G20 leaders are set to meet in London for the Summit on April 2nd, with an increasingly lengthy list of regulatory and rule-concerned topics to resolve during a time of economic uncertainty. When the focus should be on economic stabilization and restoration, the focus is on economic reform, yet again.

Some economists and policymakers have called account surpluses the main culprit for the financial crisis that has unfolded over the recent months; while others, including the official position of the IMF’s chief economist, Olivier Blanchard, say that a lack of market discipline and regulation of the financial system was one of the most serious contributors to crisis. As it stands today, an increase in regulation may be due for the long-run, but short-term, resolving issues with credit markets and the money supply is likely to have far greater effect on restoring well-being to the economy.

Of course, the IMF’s actions during the late 90s may be to blame for the Asian world’s trade balances. The Fund’s programs to stabilize currencies in South Korea, Thailand and Indonesia in particular, coupled with rescue packages provided to the entire area, assisted countries in the area in building up large reserves.

The IMF says that despite an influx of capital from China and the rest of the emerging world, the real cause was not the low-interest rate boom seen, but instead the “creativity” seen in financial institutions’ ability to develop new “financial products” which were to provide higher yields and reallocate risk in fashions that were not understood. A reliance on the credit-rating industry which was both gamed and uninformed, the International Monetary Fund, directed funds to the wrong places, and placed dependence on risk premiums much lower than reality dictated.

The inability for international monetary governance, said the Fund, allowed well-capitalized and labour-ed firms to exploit both national and international regulatory laws by taking advantage of the high level of disconnect between what it calls the “shadow banking system:” hedge funds, mortgage brokers and the banking superstructure; where some forms of financial service were subject to adequate capital and documentation regulation, others were not, and could be exploited as such. By the point where the governing bodies understood exactly to the extent that these non-bank institutions were exploiting and mismanaging risk, the IMF said, much of the sector was “too big to fail.”

With this belief, the IMF has suggested to G20 leaders that it would be supporting a whole host of legislation and papers expected to be seen at the Summit. The international institution prepared an analysis for the March 13 G20 meeting, which projected a contraction of 3 to 3.5 per cent in “advanced economies,” and a world contraction of roughly 1 per cent of GDP this year; followed by a a moderate recovery in 2010. The report seriously stressed the need for countries to keep an eye on the fiscal stimulus packages to prevent deficits from getting out of hand.

The IMF was also critical of Timothy Geithner; the Treasury secretary’s financial stability plan expected to be discussed with G20 leaders — Geithner urging last week that these “advanced economies” commit 2 per cent of their GDP for the next two years to stabilize international economies. This plan, Geithner said, would be overseen by the IMF; but the IMF contributed that the plan left no explanation for how to value “toxic assets” nor how to decide which banks to assist in stability programs.

Regulatory Problems — Shadow Banking

Back to the shadow banking system that the IMF is so stringent on its regulation, these institutions in a lot of ways fully explain the so-called crisis as it unfolded; but the solution is not as simple. Institutions avoiding regulations, in this case by creating complicated derivative products which allowed non-banking financial institutions to hold capital levels, credit and liquidity risk that they would not have been otherwise able to hold, generate a profit greater than they could within the regulations: while the risk is significant, the incentives are too. While the backwards-looking expertise of the IMF does demonstrate an accurate explanation of how this happened, it provides no forward-looking assistance: uncertainty looms over technological breakthroughs, even when those so-called technologies are derivatives and financial instruments.

The creation of credit default swaps and collateralized debt obligations was neither something expected, nor something that can be explicitly rejected as bad. A credit default swap acts as insurance on debt; if a seller values the reduced risk — unless of course the seller of the CDS does not even own the asset in which case it becomes more complicated — associated with, then a CDS produces economic value. CDO’s on the other hand allow increased efficiency in credit markets, as investors can find new equilibrium along risk curves. A lack of regulation combined with a lack of understanding (or perhaps a “buyer beware” attitude) of a broad scale risk (such as the entire market defaulting) from the credit rating agencies; combine this with swaps insuring the CDOs and you’re left in a situation where this misunderstanding results in the potential for much larger losses from these derivative instruments than would be seen otherwise.

The big firms, particularly AIG, buy and sell credit default swaps on trillions in CDO’s without adequately considering that these CDO’s are, in fact, mortgage-backed securities, and the mortgage industry has been giving out mortgages in such a way that failure is inevitable. But the credit ratings are solid, and thus the estimated losses are low. Finally, we end up in a situation with insufficient provisions for losses — because the regulatory agencies don’t mandate capital minimums for insurance companies: a liquidity crisis.

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