factor to the development of the crisis.

Late 1997 saw the financial crisis of the South East Asian countries. So-called “hot money”
was rapidly being withdrawn from the area and ASEAN governments spent their foreign
exchange reserves trying to maintain the foreign exchange peg to the US dollar in the midst
of this capital flight. When this failed and currencies were forced to float, the effect was
disastrous for the area. GDP fell by over 30% in USD terms in 1998 with Thailand, South
Korea and Indonesia being most affected. The area witnessed collapsing currencies,
widespread bankruptcies, plunging asset prices (particularly in real estate) and social unrest.
By comparison China, which also pegged its currency to the USD at a rate of 8.3 Renminbi
(RMB) to the dollar, was largely insulated from the problems of its neighbours due to two
main factors. Firstly the Renminbi was not convertible and secondly, FDI into China at that
time was in manufacturing facilities and not securities which could be monetised quickly.
China’s current position may well reflect the ruinous financial and social effects on its “tiger
economy” neighbours of a combination of current account deficit, foreign currency debts and
a convertible currency. The effect and contribution of China and in particular its trade surplus
and portfolio investments, to the current crisis will be examined in more detail.
Late 1998 saw the Long Term Capital Management (“LTCM”) crisis. In many ways this
should have been considered the first crisis of globalisation and was an indication of what
was to come. The similarities with the current crisis, namely high leverage being employed,
forced unwinding of positions in an unfavourable market environment and a Federal Reserve
Bank of New York brokered solution to the collapse, are marked. All the world’s major
investment banks injected capital in to LTCM to prevent forced liquidations that would trigger
a domino effect to their own holdings. Merrill Lynch observed in their annual report following
the collapse, that mathematical models "may provide a greater sense of security than
warranted; therefore, reliance on these models should be limited." Following large losses on
CDO positions, valued using complex mathematical models that failed in the stresses of the
current crisis, a distressed Merrill Lynch was taken over by Bank of America in 2008. The
seeds of self destruction in both the buy side and sell side mentality as illustrated here were
also a major component in the crisis.

On the first of January 1999 the Euro was born in to a changing global landscape. Having
met the convergence criteria at date of entry some countries have enjoyed historically low
rates. It is generally accepted that the countries who benefited the most from a decrease in
interest rates are Greece, Ireland, Portugal, Spain, and Italy. These are precisely the
countries in the euro zone most exposed by the financial crisis because of imbalances in
their economies. A correction of these imbalances has not yet happened, nor has an agreed
route been found. The effect and contribution of economic imbalances within the EU need to
be examined.

Two further events frame the environment in which the crisis was generated. The first is the
stock market collapse in 2000 following the bursting of the so called “dot com” bubble. The
second is the psychological effect on the US consumer of the events of 9/11, whereby family
and home took on great importance. At the same time the Federal Reserve slashed interest
rates to 1.75% making home affordability attractive. As a result home price growth in
California, Florida and most North-Eastern states grew by 10% in 2002, the biggest annual
rise since 1980. With the stock market out of vogue following the crash, much speculative
money entered the housing market encouraged by skewed and existing fiscal policies.

Global Imbalances: Not always unwanted

It is important to define what we mean in the context of this report by an ‘imbalance’. The
word itself implies an undesirable asymmetry and an unwelcome deviation from a steady
and secure state. This is necessarily not the case and we have to distinguish between
dangerous imbalances and benign imbalances as to their impact on the global financial

Imbalances on a small scale are manifest by imperfections that exist in all markets and are
arbitraged away by market participants. Their effects are therefore transitory and the
arbitrage assumption is core to most mathematical pricing and risk models and supported in
theory by the ‘Efficient Market Hypothesis’. Similarly, interest rate setting authorities’ models
assume that by fixing the overnight rate, the entire term structure of interest rates will be
efficiently priced by the market. There is no scope for a structural imbalance in these
situations. However it will be argued that the combination of scale and statistical ‘tail events’
did in fact lead to imbalances that had a direct impact on the crisis.
On a larger scale we can consider imbalances within an economy. Examples of this are:
over-reliance on the financial sector (UK); over-reliance on the export sector at the expense
of domestic consumption (Germany, China); consumer debt levels (UK, US); and large
budget deficits/surpluses. Whilst these imbalances are not independent of the crisis, it is
considered that they impact more strongly on the ability of member states and constituent
countries to react to the crisis and as such fall outside the scope of this report. The exception
to this, as will be considered later, is the China surplus/ US deficit situation and the
accumulating surplus of oil exporting countries.

Imbalances within global financial institutions

Another large scale imbalance was found in the balance sheets of financial institutions. The
major imbalance was, somewhat counter intuitively, an imbalance in diversification. This was
accentuated by leverage. The mechanisms of how this situation arose are worthy of closer
examination in order to propose effective legislation to avoid the situation recurring.
From the late 90’s onwards there was an explosion in banking, and primarily investment
banking mergers. Size was considered a necessary pre-requisite in a globalised
environment for many reasons: the ability to provide a full service to an increasingly
globalised client base, the ability to build market share and avoid being a marginal player,
having the balance sheet to provide products and services to the biggest clients and a good
credit rating thus lowering the cost of capital amongst others. The size and number of
mergers can be illustrated with respect to the formation of Citigroup. In 1993 Travellers
Group acquired Shearson having already owned Smith Barney. In 1997 they further
acquired Salomon Brothers Inc., one of the so called ‘bulge bracket’ firms. In 1998 they
merged with Citicorp to form Citigroup, then the largest financial company in the world. To
put this in perspective, consider that the very existence of Citicorp was in doubt during the
Latin American debt crisis of the 1980’s due to its large exposures in the region. The bank
has since bought Nikko Securities as well as many retail banking companies.
This picture is paralleled by many other firms and indeed there was market pressure on
company management of smaller firms to be acquired in order to release ‘shareholder
value’. Of course, larger companies had to find large market opportunities to maintain profits
growth (other than by acquisition) and this was presented to them by the explosive growth in
the credit derivatives area from a barely existing base.

The ability to isolate and trade credit risk dovetailed neatly with the existing sovereign,
corporate and mortgage debt markets. By definition the market was huge and the number of
participants very diverse in terms of funds, hedge funds, banks, insurance companies etc.
One of the first credit instruments was a credit default swap (“CDS”). From modest roots as
a hedging tool for e.g. convertible bond traders whereby the credit risk of an issuer can be
isolated and sold to a natural buyer of credit risk (e.g. an insurance company), the use of this
exploded in to a speculative trading tool. In parallel, more complex instruments were
created, in part, due to the search for yield in a low interest rate environment.
One of the better known, a collateralised debt obligation (“CDO”), involved a basket of bonds
in which investors bought tranches with different seniority rights in terms of the payment of
coupons and principle. Complex mathematical models were developed to assess the
different properties of these tranches and ratings agencies were brought on board to
ostensibly “rubber stamp” them. In this way triple A products could be sold to conservative
investors based on a basket of low quality credit assets. Such investors were keen buyers in
the search for higher returns with a gilt edge credit rating. Further products were developed
such as synthetic CDOs whereby the tranches were not backed by a physical holding in the
bonds, but rather by a basket of CDSs, further compounding the model risk. Huge fees were
made by creating the CDO vehicle and the margin on the sale of the tranches. A steady
supply of mortgage bonds from the US were issued by government sponsored enterprises
(“GSE”) whose lending standards had also become much more lax under political pressure,
but combined with the widely held “implicit government guarantee” view, were another route
of low quality loans, dressed in the protective garments of high credit into the market. End
purchasers had little or no knowledge of the makeup of the assets underlying the investment
let alone any systemic risk between these assets and the assets of any other credit

In the face of this enormous market opportunity, all major financial institutions expanded
aggressively into credit derivatives. Management at these financial institutions have been
accused of being lax and understanding little of the risk that they were dealing in, or in many
cases, warehousing. There is substance to this view and while they cannot perhaps be
expected to understand the minutiae of complex financial mathematical models, they are
expected to understand the effects of a toxic mixture of low regulatory oversight, reduced
capital requirements (and particularly risk capital allocated to new mathematically valued
derivatives with little trading history and a large balance sheet presence), the leverage effect
of these products on the balance sheet and the spiralling compensation payouts to those
involved. Perversely, the market, seen as the ultimate arbiter of risk and value, would punish
the share price of institutions that could not keep abreast of their peers and thus limit the
incentive of management to curtail risk or make any decisions that could limit the profit
growth. Indeed, it is likely that rather than “too big to fail”, the main concern of management
was “too big to maintain profit growth”.
In this way, the balance sheet and risks of the major participants were highly aligned. The
credit products were largely sold over the counter (“OTC”) and so were not marked to market
with margin requirements. In the wake of the crisis, and particularly in the wake of the
Lehman collapse, uncertainty as to the counterparty risk each institution had incurred as a
result of no margining mechanism, led to the freezing and near collapse of the system.
This imbalance of diversification, both inter and intra company, was a major driving force in
the crisis and policy recommendations follow.

Global Imbalances: the role of saver versus borrower

The other major imbalance as alluded to earlier, and key to the ensuing crisis, was the
combination of the China current account surplus and the US current account deficit. The
presence of an imbalance per se is not in itself a problem, but rather the nature of the
On a global level, the amount of savings and the amount of lending is, by definition, a zero
sum situation. It is rational and desirable that savings flow to the best investment
opportunities in terms of productivity and risk adjusted return. This would broadly
characterise the nature of the US deficit in the 1990’s. During the technology boom which
was led by the US, productivity increased and corporate profits swelled. In a benign inflation
environment, and with open, liquid securities markets, the US witnessed large foreign capital
inflows via portfolio investments and direct investment. This environment came to a halt with
the dot-com bubble burst of early 2000. Whilst the wisdom of these investments may be
questioned in hindsight, it does not invalidate the raison d’être for these foreign capital flows.
This would constitute what we term a benign imbalance.
During the last decade significant budget surpluses have continued to amalgamate in China,
and increasingly in the oil exporting countries. The reasons for the persisting current account
surpluses in these countries and the policy prescriptions to address them are widely
recognised. In China, fiscal policy is geared towards promoting export growth and the
expense of domestic consumption. This involves domestic tax policy and a managed
exchange rate regime. The provision of a welfare system, rebalancing the tax burden
between corporate entities and individuals, and the enforcement of property and human
rights, would all contribute to greater domestic consumption while at the same time reducing
the incentive to keep saving.

Similarly, it is argued that the Renmimbi is being kept artificially low and has a distorting
effect on world trade. It is beyond the scope of this report to examine this issue but it is worth
mentioning that a stronger Renmimbi would not balance world trade unless Chinese
domestic consumption was to increase. Hence, the effect of a strengthening would be to
make other manufacturers more competitive but the extent to which other countries could
compete with the established manufacturing base and a workforce without collective
representation is not clear. On the other hand, as mentioned previously, authorities are likely
cognisant of the effect of floating currencies in the ASEAN crisis, particularly when the depth
and maturity of the currency market cannot comfortably accommodate the size and speed of
speculative flows.

Whilst not a concern at the sovereign level, the build up of low interest rate foreign currency
debt by consumers and corporates can be just as destabilising. Domestic stresses such as
inflation pressures appear to be considered a price worth paying by Chinese authorities and
thus policy prescriptions are largely an academic exercise in the context of immediate
measures that can be taken to address the current crisis.

This century another source of surplus has developed in the oil exporting countries,
attributable to the huge increase in the price of oil (as an aside, confidence in monetary
policy was bolstered by the weathering of the oil price shock without the recessionary
consequences witnessed in the 1970’s). In broad terms, these countries share the attributes
of low domestic consumption, and underdeveloped societies in terms of social security; thus
increasing the saving imperative. Furthermore the status of the US dollar as a world reserve
currency and the fact that oil is a dollar priced commodity incentivises such savings to be
held in US dollars.

Unfortunately the nature of the US deficit changed in the 21st century from a benign to a
problematic situation. Rather than portfolio and investment inflows, foreign savings inflows
were used to fund government, corporate and personal borrowings. The US went from a
balanced and short lived budget surplus at the end of the Clinton era to record deficits at the
end of the Bush presidency. The issuance of treasury debt to fund this deficit across the
maturity spectrum did not result in an increase in interest rates as might be expected, but
rather a decrease. This was largely attributable to Chinese and foreign purchases of
treasuries. This mechanism is worthy of greater scrutiny as it had secondary effects on
corporate and consumer debt with its effects spreading globally.

The US government debt market is the deepest and most liquid market in the world. Also by
definition it is denominated in the world’s reserve currency. With virtually no probability of
default it represents the ‘natural’ home for a risk adverse investor. The problem that arises is
one of scale. An efficient market theory would assume that an investor would direct
investments to the best risk adjusted return. Alternatively, in the situation where an asset
class becomes expensive relative either to fundamentals or other securities, other market
participants would be expected to arbitrage the difference.

The Chinese purchase of US debt was ongoing and in such scale that the market was
unable to stand in its way. In fact, the effect of these purchases was to push down the
interest rates across all maturities. In relative value, the interest rates of other issuers, both
sovereign and corporate was pushed down. Effectively, risk premium disappeared and
funding became cheap.

Mortgages in the US are primarily fixed rate mortgages. The rally in the long end of the curve
presaged a wave of remortgaging, freeing cash for consumer spending. Furthermore, tax
relief was, and still is, available on home loans even when the proceeds were not spent on
the home itself. In other words, there was a tax incentive to release equity, increase leverage
and sustain the debt bubble. This was one of the drivers of the real estate boom, paralleled
to varying degrees in other countries.

In the US in particular, as well as the tax incentives, government policies aimed at increasing
home ownership amongst the low paid and the loosening of the credit quality of mortgages
insured by the GSEs, exacerbated the boom. The lack of an appropriate risk premium in the
government bond markets led investors to participate in riskier markets in the search for
yield. Typically this took the form of lending to borrowers of lower credit quality and at very
high loan to value (“LTV”) ratios – even exceeding 100% in some European countries.
Securitising these loans either privately or via GSEs and their global distribution via credit
derivative structures discussed earlier, maintained a steady source of funds to the mortgage
origination market.

Interestingly, in any normal market situation one would expect the risk of a transaction to lie
with the lender. However, this has not been the case in this crisis. China has largely been
protected from the effects of the crisis and it is in both the US and China’s interests to
maintain orderly and stable treasury markets. Given the continuation of the flow of funds in
this extraordinary situation, discipline on the part of the borrower is required, either through
regulation or policy prescription.

A role in the crisis for global taxation?

To the extent that ‘perverse’ tax incentives contributed to consumer debt, debt accounting
and tax issues further encouraged corporate borrowings which would have been strong in
any case as a result of the low term structure of interest rates explained earlier. Debt
issuance at the corporate level is an attractive funding option as the servicing costs of the
debt are allowable expenses against a tax liability. There is no ‘balancing effect’ in the
issuance of equity funding.

As a result, and as it pertains to the financial sector, the last decade witnessed a perfect
storm of lowered capital requirements based on risk models that proved inadequate, typically
buying back equity in the market and cancelling it as a means to improve earnings per
share, and low tax efficient debt issuance to fund balance sheet leverage. A large proportion
of earnings were used to purchase back shares in preference to using retained earnings for
capital or distributing cash dividends to shareholders.

The cheap availability of debt, due in part to favourable tax treatment, also contributed to the
explosive rise in the private equity industry, with transaction levels in individual deals and
funds in the industry reaching record levels each year. Any policy prescription for the future
must address not only a higher capital cushion but the asymmetry in the funding solutions
available to the corporate.

To the extent that it impacts on regulation, it has been suggested that so called tax havens
have had a part in the crisis. Whilst this may merit further investigation, it is not obvious that
there is any connection. Often, SPEs, SPVs or funds will be domiciled in such locations as
the entity itself is not taxed. However any distributions to shareholders or owners in the
structures are taxable in the investor’s home tax jurisdiction. The benefit of a tax free
domicile for the fund or vehicle maximises the potential investor base and while tax liabilities
may be deferred, they are not avoided.

It is not considered that the tax free domicile of these vehicles was the driving force behind
their creation for all the reasons mentioned earlier in this report, and as such was not
instrumental in the ensuing problem. The corollary of this argument would be that all the
world’s major financial institutions were acting in concert to construct tax avoidance schemes
of global proportions, which is simply not credible. Hence this report has no
recommendations to do with tax havens as it pertains to the causes and effects of the
financial crisis and any tax avoidance or tax fraud issues are better dealt with by

It has been suggested that a financial transaction tax applied within the EU, or more
beneficially on a global basis, would be a suitable response to the current crisis. However,
evidence from the UK stamp duty on share trading and other examples around the world,
would suggest that this would not deter behaviour in the financial markets. To modify trading
activity would require a punitive rate of taxation which would be impractical and inoperable
globally, across asset classes, without adversely affecting the availability of capital to the
real economy.

Monetary Policy – the low interest era

The monetary response of interest rate setting bodies to all of these developments has been
central to events globally. It has been suggested, and it is quite likely the case, that interest
rates in many countries were kept too low but this is not to suggest that central bankers did
an inadequate job. The problem lies in the strict mandate of price stability. To take the UK as
an example, this meant targeting an inflation rate of 2%. As mentioned before, the inflation
rate was measured with respect to price movements on a basket of goods and services in
the economy (CPI the consumer price index). It is necessary to define the basket in terms of
‘sticky’ prices, which have inertia in their response to the monetary climate, so that policy
does not erratically respond to short term movements in volatile prices such as energy.
Deutsche Bank Research quotes the Bank of England as stating that 25% of the CPI basket
is comprised of imported goods on which monetary policy would have little effect.
Globalisation, through lower prices of imported goods, effectively imparted price deflation on
the goods component of the basket. The policy response of low interest rates to maintain a 2
% inflation target meant that services inflation was running too high and that the economy
was therefore running faster than it should have been. This in turn contributed to the asset
price, primarily real estate, inflation witnessed in the UK.

The ECB by contrast has a two pillar strategy where it also assesses the risks to price
stability. It should be recalled that the ECB was consistently criticised during the last ten
years for too hawkish a stance on monetary policy, particularly by financial sector
economists. Even so, a tighter monetary policy was not in itself sufficient to prevent asset
price booms in some member states. The conclusion would be that monetary policy is
necessary but not sufficient to ensure price stability. However, the failure to manage other
monetary indicators such as M2/M3 monetary aggregates and exchange rate targeting
suggest that targeted policies with regard to interest rates may be needed to work alongside
monetary policy.

Monetary Policy: Subject to Inherent Modelling risks

The issue of modelling flows directly into the econometric models used to establish the
appropriate overnight interest rate. As has been documented extensively, such models do
not explicitly use inputs such as asset prices in their calculations or indeed other indicators
of imbalances specific to this crisis. Other important inputs such as the output gap, the
difference between the actual and optimal economic output, are not observable. However, it
is not suggested that central bankers blindly follow the output of a model, and in general it is
considered better to work with a well understood and simpler model, where the deficiencies
are known and qualitatively accounted for, than a complex model, with more and uncertain inputs.
It has been suggested by many that the success of monetary policy in stabilising
inflation over the past decade has owed more to the benign economic environment than to
policy success. This is not the view of this report and would recommend that monetary policy
continues to be conducted in the same established framework.

There is however a suggestion that the inflation target should be increased. A recent IMF
paper suggests that a higher target inflation rate, provided it is well communicated and kept
stable, would not affect the output gap but would mean higher average nominal interest
rates. This would provide more room for manoeuvre in a crisis using only interest rates as a
tool. It has been suggested for example, that in the absence of a zero rate floor to interest
rates, the correct policy rate in the US currently, would be 3 to 5 percentage points lower.
According to research from Deutsche Bank, a higher target inflation rate would be
accompanied by higher deviations from the target if the same standard deviations were
observed over the economic cycle. Whilst mindful of this, we would recommend that further
research be done to decide whether a higher target rate, potentially in the 2.5% - 3.5% range
would be warranted, practical and implementable, without negative consequences to
economic growth or investor confidence in the euro region.

Fiscal Policy as a tool of last resort

Fiscal policy is a tool of last resort in a crisis. As a general rule, recessions caused by crises
are relatively short lived and the time lag for the approval and implementation of policy is not
consistent with crisis. Even in the current crisis it took the US congress 12 months to pass
the stimulus bill. Furthermore, domestic fiscal policy recommendations as they pertain to
states with large deficits or surpluses are well documented, as are the political difficulties
with implementation, consequently it is recognised that these are unlikely to be implemented
in the short term and so fall outside the scope of recommendations in this report.
One exception to this would be the rise in the current account surplus of the oil exporting
countries. If one accepts that the Chinese surplus is a problem, then the combined surplus of
the oil exporting countries cannot be ignored. The difference is that the Chinese surplus has
grown in a free trade environment (with the caveat of exchange rate disagreements)
whereas the price of oil is largely manipulated by the OPEC syndicate. In any other market
this would be viewed as monopolistic behaviour and the raison d’être is to maintain a stable
oil price. Whilst the range of oil prices in the last decade from $10 to $150 per barrel may
give cause to question this, it must be recognised that pricing power should come with
responsibilities. The surpluses being accrued are a potential source of future instability and
our willingness to accept an OPEC pricing policy should be accompanied by political
pressure to invest the proceeds in establishing a social framework and stimulating domestic
demand in the OPEC countries.

In addition, given the huge macroeconomic impact of oil prices, it is questioned whether a
price setting regime set by the producers as opposed to all stake holders is appropriate.
Finally, on the issue of oil price, this report is sceptical on the suitability of financial market
participants to speculate on this commodity. The oil market is very small in comparison to
the scale of speculative capital and so very exposed to manipulation and large price
movements. This is illustrated by the general acceptance that the oil price hike from circa
$115 to $150 and back again was associated with the unwinding of oil futures contracts.
While the author of the report is very pro free markets, it again comes down to a question of
size and scale. It is proposed that the oil market is too small to easily absorb speculative
capital, and too important in economic terms to be manipulated by speculative flows.
Global Governance: the role of global institutions What has become apparent during the global
financial crisis is that the interconnectedness of the world's financial markets must be reflected
in the work of global institutions.

Organisations need to communicate effectively in crisis times and normal times in order to
ensure coordinated approaches towards regulation, monetary policy (where applicable) and
financial accounting to ensure proactive measures can be taken when markets are

G20 - The expansion of the forum from the G8 to the G20 is to be welcomed, as the breadth
of coverage reflects the global nature of the crisis and the required actions by governments.
However, discussions need to take place to ensure that agreements reached at these
summits are translated into actions agreed by all constituent members; otherwise it will
become a meaningless entity very quickly. The G20 Pittsburgh summit adopted a framework
for multilateral surveillance of macroeconomic policies, with the aim of making national
policies consistent with balanced growth and including regular consultations on commonly
agreed policies and objectives.

IMF - During the crisis the IMF's resources were tripled, however, countries still view the
available funds as a last resort and have an implied stigma attached. Proposed reforms of
the body should be implemented including: improved governance; the method of accessing
funds available and ways of building on the new crisis prevention instruments; such as the
flexible credit line and other sources of contingent financing. Beyond assisting distressed
member countries with funding and expertise during crisis situations and monitoring
multilateral policy dialogue, it has been tasked with acting as secretariat to the G20 forum in
achieving the framework detailed above by building on its existing surveillance analysis and
reporting back to the G20.

WTO -The nature of the global imbalances, particularly between the US and China would
suggest that protectionist measures witnessed so far may escalate - for example the
Chinese tyre ban by the US and the Chinese action on US poultry. The role of WTO needs
to be strengthened as an ultimate arbitrator between competing members in arising trade

IASB - The convergence of global economies, with respect to accounting standards over the
past decade, is welcomed; however, the US now needs to move permanently to adopt IAS
and the EU needs to ensure that it does not waiver from IAS in the post-crisis era.
BIS - The work of the BIS is respected and therefore supported by all major financial
centres. The recommendations from the Basel Committee on Banking Supervision,
particularly Basel II were implemented by most European Banks, although they were not
fully implemented by their US counterparts ahead of the crisis. A commitment from
regulators of all major financial centres needs to be made with respect to Basel III and its full
implementation across all jurisdictions.

Governance Issues: within the EU

The current Maastricht cap of 60% debt to GDP ratio of member states has been
systematically flouted and in the current situation has lead to instabilities in Greece with the
possibility of contagion to other member states. It seems it is not the absolute size of the
deficit in the context of the European economy that is problematic but rather the sizecompared to
the domestic economy. It is critical that member states create credible and
sustainable deficit reduction plans. Furthermore, it is critical that member states publish
financial statements that are both credible and transparent. Off balance sheet transactions,
unfunded public liabilities, labelling government spending as ‘tax credits’ to manipulate the
balance sheet are examples of so called financial engineering by governments to
deliberately mould the published public finances in a favourable light. By contrast, New
Zealand has a much more transparent policy towards public finance reporting and it is
recommended that an approach such as this be adopted to maintain investor confidence in
the euro region and better assess a member state’s ability to cope with a large magnitude

It should be acknowledged that whatever steps are taken as a result of this crisis, there will
be future economic shocks. The state is the insurer of last resort and, as such, consideration
should be given to the fiscal room for manoeuvre in the presence of a shock. Is 60% debt to
GDP - if this is adhered to - sufficiently low to withstand a future shock? An ex-post analysis
of this crisis in the terms of the debt assumed by member states and their ability to service
and reduce it needs to be carried out.
It is recognised that monetary policy within the EU is too blunt a tool, particularly in the wake
of globalisation, to address problems such as asset bubbles and financial sector imbalances.
However we have to acknowledge the destabilising effect of these factors in the ensuing
crisis. It is the recommendation of this report that research be done to identify the most
effective areas to implement a new policy to contain emerging financial imbalances. These
would almost exclusively be contingent capital triggers on the balance sheet of lenders
measured against e.g. gross lending, gross leverage, gross asset class exposure etc. This
would necessarily involve the consolidation of all subsidiaries, branches, special purpose
entities (“SPE”) and special purpose vehicles (“SPV”) in the calculation. This in itself is no
trivial task as even within Europe, the use of branches versus subsidiaries is used for
regulatory arbitrage and it is suggested than one particular American (former) investment
bank has over 7000 SPEs or SPVs.

It is recognised that some member states such as Spain had counter-cyclical balance sheet
policies in place; so-called "dynamic provisioning", and it did not fully insulate them.
However, as noted at the beginning of this report, it is the compounding effect of many
interacting imbalances that has resulted in the crisis and no one issue in isolation would be a
‘silver bullet’. Rather, it is prudent to introduce a broad range of sensible policies which
together provide a safety blanket, but any one of which is not too onerous as to disrupt the
financial system which it is in everybody’s interests to optimise.

Global Governance: Regulation of Financial Institutions

A major deficiency in the oversight system has become evident as a result of this crisis, and
opportunities for regulatory arbitrage should be minimised globally, and within the European
member states they should, where possible, be abolished. It is our opinion that the case for
a single European financial rule book is compelling, but that a lot of care should be taken in
the implementation of such a common rulebook with the creation of new European
Supervisory Authorities. In particular, the operation of these new pan-European authorities
should be free of political interference and its personnel should not be political appointments.
It is crucial that such a supervisor consist of leading operators in the field of financial
management and regulation.

Such a supervisor should, through national regulators, have the ability to impose tough
sanctions on institutions that compromise its guidelines. Too often a regulatory framework
appears to be viewed as a set of boundary conditions in which products and business are financially
engineered to operate within. In such a rapidly changing industry, adherence to
principles rather than rules is necessary, but with penalties for non-compliance.
Financial institutions are instrumental in both the cause and propagation of the crisis, and
policy recommendations need to reflect this. Global investment banks and other financial
service providers operating on a global scale need to be subject to comprehensive and
consistent regulation. Regulatory arbitrage opportunities need to be minimised and all G20
participants need to ensure a co-ordinated implementation of agreed measures. Loopholes,
which allow foreign corporations, such as the US based insurance company AIG, to operate
unregulated in European Union member states must be closed. The sharing of best practice
and knowledge between financial centres globally must be encouraged. The Colleges of
Supervisors for global companies must be made to work more effectively.
The size of financial institutions and their balance sheets have introduced the concept of ‘too
big to fail’.

EU proposals to address this include:

- Banks being required to produce a so called living will to detail their orderly
liquidation in the event of a crisis
- Increased capital requirements
- Remuneration policies within financial institutions
- Increased transparency and collateralisation of OTC derivatives trading
These need to be implemented on a global basis, on a contemporary timescale, to ensure
better regulation of global entities which pose systemic risk to the global financial system.
The current policy proposals however, do not sufficiently scrutinise the reliance of the
financial institutions and regulators on mathematical modelling. While it no doubt has a place
and has contributed to the availability of new financing channels, it has proven deficient in
crisis times. This should not be surprising for three reasons.
First, in a crisis we observe a herd mentality in financial market participants which results
from a (usually relatively short lived in terms of an economic cycle) collapse in risk appetite.
Efficient market principles, such as arbitraging market dislocations, fall by the wayside in the
drive for principle safety. This would be challenging to model.
Secondly, a crisis is by definition a ‘tail’ event in the distribution of possible market reactions.
Such tail events occur more frequently than expected by models, but are nevertheless
infrequent enough that any meaningful statistical modelling information is insufficient to
capture them. Indeed it is everyone’s desire to avoid tail events thus making it de facto a
rare event which cannot be modelled.

Finally, all financial institutions will use substantially the same models and where the risks on
their balance sheet are aligned, these models will trigger the same hedging events, at the
same time, which tests the liquidity of the underlying market and can lead to a self
reinforcing downward spiral as happened with LTCM.
This is where the size of positions has a deleterious effect and needs to be constrained. It is
not easy to imagine how a risk model can incorporate the market activities of your
competitors in the analysis. The principal policy recommendations flowing from this would be
(i) increased capital held on holdings whose values are not directly observable in a
liquid market and rely heavily on mathematical modelling
(ii) calculate capital on gross exposures. This would entail a haircut for net positions but
would recognise the effect of large exposures in unstable market conditions.
(iii) scenario analysis based on qualitative and industry/regulator agreed metrics as
opposed model based VAR or Monte Carlo analysis (iv) a capital premium on mathematically valued products
who have not been in existence for 2 economic cycles. One of the problems with credit derivatives is
that they have not been in existence for long enough to assess their behaviour
and the robustness of their valuation and risk management over a long period.


One common thread permeating all of the recommendations outlined below is the issue of
size. Size is a relative concept whether we are talking about budget deficits, balance sheet
leverage, the impact of derivatives or any other aspect of a crisis. In general, the issue of
size should be a primary consideration when assessing the risk to stability in any financial
framework, and will no doubt impact on other developments outside the scope of this report,
such as so called ‘dark pools’ and the impact of large hedge funds on market stability. In the
recommendations that follow the role of ‘size’ should be considered.

•?Too often the regulatory framework has been viewed as a set of boundary conditions
in which products and business is financially engineered to operate within. In such a
rapidly changing industry, adherence to principles rather than rules is necessary but
with penalties for non-compliance.

•?A major deficiency in the oversight system has become evident as a result of this
crisis and opportunities for regulatory arbitrage need to be minimised globally,
through firm agreement at the G20 level, and within the European Union member
states, they should, where possible, be abolished through the application of a
common rule book for financial services.

•?Loopholes which allow subsidiaries of foreign financial services to operate significant
business in the EU, unregulated, need to be closed, whilst Colleges of Supervisors
for all global firms need to ensure close supervision across all markets.

•?Risks from aligned financial sector exposures need to be identified early. The people
best placed to identify an emergent risk are the financial institutions themselves. In
an analogy of interest rate setting committees, it is proposed that the major European
financial institutions produce a bi-annual report on the current state of financial
market stability and the outlook for risks to that stability. The report would be signed
by the CEOs and CFOs of the institutions for which they would be held accountable,
and delivered to the FSB and ESRB for consideration

•?Tax incentives which favour debt financing over equity financing need to be
minimised. The problems associated with over-reliance on debt financing have
become evident, particularly for tax payers who have bailed the financial system out,
and hence any tax incentive to the extent that it is desirable at all should be focussed
on equity financing.

•?Tax policies, while still exclusively remaining the responsibility of member states,
may benefit from a more coordinated approach in order to ensure the operation of an
effective single market in financial services.

•?The size of financial institutions and their respective balance sheets have introduced
the concept of ‘too big to fail’. Proposals already made to address this, and supported
by this report are that banks are required to produce a “living will” to detail their
orderly liquidation in the event of a crisis and are required to hold increased capital.

•?Senior management and Board Members at financial institutions have demonstrated
lax control and little understanding of the risk that they were dealing in. Although not
all non-executive directors should necessarily be expected to understand the
minutiae of complex financial mathematical models, they should be expected to
understand the business model sufficiently so as to be able to provide a first stage of
regulatory oversight, to question new products and their risk management and to
assume responsibility for aligning investor and employee interests with respect to
compensation. Regulators should be tasked with monitoring knowledge and
suitability of board appointments.

•?A ban on buying back and cancelling previously issued equity needs to be
investigated as a mechanism for limiting the organic growth in financial firms. The
inability to buy back their own shares would ensure that banks have to find genuine
growth opportunities to increase earnings per share, or else retain the earnings as an
increased capital cushion. They might alternatively choose to distribute dividends
which are historically low compared to the capital allocated to bonus payments. This
would also ensure that liquidity is left in the market for other participants. Aside from
takeover opportunities, which themselves are limited by competition rules, growth in
financial firms needs to be self limiting.

•?Bank bonus culture has been a contributory factor in the search for profits at the
expense of prudence.

•?The failure to manage other monetary indicators such as M2/M3 monetary
aggregates and exchange rate targeting suggest that targeted interest rate policies
may be needed to work alongside monetary policy. Research needs to be done to
identify the most effective areas to implement this and would necessarily involve the
consolidation of all subsidiaries, branches, special purpose entities and special
purpose vehicles.

•?Member states should be required to publish financial statements that are both
credible and transparent. Off balance sheet transactions, unfunded public liabilities,
labelling government spending as ‘tax credits’ to manipulate the balance sheet
should no longer be allowed and investigation into the merits of operating a more
transparent policy towards public finance reporting along the New Zealand model is
recommended in order to maintain investor confidence, particularly in the euro
region, and allow better assessment of a member state’s ability to cope with a large
magnitude shock.

•?An ex-post analysis of this crisis in the terms of the debt assumed by each member
state and their ability to service and reduce it needs to be carried out. Each member
state should determine an appropriate debt to GDP ratio and avoid reliance on a preset
“group” criteria.

•?Consideration at a global level needs to be given to the state of the oil market which
is very exposed to manipulation and large price movements. Research needs to be
carried out into the imbalances caused by oil producing countries and the role of
global bodies such as OPEC as it is proposed that the oil market may be too small to
easily absorb speculative capital and is too important in global economic terms to be
manipulated by speculative flows.

•?Research should be carried out to determine whether a higher inflation rate target (as
proposed by IMF paper 2010) would be warranted, including whether it would be
practical and implementable without negative consequences to economic growth or
investor confidence in the euro region.

•?Recommend less reliance by financial institutions and regulators on mathematical
modelling. While it no doubt has a place and has contributed to the availability of new
and novel financing channels, it has proven deficient in crisis times. Regulators and
Board Members should be required to apply subjective judgement at times of market




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Welsh Conservatives

The European Commission has today designated European Protected Geographical Indication (PGI) status to the well-known Pembrokeshire Early Potato from West Wales.
The Pembrokeshire Early Potato was one of only three quality farm products whose applications for PGI status were approved today.
The EU PGI schemes protect product names against misuse and under these schemes more than 1200 products are already protected.
Commenting on this announcement from the European Commission today Dr Kay Swinburne MEP – who is from West Wales - said:
"I am delighted to see that this application to have "Pembrokeshire Earlies" added to the register of PGI products has been approved by the European Commission today."

"Achieving this prestigious status is a clear acknowledgment of the high-quality and distinctive produce we continue to deliver in Wales. Pembrokeshire Early Potatoes thoroughly deserve their place alongside the well-known food and drink products from right across the EU which already feature on the PGI register."


Kay was delighted to host an event to celebrate Higher Education, Science and Innovation in Wales last night in the European Parliament.  The event builds on the British Council’s “Strategic Analysis of the Welsh Higher Education Sector, Distinctive Assets”.  A number of experts spoke to share their views of Welsh HE at the event and how it can develop in the future.

In advance of the 'Fox-Hafner Report' vote on the single seat for the European Parliament, Kay and the other UK Conservative MEPs feel it is right to draw attention to the fact that the seven-year cost of the dual-seat arrangement comes to £928,000,000. Since her election to the European Parliament in 2009, Kay has strongly supported bringing the monthly Parliamentary meetings in Strasbourg to an end and therefore saving taxpayers a considerable sum of money.


Kay was delighted to meet Malala Yousafzai, who was awarded the EU's Sakharov Human Rights Prize at the European Parliament today.

Following Malala’s speech to the European Parliament, Kay said, “What an inspirational speech Malala gave to the Members of the European Parliament today. As a mother of young children myself, I hope that they can also aspire to achieve like her. Malala is an exceptional young lady who has overcome adversity by tremendous force of character and a passionate belief in the right of everybody to enjoy and benefit from education.”   


Kay was very pleased to meet with members of the Advanced Manufacturing Research Group at the European Parliament in Brussels, one of four groups set up in key Welsh research strengths to engage with EU research funds. The delegation visiting Brussels included representatives from Cardiff University, Bangor University, Swansea University and Trinity St.Davids University.

In advance of tomorrow's European Council meeting of leaders, Dr Swinburne has echoed the recommendations made in a recent report published by a number of business leaders, which highlights the importance of removing barriers to business competitiveness in Europe and getting rid of burdensome legislation by cutting EU red tape.

Last year Dr Swinburne encouraged businesses in Wales to highlight to the European Commission which over-burdensome regulations they would like to see slashed, by writing to small businesses all over Wales and asking them to tell her their red-tape problems.

Electronic cigarettes no longer face being taken off the shelves by the EU after Conservative MEPs were successful today in amending EU legislation on tobacco labelling.

Conservative MEP's led the amendment to defeat proposals that would have classified e-cigarettes as medicinal products, meaning they would have to undergo an overly burdensome and costly authorisation procedure, which would go beyond the procedures for traditional tobacco products... (Read more under 'Articles')



Welsh Conservative MEP Kay Swinburne has been sitting down with leaders in Europe's biotech field to choose the top five candidates to compete in this year's EuropaBio Most Innovative EU Biotech SME Award.

As a member of this year's judging committee, Kay is once again supporting the EuropaBio award, which has attracted applications from all three sectors of biotechnology - healthcare, industrial and agricultural, from across the EU... (Read more under 'Articles')


WELSH Conservative MEP Dr Kay Swinburne today hailed a vote in the European Parliament as a "wake-up call" in the battle to save Europe's endangered languages.

MEPs meeting in Strasbourg backed a report which calls on governments across the EU to develop action plans to encourage continued linguistic diversity.

The report, written by Corsican MEP François Alfonsi, also says governments should be "more attentive" to threats which may lead to languages becoming extinct.

Dr Swinburne, who was a shadow rapporteur for the report, has argued that Welsh can be seen as a positive example of language revitalisation which communities across the EU should follow... (Read more under 'Articles')

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