Unanswered questions about global finance

With the 14th G20 Summit scheduled in Osaka later this month, it is time to take stock of what the G20 itself saw as one of the ultimate causes of the 2008 Global Financial Crisis (GFC), namely the failure of financial regulation. 
 
Financial regulatory reform, like most G20 initiatives, was attempted through advisories to multilateral institutions, such as the Basel Committee on Bank Supervision (BCBS) for commercial banks, and the International Organisation of Securities Commissions (IOSCO) for non-banks and shadow banking. Monitoring of these reforms is being done by the G20 through the restructured Financial Stability Board (FSB). These reforms were supplemented by national initiatives, such as the Dodd Frank Act in the US, the Vickers Commission in the UK, and the Liikanen Report of the European Union.

 
The reforms for commercial banking to make the regulatory structure less pro-cyclical, known as Basel III, have been completed and their phase-in is in progress. The source of the last crisis, however, lay not in commercial banking, but shadow banking. While the FSB appears sanguine that the exposure of commercial banks to shadow banking has been contained, and the latter is now being monitored, it remains outside the regulatory umbrella.
 

With commercial banking reined in through Basel III, shadow banks have seized this regulatory arbitrage to grow faster. They no doubt have an inclusive aspect, penetrating markets that commercial banks cannot reach, shadow banking nevertheless remains the most innovative and riskiest component of the financial system. New financial technologies only magnify complexity and risk. 

While shadow banking is still a small segment of financial systems in EMDEs, its fastest growth since the crisis is not in advanced economies but in China. It is only a matter of time that its role in EMDEs grows. Can shadow banking be regulated? Are regulators taking adequate steps to educate and protect consumers of complex opaque products emanating in shadow banking?
 
At the outset of the crisis, the Alan Greenspan view that central banks cannot, and should, not call asset bubbles was challenged. There was a sense that central banks would wipe the dust off their original raison d’etre, namely financial stability. This challenge appears to have petered out, with monetary policy instruments considered too blunt, the mantle falling instead on macroprudential policies. Are these reining in asset bubbles? And is it still the view that asset bubbles are too difficult to call?

 
It is now recognised that the financial sector is a public utility. Some financial institutions are too big to be allowed to fail and bring down the financial system. But in the reconstruction that followed, big banks have become bigger. Systemically important financial institutions (SIFIs) are now better monitored by regulators, are required to hold more capital and draft “living wills” with a resolution framework in the event of their demise. Have these measures abated the threat of major tax-funded bailouts?
 
Excessive leverage underlies all financial crises, and the GFC was no exception. While financial sector debt has shrunk, the reforms have been unable to rein in the pre-crisis growth in leverage because most of the growth since has been in the public sector. Non-financial corporates in both advanced economies and EMDEs also took advantage of low rates to lever up. The overall debt/GDP ratio remains virtually the same. The underlying liquidity driving this leverage prior to the crisis was global imbalances. After the crisis, it is central banks. What does this mean for financial stability and monetary policy, going forward, especially when rates rise?

 
There is apprehension that as memory of the crisis recedes, and animal spirits return, regulatory reforms are being gradually rolled back, as in the post Great Depression era. No matter how comprehensive the reforms, nobody is making the case that there will be no more financial crises. In a globalised world, domestic and regional crises can be triggered simply by policy spillovers, and despite good macroeconomic management.
 
Purely domestic financial crises can be handled through fiscal and monetary policies. But when crises spill over regionally or globally, where a country cannot fund its external liabilities, either as a result of a sudden shock, or unsustainable external debt, the robustness of the safety nets of the International Financial Architecture (IFA) will be tested.

 
These safety nets have expanded dramatically in the post-crisis period. But is the extant three-layered architecture, comprising a global safety net (IMF), regional arrangements such as the plurilateral Chiang Mai multilateralisation and the BRICS Contingency Reserve Arrangement, and national “self-insurance” mechanisms comprising foreign currency reserves and bilateral swaps, robust enough to handle future crises?
 
The adequacy of IMF’s resources, the nimbleness of its lending and surveillance instruments to respond timely, the “stigma” attached by markets to countries that access its preventive instruments, remain debatable. The absence of effective surveillance continues to constrain the deployment of regional arrangements. Consensus on the levels and desirability of reserve accumulation by developing countries as self-insurance against policy spillovers, BOP crises and the monetary policy trilemma remains a work in progress. Has the recent decline in capital flows made EMDEs more vulnerable to a rate rise? 

 
The GFC raises two new interesting issues relating to the extant IFA. First, the major international liquidity provider during crisis was not the IMF, but the US Federal Reserve through market confidence boosting bilateral swap arrangements. What is the role of the issuer of the de facto global reserve currency in the IFA? Has the Federal Reserve effectively replaced the IMF as the global lender of last resort, especially in a major global financial crisis? This adds a new dimension to what is termed the “triffin dilemma”.
 
The second new issue is IMF lending to issuers of fully convertible currencies in the IMF reserve basket. Was its lending to countries within the eurozone justified by its Articles of Agreement? Was it necessary since the countries in crises could be bailed out by euro funding? It was the commitment of the ECB to provide unlimited liquidity, and not IMF intervention, that stanched the market revolt in the EU periphery. Although the crisis in the eurozone has subsided, the underlying fault lines remain. Who should be its lender of last resort, the IMF or the ECB?

 
Apart from real time coordinated management of the 2008 GFC, financial regulatory reform and strengthening the safety nets that can respond to crises are amongst G20’s signal achievements so far. With the current chair still suffering from the aftershocks of a financial crisis that occurred over two decades ago, the Osaka Summit could perhaps provide answers to some of these outstanding questions. 

 The writer is RBI Chair Professor, ICRIER