TWN Info Service on Finance and Development (Mar11/06)
29 March 2011
Third World Network

Dear friends and colleagues, 

Barbados has recently tabled a paper at the World Trade Organization (WTO) that analyses what it says are the unintended consequences of some of the remedial measures taken to deal with the global financial crisis, which either contravene or could potentially contravene amongst others commitments under the WTO and the General Agreement on Trade in Services (GATS).

Below is a report on this paper.  It was published in the South-North Development Monitor (SUNS) #7116 dated 25 March 2011.

With best wishes,
Third World Network

Remedial actions to tackle crisis not WTO-compliant?
Published in SUNS #7116 dated 25 March 2011

Geneva, 24 Mar (Kanaga Raja) -- Barbados has recently tabled a paper at the World Trade Organization (WTO) that analyses what it says are the unintended consequences of some of the remedial measures taken to deal with the global financial crisis, which either contravene or could potentially contravene amongst others commitments under the WTO and the General Agreement on Trade in Services (GATS).

The paper says: "The examples of the last few years have demonstrated that it was the most systemically important countries which created the problem for the rest of the world. Developing countries therefore deserve a bigger voice in setting supervisory standards, particularly with respect to their offshore impact and foreign subsidiary/branch implications, because when systems fail, developing countries are seriously affected even though they have had little or no input in the construction of the rules or the operational guidelines of the institutions."

The paper goes on to recommend for consideration a number of possible amendments to the GATS, the Annex on Financial Services and the Understanding on Commitments in Financial Services vis-a-vis the remedial measures employed during the financial crisis, with "a view to ensuring WTO compliance".

[The Understanding is not a part of the GATS or the Legal Texts adopted and part of the Marrakesh Agreement, but only an alternative approach or modality commended as part of the Final Act of Marrakesh for the consideration of participating governments, and one that participants could use to schedule their commitments, rather than that specified in Part III of the GATS - Articles XVI, XVII and XVIII.

[It has no legal validity, excepting in respect of those who explicitly or implicitly referenced the Understanding in scheduling their financial services commitments. Only some 30 countries, including the US, made commitments referencing the Understanding in their schedules. Switzerland, in the current Doha negotiations, has proposed that all members should schedule their financial services commitments in accordance with the Understanding.

[In this light, those who entered into commitments in the Financial Services Agreement and made commitments, explicitly or implicitly, in terms of the Understanding, have to modify their schedules in accordance with the provisions of Article XXI of GATS. See Chakravarthi Raghavan (2009), "Financial Services, the WTO and Initiatives for Global Financial Reform", Background Paper for the Group of 24. -- SUNS]

The Barbados paper, in the form of a JOB document, dated 18 February 2011, and titled "Unintended Consequences of Remedial Measures taken to correct the Global Financial Crisis: Possible Implications for WTO Compliance", was presented and discussed at a meeting of the WTO Committee on Trade in Financial Services (CTFS) on 9 March, said trade officials, who added that it was also agreed at the 9 March CTFS meeting that this issue will again be on the agenda of the next CTFS meeting, whose date is yet to be fixed.

According to trade officials, this issue was first raised by Barbados at a meeting of the CTFS on 16 November 2010.

Apart from examining those measures that contravene or could potentially contravene commitments given under the WTO and the GATS, and the related Understanding, according to Barbados, the paper also deals with the medium term consequences of remedial measures from a regulatory and financial stability perspective.

[In a post on the "Naked Capitalism" blog, Matt Stoller, a fellow at the Roosevelt Institute, has brought out that the US Federal Reserve, in purportedly rescuing the financial system from the crash, had in March 2008 extended $9 trillion in credit (at more or less zero interest rates) to various banks, foreign central banks, corporations, and hedge funds. These loans were often collateralized by junk bonds. Though purportedly to rescue the banks and the US financial system, the US Fed loans were availed of by such enterprises as Harley Davidson, a motorcycle maker, and the fast-food chain McDonalds to fund payrolls or getting to cheap working capital that would be unavailable to normal corporations.

[None of such credit to commercial enterprises could fall into the category of "prudential safeguards", and when the documents are obtained, by the Fed itself disclosing it, or through right-to-information requests from private parties (as in Bloomberg news agency request to see Bear Stearns rescue documents), the subsidies involved would not only affect GATS and financial services, but also the Agreement on Subsidies and Countervailing Measures and other WTO agreements in the goods sectors. The full post by Stoller can be accessed at: y-independence-takes-another-hit. html. -- SUNS]

According to the Barbados paper, there are many lessons of the global financial crisis which it is imperative that governments and regulators take cognizance of, many of which flow from their attempts to deal with the crisis. Among these is the prospect that remedial action taken may be in contravention of international agreements, conventions and commitments given under WTO GATS. Also, it is essential that measures used to mitigate the effects of the crisis do not contain the seeds of future problems.

The paper notes that while most rescue packages have helped to encourage the return of stability to the system, principally by facilitating the opening of the credit markets in the short term, it is important to ensure that measures which are part of rescue programmes do not have unintended adverse consequences over the medium term, create moral hazard or encourage cross-border protectionist actions.

"In addition, the crisis has served to highlight flaws in the global regulatory and compliance environment which hamper the implementation of corrective measures and in some cases make them open to challenge. Unless it is assumed that such problems will never again recur, they point to a need to review some aspects of the global rules including WTO GATS rules within which countries operate, so as to permit remedial measures to be implemented without running the risk of having them viewed as contraventions of commitments."

According to the paper, many countries have introduced a number of new regulatory measures governing banks and investment houses in an effort to protect depositors and investors. "Many of these remedial measures may well be in contravention of the standstill provisions contained in the Understanding in the case of those countries which have agreed to such commitments."

One remedial measure put in place in the aftermath of the crisis was the banning of naked short selling - a measure put in place in May 2010 by a European country regulator, when it enacted a ban of naked short-selling of credit default swaps on eurozone government bonds. This intention was subsequently repeated in the Annex to the G20 report of the Seoul Meeting of November 2010.

However, says the paper, under the Understanding, a Member may not ban a highly risky financial service in banking, insurance or other financial sector if it has given commitments under the Understanding.

The new financial regulatory reform bill passed in one country in North America in May 2010 includes a provision that would force some of the biggest banks to spin off their trading in swaps into special subsidiaries or be denied access to the federal emergency lending window. There is also a strong initiative led by a well known financial expert, to make credit default swaps available only to people who own the underlying debt.

However, the paper stresses, under the Understanding, Members which have given these commitments are reneging on them if they impose limits on the types of financial services which an entity may provide.

"Issues such as large size of mega financial institutions and adequate capitalization in the financial industry need to be addressed as a matter of urgency in view of the possible medium term outcomes. While these matters have been flagged, actual corrective measures have been deferred or are scheduled for future implementation."

So far, the paper says, the increased capitalization criteria agreed in principle by the Financial Stability Board in July 2010, approved by Bank Supervisors in September 2010 and applicable from 2011 apply across the board to all institutions irrespective of size. New capital criteria for large banks have been deferred, but are intended for introduction at a later date.

"The proposed limitations may very well be in contravention of the Understanding should banks argue that this adversely affects their ability to compete," the paper underscores.

The paper also emphasizes that the issue of who supplies lender-of-last-resort facilities to the non-banks and insurance companies in a normalized environment needs to be addressed. Financial institutions not regulated at the time by eventual rescuers were bailed out by either the government or the monetary authority.

"It is accepted that official intervention was necessary at the time, since the problem was severe. However, this must be seen as a one-off development as it has the potential for compromising regulatory autonomy. There is too, the related matter of the implications of risk-taking if financial institutions begin to expect to be bailed out in difficult situations and the moral hazard consequences for the essential quality of due care - where there is expectation of a back-stop."

Takeover of financial institutions by government was never anticipated under the GATS by countries which had committed those sectors, says the paper. Yet this has occurred in several jurisdictions who are signatories to the GATS. Indeed, the involvement of Government as providers of liquidity to these institutions cannot be a legitimate option as lender-of-last-resort over the long term, where government is also the equity holder.

"It is important to guard against conflict of interest situations, where governments take equity positions in financial institutions which they bail out. This may well be in contravention of the spirit if not the letter of the GATS, which leans toward defining public financial entities as those which are not providing commercial services to the public."

Furthermore, the paper says that it is generally agreed now that incentive systems needed to be reviewed and modified in such a way that compensation reflected the risk assumed by the firm at initiation and that income and prospective returns are not converted into compensation benefits merely because bad credits have been securitized and sold before their operational soundness could be established.

"However, the regulating of salaries and incomes in these sectors could be in contravention of the spirit of the GATS for those countries which have given commitments not to limit the benefits enjoyed by financial service suppliers."

According to the Barbados paper, the role and the prominence given to risk mitigation techniques needs also to be examined. In this regard, there is a view that there needs to be stricter guidelines for risk mitigators and greater analysis of the role and criteria used in offering credit default insurance as well as stricter supervision of credit default swaps. It may be necessary to impose conditions on risk mitigation techniques so as to limit the level of risk assumed by financial institutions.

In addition, it adds, where these high risk instruments have not yet been offered, it may be prudent to prevent financial institutions from offering new instruments of which regulators do not approve. This could mean that the trading of instruments in those markets that are more highly regulated are safer, though possibly less attractive, than in other markets.

"Imposition of new conditions could have implications for commitments under the Understanding, which require that there be a standstill on obligations, and further that established entities be allowed to offer any new financial service."

"One might argue that there is a prudential carve-out," says the paper. However, the GATS Annex on Financial Services require that measures imposed must not be used as a means of "avoiding the Member's commitment or obligations under the agreement." However, an obligation not to restrict financial services in a situation where a Member wishes to do so, could be interpreted as having the intention of avoiding that obligation.

"It would seem that the wording of paragraph 2 of the GATS Annex on Financial Services may need to be amended."

The paper also addresses the notion of "too big to fail", saying that this has been a concern even prior to the crisis, but the financial crisis realized banking regulators' worst fears. The concern is that big banks might opt to exercise a lower level of care because they consider that they were too big to be allowed to fail. The new financial regulations put in place in at least one jurisdiction in 2010 include a decision to establish an entity with responsibility to check that companies are not becoming too big as to threaten financial stability and to devise means of reducing their size.

The paper says: "The question now arises as to whether the rules applicable to large mega banks should be the same as those applicable to smaller banks. Should the rules vary according to the size and level of sophistication of the entity? Many small entities were allowed to fail even though, in some cases, their offences were less severe than those of large entities which were saved. Those who committed to the Understanding may find restrictions on size are contrary to the commitments given to limit adverse affects on financial service suppliers."

The paper notes that other proposals for enhanced regulation include the suggestion for a mega-regulator which would oversee the individual regulators at the national level. "The powers of enforcement of such a mega regulator and the power to impose sanctions would need to be carefully considered, so as not to endow an institution with excessive power."

According to GATS Article XVI, governments cannot prohibit or limit the size or the total number of financial service suppliers in covered sectors. "However, under a Financial Reform Bill 2010, an oversight entity is to be set up to do exactly that in one jurisdiction, that is, to make sure that the size of banks is reduced if they appear to be becoming too large," it adds.

The paper also examines what it views as some weaknesses in the regulatory system which were highlighted by the financial crisis.

Among these are that the crisis highlighted how important it is that regulators share responsibility for cross-border supervision of financial entities. For the most part, the crisis emphasized the point that even when problems are international, bailouts tend to be national. There is a need therefore to develop clearer approaches to determining the relative responsibility of host-and-home country supervisors and in extreme cases, home-and-host country rescue initiatives.

"There seems to be a need also for international protocols to be developed so that countries are less likely to opt out of responsibility for bailouts of subsidiaries outside of their borders." An example from the Caribbean is a case which forms a useful study of the relative rights and responsibility of the parties where there are multiple cross-border financial operations. For Members that have not given commitments under the Understanding, there seems to be even less clarity as to their obligations with respect to financial support, the paper notes.

The paper further finds that there are indeed other fundamental assumptions which have been brought into question by the crisis. While it can be posited that the situation of balance of payments crisis provides an escape for Members both under IMF articles and under the WTO, permitting Members to take corrective action, there are two observations which are pertinent.

Firstly, the paper points out, Members must be permitted to take preventative measures, not merely corrective measures. Secondly, the crisis was not a balance of payments crisis, either for those countries where it originated or for most developing countries.

"It would seem therefore that these clauses, based on balance of payments problems, need to be revisited to include exit clauses which relate not only to balance of payments crises, but which include causes such as collapse of the financial system and recessionary conditions and excessive fiscal and debt burdens."

"The examples of the last few years have demonstrated that it was the most systemically important countries which created the problem for the rest of the world. Developing countries therefore deserve a bigger voice in setting supervisory standards, particularly with respect to their offshore impact and foreign subsidiary/branch implications, because when systems fail, developing countries are seriously affected even though they have had little or no input in the construction of the rules or the operational guidelines of the institutions," the paper stresses.

It has been suggested that the prudential carve-out in the GATS permits Members to take action on the grounds that such action is prudentially required. However, there are some aspects to this which bear further examination, says the paper.

In this regards, it points out that firstly, when there is an increasing number of exceptions being introduced on prudential grounds, then this may be a sign that the basic rules need to be addressed. Secondly, while the prudential carve-out may permit countries to breach their commitments; the fact is that they have breached their commitments, - albeit with permission.

It may be possible to argue that they are not in contravention of GATS, but they have reneged on the commitments given. In the case of the Understanding, it is a little more difficult for Members, since there is a proviso that their actions must not be used as a means of avoiding commitments on obligations. This may well be exactly what they wish to do in light of recent painful experiences caused by certain types of activities, it adds.

The paper underscores that it does not suggest that the remedial measures taken by various governments and regulators should not have been taken. Indeed, for the most part, they have been most effective.

"Now however, given the greater perspective resulting from a longer period of time over which to examine the issues and their impact, the opportunity offers itself to review some of these measures in the interest of building a more resilient system for the long term and a more balanced approach to regulation, which takes into account both the differing impact of both the crisis and the remedial measures on developed and developing countries."

"While it had been probably in order for the WTO to wait until the markets settled and the regulators had made the appropriate modifications to their regulatory systems before reviewing their financial services guidelines, perhaps sufficient time has now passed, and it would be possible to revisit those rules and principles in the light of the lessons of the financial crisis," it concludes.

The Barbados paper recommends a number of possible amendments to the GATS, the Annex on Financial Services and the Understanding "in light of the outcome of the remedial measures used during the crisis and with a view to ensuring WTO compliance".

Among these include:

-- Section A of the Understanding (Standstill) might usefully be amended to state that any limitations and qualifications to the commitments noted shall be limited to non-conforming measures as determined at any time by the Member as compared with the current reading which limits it to limitations and qualifications on existing non-conforming measures. Any alternative wording which achieves this would be acceptable.

-- Paragraph B. 10 (d) of the Understanding (Non-discriminatory measures) commits the Member to remove or to limit any significant adverse effects on financial service suppliers of measures which "affect adversely the ability of financial service suppliers of any other Member to operate, compete or enter the Member's market". Given the proposed higher capitalization for large entities, this may require amendment. Large banks are already arguing that the higher capitalization being proposed by the Financial Stability Board will adversely affect their ability to compete.

-- Paragraph B. 7 Understanding (New financial services) states that a Member shall permit financial service suppliers of any other Member established in its territory to offer in its territory any new financial service. This might need to be amended to give the authorities some scope to determine which services they wish to discourage, given the concern about high risk instruments such as hedge funds, short-selling activities, etc.

-- Article XI: 2 (Payments and Transfers) and XII (Restrictions to Safeguard the Balance of Payments) of the GATS may need to be amended. They permit capital controls as balance of payments safeguards or at the request of the IMF. Those conditions are related to balance of payments difficulties. Following the crisis of the past three years, balance of payments crises were rarely the cause of difficulties of capital flight. There may be a need to cite different exceptions other than balance of payment difficulties. Other possibilities could include high indebtedness, severe fiscal imbalances, financial sector instability, etc.

-- Article XVI of the GATS (Market Access) prevents limitations on the number of service suppliers or the total value of service transactions or assets. This may need to be amended, given the "too big to fail concerns" and the establishment already of an oversight body in one jurisdiction which can force financial institutions to downsize or hive off some of its activities should they become too large.

-- Under Article X: 2 of the GATS ("Emergency Safeguard Measures"), Members may withdraw a commitment only after one year of its implementation, if it is shown that the withdrawal cannot await the regular three years foreseen for such an action. However, as per Article X: 3 of the GATS, those provisions in Article X: 2 ceased to apply three years after the entry into force of the WTO Agreement. If this is the correct interpretation, then this section might need to be amended to give authorities more flexibility.

-- Article XXI: 2 (a), relating to compensation following a withdrawal of commitments, could usefully be revisited to include conditions under which this is permitted, as it could make the cost of protection and the securing of financial stability very costly. +