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Two years ago governments saved the skin of the financial markets. Almost two years on, the same markets intimidate governments (or at least some of them) and financial reform remains incomplete, with the agenda itself still evolving. To public opinion, it appears as if nothing has changed except for the worse; governments wanting to domesticate financial markets have reformed little. Are governments now at the mercy of those that were previously begging them for help? Over the past few months, stronger public institutions are being created. The US and Europe are currently in the process of building institutions capable of supporting, and implementing, sustained reform. The history books are not yet written. It is premature to write off financial reform as a failure just yet.

Two years ago governments saved the skin of the financial markets. Today the same markets intimidate governments, or at least some of them. In Europe, the market for Greek debt has frozen and spreads between Irish and German euro-denominated debt recently reached alarming levels. Spain has succeeded in reducing its own debt spread vis-à-vis Germany but only after having made a policy U-turn. Portugal has just announced a major austerity package, hoping it will have the same effect. Even when they are not in danger of losing access to the bond market, most governments in the developed world nowadays anxiously await the pronouncements of the same rating agencies they were previously vilifying.
This abrupt change of fortune is shocking. To public opinion, it looks even more dreadful than the arrogance of those who have learned nothing in the financial crisis. It feeds the impression that nothing has changed except for the worse; that governments who had said they wanted to domesticate financial markets have produced a lot of sound and fury but reformed little; that involuntarily or deliberately public regulators have missed their chance to implement serious amendments to the rules of global finance; and that governments are now so weakened that they are at the mercy of those that were previously begging them for help.
This politically devastating view of the world fuels resentment against markets and financiers. It needs however to be qualified for two reasons. First, although no one would dare to claim ‘mission accomplished’, it is an error to think that that nothing has been done to reform finance. Second, the symmetry between governments and markets is deceptive. Let us take these questions one by one.
In a recent paper published by Bruegel, the Brussels-based think-tank, Stéphane Rottier and Nicolas Véron provide a comprehensive scoreboard of progress achieved in reforming financial regulation over the last two years, starting from the programme agreed in November 2008 at the Washington G20. They find that implementation has been indeed patchy and note the gap between items whose follow-up was assigned to strong international organizations such as the International Monetary Fund and those where there was merely a call for coordination among national authorities. But overall, the result is far from zero. Indeed, the US adopted wide-ranging financial reform in July, Europe is in the final steps of approval of its legislative package and the Basel committee where the main bank regulators meet has just given the green light to a substantial toughening of credit-risk rules.
The benchmark for this study is admittedly far from ideal. The Washington programme (which had been signed by George W. Bush) was neither very ambitious nor very well-structured. It did not aim to domesticate global finance and it was not based on a thorough-going analysis of the crisis. Under pressure to act without delay and unable at this early stage to identify key priorities for reform, governments set themselves a long and ragbag to-do list. There were no clear direction for change except across-the-board re-regulation and no sign of the more radical ideas for structural reform which emerged later in the debate, such as the so-called Volcker rule separating banks and hedge funds (which is reflected in the US legislation) or a bank crisis resolution mechanism whereby bank debt is converted semi-automatically into equity (which several countries are seriously considering). There was no mention either of the controversial subject of the size of banks and of ways to address the too-big-to-fail issue.
Almost two years on, financial reform remains incomplete and in fact the agenda itself is still evolving. This was inevitable as new, better defined priorities could only emerge from a period of reflection and debate. The downside is that clearly some momentum has been lost, especially at G20 level, as action takes place more and more at national level. Appetite for global solutions has diminished while national politics have more and more taken control of the agenda.
But one positive of actions taken over the last few months is the creation of stronger public institutions. The era when London vaunted its light-touch regulation is over. Now the US and Europe are in the process of building institutions capable of supporting, and implementing, sustained reform.
This is where the second question comes in. In pausing to reflect, have governments not missed the political opportunity to be tough? Have we inadvertently allowed financial markets to get a leg up on governments?
The power balance is certainly no longer what it was two years ago. Regulatory capture is at work again, even more forcefully perhaps are the stakes are higher. But it is not self-evident that the governments’ ability to regulate has been seriously harmed by their status as borrowers. True, Greece has virtually forfeited access to capital markets, but Germany has never borrowed at better conditions than now. True, governments depend on the bond markets’ willingness to lend, but this does not make them unable to reform the regulation of banks or derivatives. In any case, this situation does not prevent either the EU or a fortiori the G20 from regulating. So it is wrong to claim that markets have regained the upper hand, making governments powerless.
Moreover, in the same way as we have learned to distinguish between governments as shareholders and as regulators – and of course this must be done carefully because the actions of one do not necessarily coincide with the interests of the other - today we must think separately of governments as borrowers and as financial regulators. It would be unfortunate if governments requiring financial institutions to be more prudent in managing risk were at the same time asked to turn a blind eye to sovereign risk. Even if this sounds unfair, it is logical to expect rating agencies which had been lax in evaluating credit risk to now be rigorous in the evaluation of all forms of risk, including sovereign risk.
Thus the history books are not yet written, nor the victor declared. Financial reform could still go pear-shaped. But it is premature to write it off as a failure just yet.