New rules of the road: a behind-the-scenes look at the U.S. European struggle over financial regulation.

• Author: Engelen, Klaus C.

President Barack Obama gave some encouraging signals ahead of the second Group of Twenty financial summit in London on April 2. Ahead of this meeting to begin repairing the shattered global financial system, he said, "We can no longer sustain twenty-first century markets with twentieth-century regulation." Obama has pressed key lawmakers to overhaul the nation's financial regulatory system to restore "accountability, transparency, and trust in our financial markets." And he has used a term that is ringing especially loudly in some German ears: "Let me be clear: The choice we face is not between some oppressive government-run economy and a chaotic and unforgiving capitalism. Rather, strong financial markets require clear rules of the road, not to hinder financial institutions, but to protect consumers and investors, and ultimately to keep those financial institutions strong."

Clear rules of the road! The new U.S. president is using the semi-official German code words for a far-reaching new framework to reform the global financial system. But the "rules of the road" that Obama brought to the G20 London meeting edge much closer to what Wall Street's battered financial industry and its still-influential political allies in Congress consider acceptable than what the Europeans--especially the Germans and the French--have in mind when talking about new "rules of the road" on global financial markets.

Under the heading "Europe's New Rules of the Road," an expert group of Germany's Social Democratic Party put forward a fourteen-point agenda to fix global finance. (See "Barely Contained Outrage: What Europeans Really Think About America's Regulatory Blunders" in the Fall 2008 issue of TIE.) Using this repair list as a guidance, German finance minister Peer Steinbruck, who chaired the group, has been working hard to get broader backing for a set of rules reflecting the lessons learned from the financial crisis that has wreaked havoc on Germany. The proposals include increased liquidity and capital reserves for financial institutions, a ban on detrimental short selling, regulation of hedge funds and private equity funds, and more transparency from sovereign wealth funds.

This global finance reform list developed by the SPD grand coalition partners is not far apart from the proposals that German Chancellor Angela Merkel presented when she hosted the Group of Eight summit in Heiligendamm in the summer of 2007. So it doesn't come as a surprise that Merkel has been accusing both Britain and the United States of "failing ... to heed her repeated warnings over the need to control hedge funds and other under-regulated sectors of the financial industry." Since then, stricter regulation for hedge funds and other pools of private capital, credit rating agencies, and offshore financial centers remains high on Merkel's repair list for global financial markets.

This became apparent at the gathering of European leaders that she hosted in Berlin on February 22 in order to hammer out a joint European position for the coming world financial summit in London. There was agreement on far-reaching reforms in core sectors of the AngloSaxon--dominated global financial industry. Perhaps as a quid pro quo for German support of a doubling of IMF financial resources, the British are now joining the French and Germans in a renewed effort to move against "uncooperative jurisdictions," meaning drying up tax havens and reining in offshore financial centers. With French President Nicolas Sarkozy on her side, Merkel has been able to get the G20's European heads of government and their finance ministers to agree on several points:

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* "[A]ll financial markets, products, and participants--including hedge funds and other private pools of capital which may pose a systematic risk--must be subjected to appropriate oversight or regulation." In Merkel's own words, "We want to make sure that in future there will be no blind spots on the world map when it comes to financial market products, market participants, and instruments."

* The year-long fight of some EU governments against under-regulated and non-transparent offshore financial centers and tax havens has to bring concrete results. As Merkel puts it, European leaders are now in agreement on "a list of uncooperative jurisdictions, and a toolbox of sanctions must be devised as soon as possible." Sanctions would cover "non-cooperation in exchanging information on tax evasion with other countries."

* The European Union will speed up providing the legal framework to regulate credit rating agencies.

Some of those high-priority reforms are already underway at the EU level. In November of last year, the EU Commission put forward a proposal for regulation of credit rating agencies. This proposal is part of a package of reforms dealing with the financial crisis that also includes proposals on solvency, capital

German Chancellor Angela Merkel has been accusing both Britain and the United States of "failing ... to heed her repeated warnings over the need to control hedge funds and other under-regulated sectors of the financial industry."

requirements, deposit guarantees, and accounting. "The new rules are designed to ensure high-quality credit ratings which are not tainted by the conflicts of interest inherent to the ratings business." Introducing the new regulation, Internal Markets Commissioner Charlie McCreevy said, "I want Europe to adopt a leading role in this area. Our proposal goes further than the rules which apply in other jurisdictions. These very exacting rules are necessary to restore the confidence of the market in the rating business in the European Union."

In presenting new legislation for credit rating agencies, the EU Commission is putting up high hurdles for those seven credit rating agencies--among them Standard & Poor's, Moody's, and Fitch--that are registered as Nationally Recognized Statistical Rating Organizations by the U.S. Securities and Exchange Commission.

The proposed new European rules for credit rating agencies include banning the agencies from providing advisory services, requiring sufficient quality information on financial instruments before releasing any rating, and publishing annual transparency reports.

A long-time proponent of free markets, McCreevy wants credit rating agencies to register to operate in the 27-nation European Union and undergo day-to-day supervision and regular inspections. He has blamed the agencies for failing to "sniff out the rot" in securitized products--in particular subprime mortgage securities in the United States that collapsed in value amid home loan defaults despite triple-A ratings. Under the terms of McCreevy's proposal, registration and supervision would be done jointly by national regulators and the Committee of European Securities Regulators--all national regulators of securities markets in the European Union. The European parliament and EU governments are still in the process of making up their minds...