Geneva, 4 Feb (Kanaga Raja and Riaz K Tayob) — The World Trade Organization (WTO) has once again claimed that none of the root causes of the global financial crisis, which originated in the United States back in 2007, can be attributed to services trade liberalization as provided for in the General Agreement on Trade in Services (GATS), namely, the granting of market access and national treatment.

The WTO claim was made in a Background Note issued by the WTO Secretariat for a meeting Thursday of the Committee on Trade in Financial Services (CTFS).

A number of delegations privately complained that the lengthy 76-page document has landed on their desks just two days before the CTFS meeting commenced, giving them little time to read through, leave aside digest and make comments on, the document at the meeting.

Issued under the Secretariat’s own responsibility, the Note argues that for one, excesses in monetary policy or the build-up of a bubble in real estate markets, and the policies that could potentially curb the detrimental effects arising from those situations, are in no way connected to liberalization commitments undertaken by Members.

On the other hand, the paper says, malfunctions of the financial services sector in recent years seem to be more related to idiosyncrasies of the sector (e. g. search for yield, absence of due diligence, lowering of lending standards) and regulatory loopholes (e. g. regulatory arbitrage, inadequate capital and liquidity regulation, unregulated suppliers).

“Even though a large exposure to foreign financial institutions and markets may exacerbate the transmission of shocks, the crisis cannot be attributed to the involvement of foreign financial institutions per se.”

[However, there is no clear consensus view among mainstream economists in the US, whether of the “saltwater” neo-Keynesian or the “freshwater” neo-classical Chicago School varieties, on the causes of the financial crisis and the solutions to avert future ones, and much of their writings are in non-understandable jargon, posing problems for policy-makers. And according to Keynes biographer, Prof. Robert Skidelesky, in his latest book “The return of the master”, among the leading economists, only Nobel laureates Paul Krugman and Prof Joseph Stiglitz are attempting to explain the policy problems to the public and try to win them over.]

In another section of the WTO paper that focuses on particular provisions of relevance to financial services, the Secretariat says that measures that do not constitute a limitation on market access as defined by the Agreement (the GATS), nor a limitation to national treatment, fall within the realm of regulation, whose exercise is guaranteed by the GATS.

“Liberalization in the GATS sense is therefore not synonymous with deregulation of service activities,” says the paper. As a matter of fact, even within the context of comparable commitments on market access and national treatment, Members may operate completely different regulatory frameworks, ranging from leaving the services concerned unregulated to establishing stringent regulatory requirements in areas such as licensing, capital adequacy or liquidity.

[This view of the Secretariat however appears to be contrary to the WTO law as laid down by the Appellate Body. In a post on 14 January at the International Economic Law and Policy Blog, trade law academic Prof. Simon Lester has questioned the Secretariat view and said the WTO’s purpose is to discipline the inherent right of Members to regulate. Lester was commenting on a speech of the WTO Director-General, Pascal Lamy, on “Trade and Human Rights” where Lamy had made the point that “WTO’s purpose is to regulate’ trade and not to deregulate… and that the WTO aims to create a global level playing field, where fairness is the rule and where the rights of individual members are safeguarded”.

[Lester in his post said that he was not sure that use of either of these terms “regulate” or “deregulate” is particularly helpful in describing the WTO’s purpose. The recent statement by the Appellate Body in China – Publications, he adds, has been pretty good in this regard. The Appellate Body report (adopted by the DSB on 19 January) in para 222 said:

[“We read the phrase in a manner consistent with the WTO Agreement’ (in the China accession protocol and agreement) as referring to the WTO Agreement as a whole, including its Annexes. We note, in this respect, that we see the right to regulate’, in the abstract, as an inherent power enjoyed by a Member’s government, rather than a right bestowed by international treaties such as the WTO Agreement. With respect to trade, THE WTO AGREEMENT AND ITS ANNEXES INSTEAD OPERATE TO, AMONG OTHER THINGS, DISCIPLINE THE EXERCISE OF EACH MEMBER’S INHERENT POWER TO REGULATE BY REQUIRING WTO MEMBERS TO COMPLY WITH THE OBLIGATIONS THAT THEY HAVE ASSUMED THEREUNDER. When what is being regulated is trade, then the reference in the introductory clause to consistent with the WTO Agreement’ constrains the exercise of that regulatory power such that China’s regulatory measures must be shown to conform to WTO disciplines.” (portion in caps is emphasis added in the IELP post.)

[Lester adds: So it’s not that the WTO “regulates” or “deregulates” trade, but rather it “DISCIPLINES THE EXERCISE OF EACH MEMBER’S INHERENT POWER TO REGULATE (emphasis in the post).” As the Appellate Body’s statement indicates, it is governments that regulate trade. As for the WTO, rather than regulating trade, it regulates governments’ regulation of trade.

[“Of course, in restricting domestic regulation in this way, it is, to some extent, deregulating trade. Thus, you could argue that the WTO’s impact is closer to “deregulating” than “regulating.”]

In a section tracing the origins and effects of the financial crisis, as well as the policy actions that have been taken, the Secretariat paper says that the financial crisis that broke out in the most advanced markets in the summer of 2007, and that spread quickly to the rest of the world leading to a global economic crisis, was the culmination of an exceptional credit boom and an unprecedented expansion of leverage in the financial system. This had been fueled by an expansionary monetary policy in industrialized markets (particularly in the US) that led to historically low real interest rates and abundant liquidity.

A particular feature this time was that the credit boom was combined with the expansion of (riskier) lending to borrowers with little creditworthiness (the so-called “sub-prime”), the increasing use of complex financial products, a vigorous “search for yield” by investors and financial institutions, the mis-pricing of risk (which is usual in contexts of excessively low interest rates), the degradation of credit standards, and the apparent failure of regulators and supervisors to restrain excessive risk-taking, the paper adds.

Securitisation allowed the repackaging of mortgages – traditionally illiquid assets originated and held by local banks – into higher-yielding complex securities with triple-A rating. Mortgage-backed securities or more complex products based on those securities were in high demand by banks and investors around the world who were “searching for yield” in an environment characterised by low interest rates.

According to the paper, the crisis revealed that both the securitization process and the so-called “originate-and-distribute” model were mired with agency problems which blurred investors’ risk perception and prevented them from playing a disciplining role in the securitisation process.

To compensate for the lack of transparency in high-yield products, investors relied excessively on the credit ratings issued by credit rating agencies (CRAs) rather than conducting their own quality assessments, e. g. of structured finance products. Additionally, the crisis raised questions about the CRAs’ proper execution of their functions.

The growing size of the financial sector was accompanied by an increase in total system leverage, which – considered in all its forms – played an important role in driving the credit boom and in creating vulnerabilities in the financial system that have increased the severity of the crisis.

Additionally, says the paper, with the benefit of hindsight, it appears that extensive regulatory arbitrage was under way. In other words, financial institutions were transferring a large portion of financial intermediation from more-heavily-regulated-banks to non-bank financial institutions such as broker dealers, hedge funds, and structured investment vehicles (SIVs).

As a result, the run up to the crisis saw the rapid growth of off-balance sheet vehicles, which were highly leveraged and became systemically important due to their interconnectedness with many other financial institutions. At the same time, the pattern and the locus of maturity transformation was changing, creating huge and inadequately appreciated risks, the paper adds.

A growing proportion of aggregate maturity transformation had not been occurring in banks, but in the so-called “shadow banking system”, which had come to perform large-scale maturity transformation between short-term promises and much longer-term instruments held on the asset side; and in investment banks, which increasingly funded holdings of long-term maturity assets with shorter-term liabilities like repurchase agreements (repos).

Remuneration schemes based on rewarding short-term profits tended to predominate throughout the system, distorting risk management and internal controls, often to the detriment of the longer-term health of financial institutions. Additionally, risk management was complicated by the fact that certain risks are hard to quantify and measure. Inadequate accounting rules, and insufficient transparency at all levels further complicated matters.

The paper notes that although data are still scarce and not equally available across countries, the impact of the financial crisis on output and employment in the sector seems to have been immediate and significant. For example, in the US, real GDP in financial services and insurance declined for five consecutive quarters between Q4 2007 and Q4 2008 inclusive, before resuming positive growth rates in 2009.

By the same token, the financial crisis has severely hit trade in the sector, as captured by Balance-of-Payments statistics. The sharp fall in the value of financial assets following the crisis in financial markets – some US$16 trillion only in 2008 according to the McKinsey Global Institute – has translated in a steep reduction in the commissions and fees earned by resident banks, and, thus, a collapse in exports of financial services.

The international banking market has also been severely affected by the crisis. International banking activities started to reflect the tensions on bank balance sheets in the second quarter of 2008, when international bank lending fell by an unprecedented US$1.1 trillion.

The paper notes that the financial crisis does not seem to have prompted a widespread introduction of trade restrictions in financial services. With only few exceptions, most countries have maintained their policies regarding typical market access limitations (e. g. foreign equity caps, incorporation requirements). In general, policies have focused on providing support to
financial institutions in various forms, and closing regulatory loopholes that were considered to have contributed to the crisis.

According to the paper, the extent and depth of the financial crisis have prompted the reassessment of financial services regulation across the world, becoming a central topic for academics, regulators, and policy-makers.

The paper acknowledges that the scope of financial regulation and supervision is widely regarded as having been inadequate. There will certainly be an expansion in the “perimeter of regulation” in the years to come. The objective is to ensure that all systemically important activities are subject to appropriate regulation and oversight.

This concerns not only institutions that were unregulated and non-transparent, such as those constituting the so-called “shadow banking system” but, more importantly, the most regulated of all financial institutions – banks – which could escape capital regulation by using off-balance sheet special investment vehicles (SIVs).

Another issue on the agenda relates to the challenges posed by the so-called “too-big-to-fail” (TBTF) financial institutions, which have grown in the 2000s through a process of intense consolidation, not only within borders but across countries, says the paper, pointing out that the problem raised by the TBTF phenomenon is, on the one hand, one of size – the larger the bank that fails, the bigger the potential impact – and, on the other hand, one of interconnectedness – the more banks are linked by counter-party relationships and inter-bank funding, the greater the danger that the failure of one will pull down the system.

Policies to deal with this problem range from reducing interconnectedness in counter-party relationships (something which at this stage seems uncontroversial), increasing capital and liquidity requirements well above those enforced on smaller financial institutions (which also seems uncontroversial at this stage), breaking up financial institutions through antitrust
mechanisms, or a variant of the “Glass-Steagal” regime that prevailed in the US until the late 1990s.

The new regulatory and supervisory approach that seems to be emerging is likely to be more intrusive and more systemic, including not only micro- but also macro-prudential oversight. Moreover, it will require supervisors to exercise more judgement across a wide range of areas, including capital, liquidity, and stress testing, says the paper.

The paper reviews some of the regulatory initiatives put forward in different countries and fora that are likely to have significant and durable implications for the supply of financial services.

Presumably referring to what is now called the “Volcker Rule” proposals unveiled by US President Barack Obama, but yet to find endorsement and acceptance by Congress, the WTO Secretariat notes that profound changes have been recently announced by the US. The US plan consists of two parts, the first dealing with restrictions on the scope of banks’ activities. Banks that accept deposits will no longer be allowed to own, sponsor, or invest in hedge funds or private equity funds.

Nor would they be allowed to engage in proprietary trading operations for their own profit, unrelated to serving their customers (though they could presumably continue to offer investment banking for clients, such as underwriting securities, and advising on mergers).

The second part focuses on size, and aims at preventing further consolidation of the US financial system. In addition to the 10 per cent cap on national market share of deposits that has long been in place, large financial institutions operating in the US would be subject to a cap on wider forms of funding, most notably wholesale funding.

Any of these initiatives will affect the supply of financial services in national markets and beyond. The pace and direction of change are very difficult to predict at present. For example, it is not yet clear whether counter-party clearing services will be channelled through a single or multiple central counter-party clearing providers (CCPs).

Additionally, says the paper, the new requirements may reduce much of the competitive advantage of TBTF (too big to fail) institutions. For one, if an institution ceases to be considered as TBTF, and both an institution and the public perceive that, if there is a problem, the institution might be led to fail, then its products will have to be priced differently reflecting the reduced incidence of the implicit subsidy granted by the government guarantee.

Additionally, higher capital requirements may potentially affect the competitive position of these institutions, which used to be subject to relatively lighter capital requirements under Basel II, it adds.

These regulatory initiatives seem genuinely motivated by the need to avoid systemic risk, either because of excessive risk-taking by financial institutions or cross-border contagion. Such initiatives, particularly those of a clear regulatory nature, would not be hampered by the GATS.

But even if any specific measure could be considered as inconsistent with an obligation or commitment in the GATS, Members could still have recourse to the prudential carve-out, which, as explained in previous sections, recognizes the right of Members to take any measure for prudential reasons notwithstanding any other provisions of the Agreement, the paper maintains.

In a section on GATS provisions dealing with payments, transfers and capital movements, the paper recalls that the GATS contains in Article XI: 2 a general proviso to preserve the rights and obligations of common IMF/WTO Members. The Article states that nothing in the GATS “shall affect the rights and obligations” of Fund members under the Fund’s Articles, including the use of exchange actions consistent with those Articles.

The GATS deals with payments, transfers and capital movements in Articles XI (Payments and Transfers) and XII (Restrictions to Safeguard the Balance of Payments), and in footnote 8 to Article XVI (Market Access).

The paper notes that GATS obligations on payments and transfers in Article XI are based on a distinction between current transactions and capital transactions. Under Article XI, a WTO Member having undertaken specific commitments on financial services (or in any other services) is under the obligation not to impose “restrictions on international transfers and payments for current transactions relating to its specific commitments.”

The GATS does not define terms such as “payments and transfers for current transactions”, “current transactions”, “capital transactions”, “movement of capital”, or indeed “restrictions”, says the paper.

It adds that it is worth noting that some of these expressions have already been defined by the International Monetary Fund.

According to the paper, restrictions on transfers and payments for current transactions must not be maintained where a Member has made a commitment on financial services. Neither can they be inscribed as limitations in the schedule of specific commitments. In other words, a Member cannot derogate from a general obligation through its schedule of specific commitments.

Permissible measures depend on the definition to be given to the term “restriction” contained in GATS Article XI, which, however, is not further specified in the Agreement. In that regard, it is worth noting that the IMF distinguishes between restrictions on payments and transfers – including exchange restrictions – from the underlying transaction on the basis of a technical criterion: “The guiding principle in ascertaining whether a measure is a restriction on payments and transfers for current transactions under Article VIII, Section 2 [of the Fund’s Articles of Agreement], is whether it involves a direct governmental limitation on the availability or use of exchange as such.”

The Fund therefore identifies these restrictions by this technical criterion, rather than by the purposes or economic effects of the restrictions, which would be the way to identify trade restrictions only. If no such technical criterion were used, it would be almost impossible to distinguish between trade and exchange restrictions, as both may be used to achieve the same purposes and have the same economic effect.

For instance, an outright prohibition to provide a certain financial service would be a trade measure subject to scheduling under the GATS, but would not constitute a restriction on payments and transfers for that transaction, says the paper.

Highlighting the second part of Article XI: 2 of the GATS that deals with capital transactions, the paper notes that Members undertake not to impose restrictions on any capital transactions inconsistently with its specific commitments regarding those transactions, except under Article XII of the GATS (i. e. in the event of serious balance-of-payments and external financial difficulties or threat thereof) or at the request of the International Monetary Fund.

In addition, the extent of capital movements required by specific commitments is defined in footnote 8 to paragraph 1 of Article XVI of the GATS. First, if the Member undertook a commitment on the cross-border supply of a service (mode
1), “and if the cross-border movement of capital is an essential pat of the service itself, that Member is thereby committed to allow such movement of capital.”

Secondly, if the Members undertook a commitment on the supply of service through commercial presence, “it is thereby committed to allow related transfers of capital into its territory.” The term “cross-border movement of capital” used in reference to commitments under mode 1 suggests that the requirement covers both inward and outward movements of capital; whereas the expression “related transfers of capital into [its] territory” used in reference to commitments under mode 3 suggests that only capital inflows are envisaged, and not outflows (such as repatriation of capital), says the paper.

Since these minimum obligations on capital movements for modes 1 and 3 are not individually negotiated as part of the schedules, it would appear that no reservations can be introduced with regard to these obligations under these two modes. The absence of reference to the other two modes of supply (modes 2 and 4) suggests that Members would not be prevented, with regard to related commitments from restricting any associated capital movement.

In a section on the Annex on Financial Services, the paper addresses the issue of the prudential carve-out, saying that the Annex provides for a specific exception for measures taken for prudential reasons. “The scope of this exception has not yet been interpreted in WTO jurisprudence, but a few observations may nonetheless be warranted,” it adds.

For one, as in the case of other exceptions, a measure falling within the ambit of the carve-out, although inconsistent with other provisions of the GATS, would still be legally permitted. This is made clear by the expression “notwithstanding any other provisions of the Agreement” that opens the paragraph. In other words, “measures for prudential reasons” could include measures that are inconsistent with a Member’s MFN obligations, or specific commitments on financial services, says the paper.

Any measure adopted for prudential reasons is covered a priori. The “prudential reasons” mentioned are the protection of investors, depositors, policyholders or persons to whom a fiduciary duty is owed by a financial service supplier, and the preservation of the integrity and stability of the financial system. It is worth noting that this list of “prudential reasons” is only indicative, as evidenced by the term “including” that precedes it.

Other “prudential reasons” or more specific formulations or elaborations of the reasons mentioned in the carve-out are therefore possible, particularly taking into account that what might be perceived to constitute “prudential reasons” may evolve over time.

According to the paper, observers have considered that the carve-out “affords Members considerable autonomy to enact financial regulatory measures.” However, it is not an unqualified exception. Even though a measure may have been taken for prudential reasons, and may be considered a priori covered, the measure concerned shall not be used as a means of avoiding commitments or obligations under the GATS. This provision is clearly intended to avoid abuse in the use of the exception.

In a section on the Understanding on Commitments in Financial Services, the paper says the Understanding starts by imposing a standstill obligation, according to which any conditions, limitations and qualifications to the commitments made must be limited to existing non-conforming measures at the time of making those commitments. In contrast, the GATS is silent on this matter, and therefore allows Members to inscribe limitations and conditions in their schedules that represent less than the level of liberalization achieved with regard to the measure concerned.

Meanwhile, the US, in a communication, has supported a discussion within the CTFS on the effects of the financial crisis on trade in financial services. It recognized that this discussion will necessarily be qualitative in nature because of the weaknesses in services trade data, including a considerable time lag, lack of detail, poor comparability across countries and the absence of meaningful data on trade through Mode 3.

Nevertheless, it said that it may be constructive for Members to share views on the relationship between the financial crisis and measures aimed at mitigating the crisis with international trade in services.

It said that in order to facilitate this discussion, Members may wish to consider sharing experiences on any of the following issues:

— The effects of the financial crisis on exports or imports of financial services through Modes 1 and 2, and sales and purchases of financial services through Mode 3;

— The effects of the financial crisis on the operations of foreign or domestic financial services suppliers, such as changes in investment, employment, product or service mix;

— Whether these effects vary by product or service, for example, banking relative to insurance or securities; trade finance as compared to other banking services; marine, aviation and transport insurance versus other non-life services;

— The effects of government measures in support of the financial sector on trade in financial services and global financial stability.

According to trade diplomats, WTO Members on Thursday appeared to have reached a compromise in the CTFS on holding an “event” on the “global financial crisis that will discuss the pro’s and con’s of the recent bailout packages” (a full report will appear in the next issue of SUNS). +