Page last updated at 23:00 GMT, Monday, 6 July 2009 00:00 UK

The challenges facing the G8

By Andrew Walker
Economics correspondent, BBC World Service

Italian Prime Minister Silvio Berlusconi (R) and Chinese President Hu Jintao arrive for the G8 meeting
The G8 has lost its monopoly on tackling global economic issues

The G8 circus has moved half way round the world - from Japan last year to Italy now. The economic problems they have to confront have moved just about as far.

At the Hokkaido Summit in Japan, they acknowledged a bit of a slowdown in economic growth but were positive about the future. They were worried about oil and food prices and inflationary pressures.

They misread the situation.

A year on as they get together at L'Aquila, and it is more than a slowdown.

In fact it was just two months after the Hokkaido summit that the financial crisis took on a new and more menacing form, with the implosion of the investment bank Lehman Brothers.

The result is that the world economy is likely to contract this year for the first time in the post-war era.

Worried about the price of oil? It is half what it was when they last met.

Inflation has vanished from view, though it could be lurking beyond the horizon due to measures taken to tackle the recession.

G8 crisis

The G8 has lost its monopoly as a forum for wrestling with global economic problems.

The financial crisis has raised the profile of the wider G20, which includes the leading developing economies, from a rather obscure gathering of finance minsters and central bankers into a high profile summit.

One area that is sure to change as a result of the crisis is financial regulation and it is G8 countries that are in the lead

But the G8 retains an important role. It was to a large extent a G8 crisis.

There is a debate to be had about the extent to which the currency policies of China and others provided the fuel for the credit firestorm.

But it was developed economies, or some of them, that struck the match.

And within the G20, the heavy lifting on many issues has been done by G8 countries.

Capital requirements

One area that is sure to change as a result of the crisis is financial regulation and it is G8 countries that are in the lead.

The reform effort is already under way in the US. President Obama has set out an extensive package of measures intended to reduce the risks of a repeat.

The debate is underway elsewhere, including in the UK, where proposals are due very soon.

Oil rig in Bahrain
Rising oil prices are no longer an issue

But some aspects will have an important international dimension, in particular the question of capital requirements for financial institutions.

Change does look likely in this area.

One of the key lessons of the financial crisis has been that many financial institutions did not have large enough financial shock absorbers to enable them to ride out the massive and unexpected losses they have accumulated.

The shock absorber is capital. The most important element is in the shape of shares and retained earnings, profits not handed out to shareholders as dividends.

The more a bank has, the larger the losses it can take before it sinks - or needs rescuing by a government lifeboat.

The chances are that banks will have to keep more capital in future relative to how much they lend.

That means either raising more from the stock market, paying out less of the profits to shareholders, or restraining the growth of new lending.

Lending worries

There is also a problem with capital requirements aggravating the economic cycle.

If a bank loses money in a recession, which eats away at its capital, one quick way of improving its capital ratio is to lend less and just salt away any loan repayments that come in.

There are not so many toxic assets on the banks' books in Canada

It has been a familiar problem in the current downturn. Banks anxious to repair their frayed safety nets have become more wary of making new loans.

The challenge then is to make bank capital requirements "counter-cyclical" in the jargon.

That is, to make them restrain booms and ease the retrenchment in the bust.

It is a nice, even obvious idea. But it is hard to do in practice.

Reform momentum

Bank capital is an issue that has already had a push from the G20, which essentially said, "let's do it once economic recovery is assured".

But it is in G8 countries that the financial system blew up, though there is one member of the group that might feel a little smug - Canada.

Jet carrying Japan's Emperor Akihito arrives in Canada
Canada has not been hit as hard as other G8 nations

It is not unscathed, but has not sustained anything like the damage that its southern neighbour has.

The reasons include the fact that Canadian banks had plenty of capital when the crisis hit, along with management with less enthusiasm for risky business.

There are not so many toxic assets on the banks' books in Canada.

All this is far too technical for the G8 leaders to settle it at a summit.

But it is important enough to justify them spending a little time trying to give the reform some momentum.

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