Reform Of The Global Financial Architecture

By M. Isi Eromosele

The global financial system has three components: private sector institutions, the nations that have supervisory jurisdiction over the private institutions, and the international institutions through which the national authorities coordinate and cooperate.

The Global Financial Architecture (GFA) is the collective governance arrangements at the global level for safeguarding the effective functioning (or the stability) of the global financial system.

The GFA is governed first and foremost by the countries that have agreed to be part of it, for example, through their IMF membership, their participation in other institutions and agreements, and their adherence to various codes, standards, and understandings.

Accordingly, accountability for the successes and failures of the GFA rests squarely with its member countries, in particular those that strongly influence it. These same countries are accountable to their own constituencies for the performance of the GFA and any implications its performance may have on national, regional, continental, and global economic and financial outcomes.

The global financial and economic crisis of 2008 to present revealed that the pre-crisis GFA was flawed both in its implementation and in its structure. With the benefit of hindsight, there were warning signs and policy mistakes and misjudgments.

But as structured and implemented, the Global Financial Architecture was not effective in encouraging or persuading remedial actions at the national, regional, continental, or global level until a full-scale global systemic crisis was a reality to be dealt with.

The GFA was revealed to be structurally flawed. Its coordination mechanisms failed to resolve cross-border problems without the resort to national ring-fencing, unprecedented volumes of liquidity provided by Central Banks to markets and volumes of credit guarantees and recapitalizations provided by national treasuries to individual financial institutions not previously witnessed on a global scale.

In light of the need for unprecedented massive interventions, one important and perhaps overriding lesson for global governance emerging from the crisis is that the international community lacks a body of international law, or at least official agreements and conventions, and importantly ex ante, burden-sharing mechanisms (or balance sheets) for resolving the weaknesses or insolvencies of large, complex, interconnected financial conglomerates.

Systemic Issues Revealed By The Global Financial Crisis

The global crisis revealed fundamental weaknesses in the pre-crisis global financial architecture for preventing, managing, and resolving crises in the GFS. All lines of defense against a systemic crisis were breached during the crisis.

Pre-crisis Framework for Safeguarding Global Financial Stability

The pre-crisis framework for safeguarding financial stability and encouraging economic and financial efficiency can be seen as lines of defense against systemic problems that could threaten stability.

It was put in place over time by both private and public stakeholders in the major financial centers. This architecture evolved over time as events occurred. It was the result of neither a grand design nor an underlying genetic code that predisposed the evolution of the system to emerge in the way it has.

It is more akin to an evolving patchwork quilt of consensus decisions by stakeholders in the major financial centers to deal with problems as they emerged and as an organic collection of private and public international agreements and conventions.

There were four important sources of global systemic financial risk: (1) global financial institutions, primarily large, international banks/groups but also including global investment banks and insurance/reinsurance companies; (2) global financial markets, foreign exchange, bond, and over-the-counter derivatives markets; (3) unregulated financial-market activities of institutional investors such as the capital markets activities of insurance and reinsurance companies and of mutual, pension and hedge funds; and (4) economic and financial-stability policy mistakes.

What Is Known From The Crisis

Although the global financial crisis has been characterized by some as caused by the US sub-prime mortgage crisis, the continuing crises in the Euro area, and in Europe more generally, suggest that the earlier and ongoing US problems should be seen as symptomatic of an economic and financial environment that encouraged imprudent risk taking, excessive leverage, a worldwide credit boom, and the accumulation of an unsustainable amount of private and public debt.

The pre-crisis policy framework and architecture described earlier failed to prevent and resolve in a cost-effective manner the kind of financial imbalances that ultimately created systemic risks and events that threatened to create a worldwide depression.

This framework, created over time primarily by U.S. and European policy architects, relied heavily on achieving and maintaining a balance between market discipline and official oversight, with the objective of providing checks and balances to prevent systemic threats to financial and economic instability.

The balance was wrong. Neither market discipline nor official oversight by national authorities and international institutions such as the IMF and FSF performed its function as intended.

Regarding the balance, it was tilted too heavily toward ex ante market discipline, which proved to be elusive until it was too late, at which point the ex post exercise of market disciplining behavior created panic and market dysfunction.

It also relied too little on official oversight, which failed to foresee the buildup of systemically significant imbalances and weaknesses; it also failed to deal as effectively as it might (in a least cost manner) with the crisis once it was upon the world.

In summary, the pre-crisis lines of defense against threats to systemic stability proved to be inadequate and were breached most visibly in the European Union and the United States:

• Private risk management and market discipline failed and markets dysfunctioned, the result of a combination of imperfect information, poor incentive structures, insufficient capital and inadequate governance/control by top management.
• Official supervision failed to promote safety and soundness of systemically important financial institutions (SIFIs).
• Macroeconomic policies contributed to conditions conducive to financial crisis.
• National and global market surveillance failed to identify the buildup of institutional, market, and system-wide financial imbalances with sufficient clarity and rigor.
• Pre-crisis Central Bank and finance ministry tools for addressing liquidity/solvency issues proved to be inadequate and were out of tune with the fast-paced nature and global reach of 21st century finance.

Principal Areas where Reforms Are Necessary

Six broad and closely related and overlapping areas can be identified that are particularly relevant for considering reforms of the global financial architecture as it impacts the stability of the global financial system.

Regulatory Requirements for Capital, Liquidity, and Leverage and the Potential Benefits/Costs of Systemic-Risk Taxes

The global crisis revealed that regulatory requirements for ensuring the safety and soundness of individual financial institutions (or micro-prudential bank regulations) were inadequate.

There are many facets of these requirements that contributed to the buildup of imbalances and risks including Basel II methodologies were flawed in determining capital requirements, liquidity risks were misunderstood as was private risk management and regulations, leverage limits were either inadequate or unbinding, or in Europe completely absent.

Perimeters or Boundaries of Financial Regulation, Supervision, and Infrastructures

The “perimeter” or “boundary” of financial regulations, supervision, and infrastructures proved to be too narrow or ill-defined to prevent systemic problems from arising and worsening.

For example, US authorities in charge of managing crises and resolving bank failures had no legal authority or standing in resolving the problems of Bear Stearns and Lehman Brothers.

Regulation and Surveillance of Global Money and Financial Markets

Effective and enduring reform efforts in this area will require changes in many dimensions: legal, process, architecture, and cross-border cooperation. Reform proposals across the Atlantic differ, and fierce competition between the major financial centers is active, but there is also much common ground.

Systemically Important Financial Institutions or the “Too Big to Fail (TBTF)” Problem

It is now more widely understood that some financial institutions pose risks to the stability of the entire global financial system because of their size, complexity, and

interconnectedness.

The pre-crisis architecture for safeguarding global financial stability can be judged to have failed to assess, monitor and manage the wider implications of financial imbalances and weaknesses that emerged within individual financial institutions.

Crisis Management, Rescue and Resolution

Systemic Risk Board are necessary and worthwhile efforts aimed at improving the ability to assess the potential for systemic risk in the absence of market pressures and adequate supervision and regulation.

Early detection of financial imbalances is necessary to avoid systemic problems through the implementation of risk-mitigating measures that could reduce the potential for financial imbalances becoming systemic and threatening financial stability.

Effective Management of Volatile Capital Flows

The epicenter of the global crisis was the US financial system and economy and the principal locus of secondary eruptions was Western Europe. But the crisis became global, encompassing Central and Eastern Europe, Latin America, Asia, and Africa before running its course.

A major transmission mechanism was the global financial system and associated capital flows, which dried up, first, for Iceland and Eastern Europe and ultimately for many of the major emerging-market economies.

A second transmission mechanism was the recession in the advanced countries that led to a collapse in global trade that was unprecedented in the post-World War II era.

Macro-prudential Orientation

An important failure of the pre-crisis framework for safeguarding global financial stability was that it was focused too heavily on micro-prudential regulation and supervision and not enough on assessing, monitoring, and resolving problems at the system-wide level.

The macro-prudential orientation of supervision and regulation should have two major focal points: (1) the impact of the aggregation of financial risks on the system as a whole, including externalities and cross-correlations of risks (that is, a focus on systemic risk); and (2) the impacts on the financial system as a whole of macroeconomic policies - monetary, fiscal, and financial.

Recommendations

The structural financial weaknesses revealed by the global crisis require further reforms of the global financial architecture if future crises are to be managed and resolved more

cost effectively, both in terms of preserving the efficiency gains of global modern finance and in terms of taxpayer monies.

First and foremost, reforms are required at national levels. However, to maximize the probability that these reforms contribute to greater stability of the global financial system and are implemented consistently, the financial-stability roles of the relevant international institutions, the IMF and FSB in particular should be enhanced individually and collectively.

More specifically, the IMF and the FSB must cooperate and collaborate as closely as possible on the reform and operation of the global financial system in order to achieve their mandated objectives that overlap in many areas.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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