A View of How The 2008 Financial Crisis Affects Global Economy and Policies Set by Financial Institutions

Following the financial crisis in 2008, there is much more enthusiasm in the policy-making classes for supra-national regulation, or , at least, coordination of regulatory rules. A good example of rules being set on a global scale is the Basel Committee's rules on bank capital reserves and liquidity rules. However, a robust international regulation will undermine the competitiveness of some countries as their financial system and macroeconomic environment are different. Moreover, the intention of the national policy makers too often seems to be "to find a regulatory regime that crimps competitors more than one's own companies" (Stiglitz 2010).

Do you think that there needs to be greater international cooperation in the regulation of financial service? A recent report by the International Monetary Fund (2009) explains that the current financial crisis, which many economists consider to be the worst crisis since the economic depression of the 1930’s (IHS, 2009), has revealed numerous weaknesses in the global financial system, which should be strengthened in order to avoid similar situations in the future.

According to Mario Draghi, the current President of the ECB, the global financial crisis should be analysed in such a way to draw useful lessons from it, as it is obvious that the inability of the banking system to deal with unexpected stress is the reason why governments have been using taxpayers’ money to save banks. (Barua, R. et al., 2010)

That is what the Basel Committee of Banking Supervision (BCBS) did and its analysis resulted in a new accord, known as Basel III, whose goal is to impose new capital reserves, leverage and liquidity rules, thus setting higher standards and increasing transparency within the banking system. (Barua, R. et al., 2010)

However, several economists believe that the standards set by the Basel Committee were meant for the American and European markets and, therefore, should not be imposed on developing countries, as they would almost certainly damage their economies. (Masters, B., 2012)

Changes in financial regulation

Before the 2008 financial crisis, financial regulation was characterised by two opposite trends, namely specialisation and consolidation. Under the influence of specialisation, the financial system was seen as a combination of different sectors, each of which had to be supervised by a specific body. This process gave rise to better-defined financial supervisors which several banks have decided to keep, for the sake of prudence.

However, other countries and regions, including Europe, the United States and Japan, have opted for the so-called “integrated model”, introducing new reforms aimed at simplifying financial regulation by reducing the number of regulatory and supervising bodies. These reforms have resulted in the Federal Reserve System, the Bank of Japan and the ECB being responsible for both prudential supervision and monetary stability. (Eijffinger, S. and Masciandaro, D., 2012)

As Mavrellis (2011) observed, if financial markets were supervised by regulatory bodies that can actually predict and avoid financial crises, both investors and consumers would be protected. However, in order for this scenario to become real, financial markets would have to be subject to severe policies aimed at increasing transparency and reducing the likelihood of economic contractions damaging the real economy.

In fact, the current global financial crisis has damaged not only investors, but also consumers across the world, causing numerous countries to experience a severe recession which has not yet ended, as globalisation has made global economies strongly linked to each other. (BBC News, 2012; Rooney, B., 2012; Rampell, C., 2011)

In response to the weaknesses in both financial supervision and regulation which have contributed to triggering the current financial crisis, the BCBS approved a reform package (Basel III) including capital and leverage regulations and global liquidity requirements. (Barua, R. et al., 2010)

The agreement states that banks will have to hold at least 4.5% of their RWA (risk-weighted assets) in common equity capital and 6% in Tier I capital. It also introduces a countercyclical buffer thanks to which national regulatory bodies may require an additional percentage of capital ranging from 0% to 2.5%, especially in times of stress and credit growth. (Barua, R. et al., 2010)

In order to prevent banks from accumulating excessive leverage, the BCBS has introduced a liquidity ratio which requires banks to ensure that their cash outflows do not exceed their cash inflows over 30 days, as to avoid dangerous mismatches, a leverage ratio of at least 3% and a net stable funding ratio which requires banks to have enough liquidity to meet their cash obligations in case of extended stress. (Barua, R. et al., 2010)

European Union and United Kingdom

As Stichele (2008) reported, as of 2008 financial regulation in the European Union was still fragmented, as member states still had different laws, regulations and supervisory methods. However, this fragmentation was incompatible with the liberalisation of financial markets and the expansion of numerous banks.

That is why EU governments started suggesting that financial deregulation and market liberalisation not only at European level but also internationally, would strengthen European financial regulations. Their motivation was certainly increased by the negative effects of the global financial crisis, which resulted in the acceleration of the integration process.

However, as Hagenfeldt (2011) pointed out, although the progressive liberalisation of EU financial markets has increased financial stability, there could be side effects associated with this process, including the potential cross-border contamination in case of financial crisis, as a result of the increased interconnectivity among member states.

With regards to the relationship between EU members and the United Kingdom, Benson suggested that they should co-operate to identify the causes the have led to the 2008 financial crisis. (Great Britain: Parliament: House of Commons: Treasury Committee, 2011)

With regards to the measures put in place by EU governments to minimise the effects of the financial crisis and promote integration, in 2011 the UK Treasury Committee and Parliament discussed the government’s proposals aimed at renewing the UK financial regulation architecture. (Great Britain: Parliament: House of Commons: Treasury Committee, 2011) The proposals place great importance on the credibility of the Ombudsman Service and, even though most of them were formulated on the basis of domestic issues and needs, the Treasury Committee is aware that the UK is strongly linked to the EU and that domestic financial regulation shouldn’t conflict with European or international regulation. (Great Britain: Parliament: House of Commons: Treasury Committee, 2011)

United States

As Battilossi and Reis (2010) pointed out, the 2008 financial crisis has revealed the weaknesses of the US financial regulatory system, to the extent that many economists and analysts are starting to view market deregulation as the best solution to avoid future crises. While the European Union and the United Kingdom have used policies and financial instruments such as liquidity ratios, credit ceilings and credit allocation standards, the United States approved the Dodd–Frank Wall Street Reform and Consumer Protection Act 2010 and has taken steps to implement the requirements set by Basel III into its regulatory architecture. (Battilosi, S. and Reis, J., 2010)

Market liberalisation and domestic regulation

The several financial crises that have marked the last century have resulted in calls for new, severe international financial regulations aimed at regulating financial markets through both structural and legal changes. (Alexander, K. et al., 2005)

In fact, although the financial markets have been significantly liberalised over the past few decades, the liberalisation process was not followed by adequate changes in local and international financial regulation, as regulatory bodies adopted a reactive, rather than a proactive approach, setting new requirements only after financial crises had already been triggered.

As Krajewski (2003) observed, when financial markets are liberalised domestic/national regulations are automatically put under pressure as the interconnectivity among markets increases. Provided that not all countries respond to the same legal system, it is obvious that the liberalisation process would lead to serious difficulties if international rules were not set. That is why Krajewski (2003) argues that liberalised financial markets are incompatible with domestic regulation and that the only way governments and institutions can avoid the negative effects of globalisation is to set international standards applicable to all financial markets.

The fact that the 2008 financial crisis was not caused by inefficient macroeconomic policies approved by governments suggests that financial crises are not only triggered by macroeconomic phenomena. In fact, analysing the events that have led to the U.S. subprime mortgage crisis and the consequent global financial crisis, it is clear that unethical behaviour and poor corporate governance within the private sector should be addressed as the main causes of the difficulties governments and citizens across the world are still facing. (Hansen, L. H. et al., 2009)

This clearly indicates that the liberalisation of financial markets has created a strong connection between microeconomic phenomena and macroeconomic contagion, making it practically impossible for domestic regulation to prevent financial crises from spreading across countries.

As Alexander et al. (2005) observed, the potential impact that microeconomic risk can have on the entire world is a good enough reason for institutions to focus on international regulation.

International regulation and emerging markets

With regards to the creation of an international financial architecture, Peter Sands, CEO of Standard Chartered, pointed out that even though new policies are needed, these should be aimed at regulating the American and European markets, where the financial crisis originated, and should not be imposed on emerging markets as the consequences of such a decision would probably include an increase in the cost of credit, slower economic growth and a decrease in the supply of credit. (Masters, B., 2012)

Sands’s point of view may seem overly pessimistic, especially considering that emerging markets have managed to recover from the global financial crisis more quickly than the United States and the European Union, which is still struggling to find a solution to the economic recession.

Moreover, a set of regulations aimed at making financial markets more stable and transparent would certainly benefit any country, as a balanced and solid financial system makes it easier to overcome critical periods and absorb shocks.

However, developed countries do not have the same needs as developing ones; in fact, while sophisticated economies need regulations aimed at minimising risks deriving from advanced financial innovations, emerging markets need to be protected against the risks that are typical of underdeveloped economies. As Kawai and Prasad (2011) observed, these significant differences would make it very difficult for developing countries to implement international regulations aimed at developed countries, mainly as a result of their weak legal systems, inadequate public institutions and poor regulatory capacity.

With regards to Basel III, which is a perfect example of international regulation, the measures regarding liquidity coverage would almost certainly damage countries with weak financial systems where low-risk government and corporate bonds are not as common as in developed countries and countries that follow Islamic financial rules, where the said bonds do not even exist. (Masters, B., 2012)

Moreover, banks in developed countries can hedge risk thanks to sophisticated financial instruments, including credit default swaps, which most banks and companies in developing countries have no access to. (Masters, B., 2012)

All these potential difficulties suggest that developing an international regulation that meets the needs of every single country in the world is an incredibly challenging task as there are many fundamental factors that should be taken into consideration in order to avoid benefitting certain countries whilst penalising some others.

Conclusion

The 2008 financial crisis has had a significant impact not only on the world economy, but also on how policy-making classes view financial regulation. According to Mario Draghi, governments should implement policies aimed at strengthening the banking system, as it is evident that banks’ inability to absorb losses and deal with unexpected stress, combined with weaknesses in corporate governance, should be addressed as the main causes of the global financial crisis. (Barua, R. et al., 2010)

Also, it should be noted that as a result of globalisation, the interdependence and interconnectivity among countries have increased significantly, to the extent that minor microeconomic phenomena can have significant macroeconomic consequences that can affect the entire world. (Hansen, L. H. et al., 2009)

That is why over the past few years, western governments have started to realise that the liberalisation of financial markets should be accompanied by policies aimed at creating a robust and solid international regulation. A perfect example is Basel III, a set of standards fixed by the BCBS which the United States has already started implementing in its national financial regulation.

The problem is that while international regulations like the ones set by Basel III would strengthen financial markets and relatively benefit western countries, they would almost certainly damage developing and Muslim countries, where certain sophisticated financial instruments are either inexistent or forbidden.

However, considering that globalisation has made countries strongly interdependent, it is crucial that they should all co-operate to implement more severe regulatory standards and avoid future crises that would have a negative impact on their economies. A convenient solution would be to set international regulatory rules that countries can implement at different stages and in different ways (through a system of exceptions and special permissions) depending on their specific needs and level of development.