"Vulnerabilities to Global Growth"

The Financial Times today reports on an open letter from Charles Dallara, the head of the lobbying group representing the world’s largest financial institutions, to Gordon Brown, the UK chancellor and chairman of the IMF’s governing council, on the risks to growth.

What is fascinating, and worrisome, is that the letter doesn’t talk about the usual suspects, say lack of enough knowledge workers, or excessive regulations. Instead it focuses on global imbalances and the risk of new instruments and new players being exposed to “stress events” for the first time.

It is hard to say strongly enough how contrary this letter is to the prevailing wisdom (or is it current party line?) about the explosive growth of new financial products, like collateralized debt obligations, and the marked shift of holdings in the credit markets away from traditional, regulated players like banks to unregulated (in terms of their balance sheet) concerns, primarily hedge funds. To date, the powers that be, from Hank Paulson to the Fed, have been reassuring: innovation is good, risks are diversified, it’s a sign of confidence in the US that foreigners want to hold so much of our paper.

As we have noted (see here, here and here) this optimism is way overdone. Yes, it’s possible that things will work out fine. But financial regulators have no basis for their confident pronouncements. Federal Reserve officials, the most recent being Timothy Geithner, the president of the Federal Reserve Bank of New York (and in charge of derivatives) have consistently stressed the positive while being factual. Geithner said in a recent speech that this new world of financial innovation is outside historical experience, and the authorities lack a full view of the players and the distribution of holdings. If the regulators don’t know what is going on, how can they possibly opine with any certainty as to the safety of the system?

Similarly, the head of Harvard Management, Mohamed El-Erian, recently noted that the current pattern of global imbalances, while outside traditional economic theory, made sense. However, he further observed that they were not sustainable and while they could unwind in a orderly fashion, that wasn’t assured.

So Charles Dallara’s letter is a welcome bout of realism from a very unexpected source. No one expects a lobbyist to be the bearer of possible bad tidings. Watch whether his comments are taken seriously or brushed aside. Dallara approached the IMF and calls for an initiative among regulators, financial institutions, and major multinationals. Will the US authorities participate, or will they hold back out due to turf issues or a difference of view about the urgency of the situation?

From the FT:

There are “growing vulnerabilities to the outlook for global growth”, the head of the lobby group representing the biggest financial institutions warned on Thursday.

The International Monetary Fund should consult more closely with the private sector to address the risks, said Charles Dallara, managing director of the Institute for International Finance. In an open letter to Gordon Brown, the UK chancellor and chairman of the IMF’s governing council, Mr Dallara said “geopolitical developments and persistent global imbalances cloud the future”.

The spike in volatility since February and the decline in some asset prices likely reflect both “concerns about the outlook for the US economy” and “prospects of a return of risk aversion”.

While the development of new financial derivatives had increased liquidity and enabled greater diversification of risks, the “systemic implications of the rapid expansion of these instruments have not been tested during times of stress”.

He raised some concern about potential risks related to the “rapid growth of non-traditional participants in emerging markets” – code for hedge funds and other new investment vehicles. There was an “unusual sense of unease and anxiety amid general prosperity”.

Mr Dallara called on the IMF to “reassert its leadership” on issues of global financial stability.

Rodrigo Rato, IMF managing director, has been considering launching a multilateral consultation on financial stability and this is an idea that could be endorsed at the spring meetings in Washington this month.

Mr Dallara urged the IMF to build on recent successful public-private initiatives on risk management by holding meetings with senior figures in the banking industry.

The governing council “should engage directly from time to time with chairmen and CEOs of major financial institutions and key multinational corporations”

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