Wanted: a new global watchdog

No doubt there will be much comparing of notes about the different approaches countries have taken to bailing out defunct financial firms. But the big financial policy issues now are: who should do what to make sure that this crisis never happens again and how should we change the rules that governments oblige banks to follow?

On the "who should do what" question (in grander terms: the regulatory architecture), Europe governments have been squaring up to each other, with the usual suspects calling for a pan-European regulator, while others, again easy to identify, argue that this would dilute national authority and competence.

You do not have to be a financial wizard to grasp that just co-ordinating within Europe will not ensure a stable financial system.

The current crisis grew out of weaknesses in the ways US mortgage lenders financed their loans.

When the US housing market crashed, fraud and poor underwriting standards endemic in that market led to the collapse in the market in parcelled-up mortgages.

Someone should have been looking at that on behalf of European taxpayers as well as those in the US, since our economies have been just as blighted as theirs.

So co-ordination and monitoring that looks across the world financial system is what is really needed.

Similarly, the ratings agencies that give seals of approval to much of what happens in credit markets were missing tricks.

When the market realised this, confidence in the ratings agencies' judgments fell and confusion reigned in bond and structured-product markets.

To restore trust, ratings agencies should be assessed and monitored by more than just the lawyerly US Securities and Exchange Commission, which has up to now been the nearest they have had for a regulator.

And whoever monitors them should have global reach and authority. Of course, there are proposals within Europe to keep tabs on ratings agencies. But clued-up and influential oversight is needed, not some new activity for European bureaucrats.

So who should play a broad international oversight role? Perhaps, the IMF or the Bank for International Settlements (the central bank of central banks)? Actually, the more astute betting may be on a new institution that reports to the appropriately named Financial Stability Forum.

Functioning as an elite club of finance ministers and central bankers, the Forum has produced illuminating reports on key issues in recent years.

It has a tiny secretariat in Basel that could possibly be expanded into a set of financial experts in a small but influential organisation. An institution with many chiefs and relatively few Indians would be advisable because it needs to be able to out-expert the experts.

On the "how should we change the rules" question, regulators have spent much of the past decade constructing with loving care an elaborate set of rules designed to ensure the total solidity of the banking system. (As a Special Adviser to the Bank of England through this period, I myself was one of the community of regulators engaged in this effort.) How sad are they now?

The main flaw in the system was to neglect whether banks could survive when short-term lending markets dried up; in other words, whether or not the banks were "liquid".

The whole framework, bearing the somewhat charmless name Basel II, revolved around the risk that bank loans would default, ignoring the risk that the banks' own ability to borrow would disappear.

Making things worse was the fact that many of the complicated, parcelled-up mortgage securities the banks were buying and selling suddenly became unsaleable.

Again, one might say the liquidity of this market fell through the floor. So Basel II Part 2 (if it ever arrives in the cinemas) will undoubtedly be full of restrictions on banks that dare to be illiquid by borrowing in undependable wholesale markets (as Northern Rock did) or by holding opaque securities, trading in which could collapse in a crisis. Liquidity will be the buzzword.

But changing complex systems of regulation is not an easy undertaking. The subtleties involved are legion, and short cuts just provide loopholes through which clever investment bankers can slip.

So it is likely that Basel II part 2 will look pretty much like the current package with the requirements on banks to hold capital beefed up and a lot of new restrictions for banks tempted to follow illiquid business models.

What progress in these directions are we likely to see coming out of the G20 summit? Some big announcement about the "who does what question" on regulatory architecture is reasonably likely.

On the nitty-gritty issue of what rules the banks should face, one may expect little of substance but plenty of noise.

William Perraudin is Professor of Finance at Imperial College Business School and a former Special Adviser to the Bank of England