III-1.11: Global Financial Integration, Thirty Years on. From reform to crisis.

Geoffrey R. D. Underhill, Jasper Blom, Daniel Mügge (eds.), Global Financial Integration, Thirty Years on. From reform to crisis, Cambridge University Press, 2010, 376p.

 “Global Financial Integration, Thirty Years on. From reform to crisis” combines many academic contributions on international financial governance, that each offer original and in-depth analysis of the financial crisis’ causes. To safeguard the authors’ legal and economic reasoning, the bibliographical report has been divided in three parts and will be brought to The Journal of Regulation’s readers in three successive issues[1]. The following report analyses the second part of the volume.

Andrew Baker, in his Deliberative financial governance and policy forums, takes interest in the mechanisms that form global financial governance. Amongst the world’s international financial governance and deliberative institutions, Andrew Baker suggests studying the impact and efficiency of apex policy forums. Such term refers to forums bringing together the most senior national figures from national finance ministries and central banks, to engage in processes of recurrent informal deliberation with the intention of formulating international consensus (consensus on strategic priorities, agendas and normative parameters for our global financial governance etc.). Such forums include the G7 and the G20 since 1999. Based on the assumption that there is a clear relationship between input and output, Baker suggests that although apex policy forums do have a certain amount of powers, there are so homogeneous that they form restricted input which causes flawed outputs (based on error of judgment in policy making, lack of implementation etc.), as the recent 2007-9 crisis demonstrated.

Apex policy forums operate at the highest levels of national officialdom and seek to define priorities, directing, steering and framing work conducted elsewhere. Their deliberations and statements (or communiqués) design the strategies, agendas and policy orientations of national authorities, markets, press and other specialist bodies or committees involved in the global financial architecture (IMF, Basel Committee, FSB etc.). Whereas the G10 was created in 1962, little macroeconomics policies or exchange rates debate have been recently debated, but rather normative consensus about what the global financial system should look like (its functioning, its values etc.). For example, the G20 played a politically significant role when implicitly mandated to define post-crisis agreement on international and domestic action, arrangements on crisis prevention or consensus on the decision-making in other institutions such as the IMF.

Although G’ groups have no formal or legal mandate, Baker estimates that they have 3 powers: first, the power of veto which influences how other multilateral institutions can function or adopt proposals (e.g. the G7 finance ministries and central banks decided to reject the SDRM proposal, that the IMF therefore had to retract). Second, they benefit from an instigation power as they set broad agendas and priorities for the wider institutional complex of global financial governance (often staffed by less senior officials whereas apex policy forum are staffed at the most senior level). Third, they have a power of endorsement, such as the approval of the findings of more specialist committees that produce norms and technical reports such as the Basel Committee, IOSCO, the FSB and the IMF (which, to enjoy political authority, need the approval of apex policy forum). In a nutshell, they “light fires under civil servants and bureaucrats” (p.62) and give a sense of urgency.

Whether or not powerful, apex policy forums and their output (standards, agendas etc.) however suffer from their input. For example, during the 2002-2007 calm period, apex policy forums managed to endorse and reinforce a neoliberal model of financial based on an Anglo-American-centric view of the world, simply because forums were far from neutral and value free deliberative process. Baker gives the example of G20 workshop held in 2004 on the development of capital markets, during which the only private/civil society representative was an economist from the Institute of International Finance (IIF) representing the largest international banks, while any form of dissent appeared to be absent. Such forums are defined as relatively isolated from perspectives outside the forums’ normative parameters, consensual forms of deliberation and composed of ministers and governors with strong social bonds based on similar shared academic background. Moreover, because they are informal, there seems to be group pressure to conform with participants unwilling to too openly dissent from the majority opinion (Baker gives the example of a Chinese representative who was dissenting with the G20 pro-capital account liberalization but did not disclose it due to group pressure ; he however showed doubts within the IMF, a more formal institution). “In this respect, the context in which debates take place (input) appears to have a powerful influence on the resulting consensus (output)” (p.64). In a nutshell, because such forums are rooted in the social, political and intellectual dynamics of apex policy forum decision-making mechanisms, and do not give a fair hearing to other arguments, such forums can be defined as a “limited argument pool’ involving ideational bias and creating powerful conformists affects.

Due to this “limited argument pool” issue, the standards and codes agenda of such forums did not encounter the success expected, whereas due to cost implementation, lack of adequate technical assistance, their lack of appropriateness in particular national contexts or their poor implementation record of many developing countries. The author suggests that “these problems are directly related to the restricted input process (the limited argument pool) which has constrained debate in apex policy forums, and has allowed flawed intellectual assumptions to reign unopposed, resulting in the adoption of questionable outputs (standards and codes)” (p.66). Indeed, standards and codes as edited by apex policy forums were all based on the prime assumption that crisis are rooted not in the nature of financial market, which are efficient and rational, but in the lack of transparency, which will automatically be implemented by national policy makers as they fear investors will withdraw their money. Baker also suggests that these codes were never taken into account by market or investors themselves to guide them in investments decisions, but solely by regulators and national authorities. Baker argues that the reason why such assumption that markets are rational was spread globally without dissent from other countries is due to the “limited arguments pools” and social pressures within apex policy forums. In Baker’s view, the content and detail of the macro prudential regulation agenda emerging from the current crisis will without doubt be minimized and diluted by private actors, through national lobbying and expert contributions to the reports and recommendations of bodies such as the FSB, IOSCO and Basel. Because G20 officials resonate with their own intellectual beliefs and prejudices (Baker suggests that they have a genuine intellectual faith in Wall Street’s ideas which come to resemble an ideology), this leads to “enclave deliberation”.

On the contrary, heterogeneous deliberative forum must be preferred to deliberation among like-minded people. Baker, setting aside issues such as legitimacy, focuses on mere likelihood of error: in such instance where certain policy are favored not because of their merits but because of social dynamics and limited nature of counter argument, limited input processes directly damage output efficiency and legitimacy. According to Sustein, “what is necessary is not to allow every view to be heard, but to ensure that no single view is so widely heard”. Such enclave deliberation should therefore be limited as much possible, especially because of the influence and the normative setting of such forums.

Baker concludes that only a more heterogeneous forum that at “least attempted to realize some degree of deliberative equality would constitute a reasonable first step towards achieving a more inclusive, socially aware and progressive system of global financial governance”. Yet Baker seems optimistic as his recommendation (that heterogeneous groups generally produce better judgments because they consider more information) seems to have been heard by the G20. The latter’s recent communiqués have expressed support for something resembling a more interventionist top-down rules-based form of macro prudential regulation, due to the recent summits which have appeared as to have resulted in emerging markets developing a more distinctively vocal and assertive position.

The assertion that only heterogeneous forum will lead to legitimate output is backed up by the study of Danny Cassimon, Panicos Demtriades and Björn Van Campenhout, Finance, Globalisation and economic development: the role of institutions, which demonstrates the heterogeneity of national reaction to financial integration and the role of institution in coping with such issue. Cassimon, Demtriades and Van Campenhout argue that the relationship between financial integration/openness (the virtues of capital mobility) and economic development (in theory, financial development is good for growth as it allows for the efficient mobilization of savings for productive investments) vary considerably across countries. Moreover, while the development of financial systems and banks can have a positive effect on economic growth (it was the basis for the 1980 and Washington Consensus financial architecture), poorer countries risk entrapment in a vicious cycle of low financial integration and encounter no relationship between cross-border financial integration and economic development. Authors suggest studying the role that institutions play or should play in financial and economic development, especially in emerging countries. They argue that the absence of financial integration is mainly due to the low quality of institutions.

Authors underscore many exceptions to the assertion that development of financial systems and especially banks can have a positive causal effect on economic growth. Indeed, based on a study made on sixteen emerging countries, it is economic growth that causes financial development and not vice versa. Other studies show that financial development has greater effects on growth when the financial system is embedded in a sound institutions framework. Therefore, the finance-growth relationship is sensitive to the level of economic and/or financial development, as well as to the institutional development, including institutional quality. “Financial developments may thus not be the quick fix to promote growth in those parts of the world that most need it, such as Sub-Saharan Africa, unless it is accompanied by the strengthening of institutions such as rule of law and property rights” (p.77).

The authors put forth four different theories why financial development varies sharply around the world, with some countries experiencing low levels of financial developments. Authors recall the “legal origins hypothesis” (common law countries are more apt than civil law to handle market-based financial integration), the “political view of state owned banks hypothesis” (the effect of state owned banks on countries on credit or depositors’ protection), the “initial endowment hypothesis” (such as the effect of colonization on institutions) and the “incumbents and openness hypothesis” (the idea that opening both trade and capital accounts is the key to successful financial development) while not accepting that such hypotheses are relevant to developing countries today. On these different theories, the authors conclude that “financial and industrial incumbents, income and wealth inequality and institutions appear to be the players which interact to determine whether financial development in any given country takes off at a particular point in time” (p.80).

The authors further suggests that the neoclassical growth theory (which predicts that integration of local financial markets in the global financial system will boost economic development) is not correct, especially because capital flows from rich to poor countries are far less than the theory predicts. Based on empirical evidence of the continuing divergence in capital flows between groups of developing countries, the authors argue that certain threshold conditions need to be in place to reap the benefits of financial globalization. The empirical data put forth by the authors suggest that financial market development, institutional quality, governance, macro-economic policies and trade integration are these preconditions. However, the authors suggest that policies matter less that institutions since it is the institutions which place constraints on the executive, guarantee property rights, a minimum amount of equal opportunity, broad based education, which all lead to higher growth and less volatility. Authors agree with studies which, “controlling for the quality of institutions, (…) find macroeconomics policies do not play a direct role, and thus view distortionary macroeconomic policies not as the cause of low growth or high volatility, but as a symptom of weak institutions” (p.82). Therefore, the credibility of policies will depend on as good or bad institutions are.

Based on the several data used by the authors and other studies they rely on, if financial globalization occurs in the context of weak institutions, there is no or low GDP and TFP growth, while the probability of crises increases. Many reasons support that volatility and financial globalization are directly linked to institutions. Indeed, in institutionally weak societies, there are few constraints on rules, and any change in the balance of power may lead to politically ascendant groups to redistribute assets and income to themselves, which creates economic turbulence. Moreover, weak institutions will drive entrepreneurs to invest in sectors in which they can swiftly withdraw their investment, also contributing to economic turbulences.

Finally, authors provide for empirical validation of thresholds and multiple equilibria in the dynamics of financial integration. They sustain that an economy characterized by poor property rights institutions will not attract a lot of sovereign capital, and that if global financial integration was to strengthen such institutions as collateral benefits, “we again have a self-sustaining effect of poorly integrated economy trapped at a low level equilibrium (…). Economies that do not have the preconditions in place will find it difficult to integrate in the world economy” (p.85). Authors therefore expect multiple equilibria in the dynamics of financial globalization to disappear once we control for the quality of institutions, and to persist when we just control for policies. Based on a stock-based indicator of financial integration, authors find that “dynamics adjustment to the low-level stable equilibirum is faster than adjustment to the high-level stable equilibrium” (p.88). Authors underscore the difficulty to compare qualitative data furnished by international organizations with their qualitative measure based on multivariate analysis. Therefore, they conclude that “political economy explanations of financial (under-) development –focusing on the role of incumbents, income and wealth inequality and the evolution of economic institutions- are promising as hypotheses, but need to be further tested” (p.88). They also conclude that controlling for the institutional context eliminates the multiple equilibria (itself based on contract viability/expropriation risk, payment delays, corruption).

Based on these findings, the authors conclude that “global financial architecture focusing on the promotion of openness and its primary policy output is insufficient to produce economic growth (...). The system remains exclusionary, as poor countries are not only underrepresented in international policy forums, but also underserviced (…) [which] implies that financial integration cannot replace country-specific development strategies focusing on the improvement of domestic institutions” (p.89). In this view, along with other proposals made in the volume, such as amending contra-cyclical frameworks (Ocampo and Griffith-Jones), challenging the IMF intervention on private financing for low-income countries in debt workout (De Jong and Van de Beer), or finding a new aid paradigm (with donors seeking alignment with recipient country priorities and systems, Claessens, Cassimon and Van Campenhout), the authors insist that there is a case to be made for public intervention directly targeting and supporting the development better institutions. 

Indeed, if institutions are not improved, the chance of national regulatory fragmentation will remain, as Andrew Walter in Adopting international financial standards in Asia: convergence or divergence in the global political economy? demonstrates, while showing how Asian countries’ financial regulation and implementation creates important gaps in global coordinated regulation. Walter first recalls how the last wave of crisis (the 1990s) triggered a reform project for financial governance led by the G7 targeted at emerging countries, although the latter had little input into the development of these standards. The author argues that although emerging countries’ regulation quality has increased ever since the 1990s, there remain important implementation gaps, first because of the difference between official policies and actual behavior. Second, the lack of systematic convergence with western regulatory standards by emerging countries is also due to the remaining national “policy space” in financial regulation, either because international standards are flexible in their application or because enforcement by international actors is of limited effectiveness. Third, implementation gaps may be explained by the influence that national-level private sector actors can have on constraining, modifying and sometimes blocking the implementation of international standards at the domestic level.

Walter suggests demonstrating the unevenness of financial regulatory convergence by taking examples such as the Basel Core principles, the OECD’s principles on corporate governance, the IFRS and the IMF’s Special Data Dissemination Standards (SDDS). Whereas Basel I implementation is also universal, SDDS and IFRS are more variable. But the real issue to the author is not the “official” implementation of such standards but the “effective” one. Indeed, the author suggests taking into account the important factor of “mock compliance”[2]. The latter can occur for different reasons such as low bureaucratic enforcement capacity or corruption, deliberate regulatory forbearance by the governance or its agencies, and behavior by private sector inconsistent with the intent of the rule. For example, on IFRS, the survey put forth by the author suggests that, although mock compliance certainly exists on a certain level in the USA and UK, “the quality of corporate compliance in countries like China, Indonesia, Korea and Thailand lags well behind that in the USA, UK and regional leaders such as Singapore” (p.102). On matters such as banking supervision, implementation and mock compliance even diverge on a regional scale: Singapore and Honk Kong show high compliance whereas China and Thailand are at the bottom; and beneath these country average lie even larger variations in the degree of corporate compliance with international and domestic standards.

The author explains this uneven convergence because, first, market incentives for substantive compliance are often weak even when formal compliance is ubiquitous, as is the case for Basel 1. Second, private actors can also be thrown by the fact that some stocks of companies with worse corporate governance practices tend to perform better than average. Finally, standards setters and IFIs enjoy limited influence over substantive compliance and many emerging countries, although member of such IFIs, refuse to participate in a Financial Sector Assessment Program review (FSAP, organized by the IMF).

Walter believes that the reason why domestic political resistances to substantive convergence vary greatly from one area to another is because governments often underfund regulatory agencies or subvert regulation in other ways if the political incentives favoring mock compliance are strong. His explanation is that “public and private sector actors are likely to prefer mock compliance when visible non compliance and substantive compliance are both costly to powerful domestic actors (…) Once [adoption achieved] much depends on the interaction between the domestic private sector costs of substantive compliance with particular standards and the difficulty that outsiders encounter in monitoring the quality of compliance” (p. 105). The difficulty for third party monitoring will also affect the degree of pressure on the government and on the private sector to comply, because when such monitoring is hard, third party sanctions are unlikely to be deployed. IFIs have no mean of detection or sanctioning non observance within the public or private sectors. In the author’s view, the difficulty for external actors to assess compliance is the main factor which, next to the fact that private domestic interest coalitions have too much to lose from the international standards agenda, will not make divergence stop.

This is particularly true when it comes to implementing standards which often leave room for national interpretation or to regulatory capture, such as Basel II standards. Stijn Claessens and Geoffrey R. D. Underhill describe in The political economy of Basel II in the international financial architecture, how Basel II established a new approach to measuring capital adequacy of internationally active banks in a context of consolidated supervision of increased cross-border banking activities. The authors suggest that Basel II and its market-based approach is the result of regulatory capture on the input side which led to a skewed output, both for western countries as it enhances risk taking, and for emerging countries which are more sensitive to pro-cyclicality and for whom there are high costs of implementation.

The authors first recall the origin of the Basel Committee which helps understand how private sector actors managed to make their way through the negotiation of Basel II standards. Indeed, because capital adequacy norms can affect the costs of competition among banks, the Committee early on called for impact assessment on the banking sector, and for that purpose directly consulted with the private sector, particularity with the Institute of International Finance (IFF), representing today 350 banks worldwide. During negotiations, the IFF’s positions were mainly unchallenged and far more pressurizing than that of emerging countries (simply absent the Committee) or even civil society argument (consumers etc.) which were neither represented. IFF preference managed to be transposed into Committee Policy. “In essence, financial globalization had rendered the supervisory process increasingly difficult and beyond the reach of national supervisors. The conclusion of the report argued that regulatory agencies should rely more on the private institutions that they supervised and that the private institutions themselves would accept more of the responsibility to improve the structure of and the discipline imposed by their international risk management mechanisms” (p.118). There lie the origins of the market-based supervisory approach contained in the three pillars of Basel II. Indeed, although the Committee invited broader consultation for its Basel II proposal, the IFF remained its main interlocutor. Comments were mainly coming from European and American financial institutions, whereas the voice of academics, agencies, chambers of commerce, where less and less taken into account, even though skepticism towards market-based approach to supervision was already being pointed out. Doubts were already focused on the risk of pro-cyclicality of lending and risk taking by banks, leading to asset bubbles and an increased tendency toward the occurrence of crises. 

The authors further describe how Basel II works: based on three pillars[3], its main evolution is that banks supervisors would no longer be exclusively responsible for specifying and monitoring levels of capital adequacy. Three different option for measuring risk became available: for less sophisticated banks, the standardized approach based on external credit assessments, such as by exporting the ratings of credit rating agencies ; ‘Fondation’ International Rating Based (IRB) approach to risk management based on international Value at Risk models (only the probability of default is calculated by the banks, other ratio are left to supervisors); and for largest sophisticated banks, ‘Advanced’ IRB approach, in which all aspects of credit risks are estimated by the bank itself.

Due to the dangers promoted by such international risk measurement, the authors further describe Basel II’s impact on systemic risks, mainly in regards to pro-cyclicality and volatility of financial markets. Authors argue that the IRB approach favors the very sort of financial innovation and risk management practices which led to the current financial crisis. Further, smaller US/EU banks and banks from developing countries were already at a competitive disadvantage in cross-border markets, and now face higher Basel II capital charges. Basel II also encourages the risk reduction effects of portfolio diversification, leading to a higher concentration of lending in less risky, but more correlated segments of the world economy, leading to higher systemic risks (such as the sub-primes). Moreover, the question of the role of credit rating agencies is also crucial (they are involved when banks must apply the Standardized approach), particularly regarding the incentives they face (conflicts of interests) and their effects on macro-prudential and systemic risk. Finally, EU and US supervisors have been applying Basel standards quite differently within their own jurisdiction while recent G20 reform discussions encourage harmonization.

Moreover, the authors devote a particular section to the impact of Basel II on emerging countries. The economic survey shows that there is little impact on the cost for developing countries. However, they underscore that Basel II may “adversely affect developing countries by reducing the availability of and increasing the volatility and pro-cyclicality of external financing. Under Basel II, banks, relying more on their risks models, may more automatically decrease/expand their lending at time when asset prices are already depressed/elevated, thereby further lowering/raising economic activity and asset prices and producing crises/bubbles” (p.129).

In conclusion, the authors suggest ways of improvement for Basel standards. First, sophisticated institutions should have equal or higher, not lower, capital ratios relative to Basel I. Second, “if it is true that Basel II encouraged the very risk management practices which led to the current crisis, supervisors need to be far more skeptical about the claims made about the low risks of new product rangers characterized by securitization, and adopt a “precautionary principle” whereby the onus is on banks to demonstrate over time that new innovation deserve low capital charges because they have limited both bank and systemic risks” (p.132). Third, it is evident that banks need to be assessed in their entirety, including their off-balance sheet activities and unregulated affiliates. Finally, the authors state the from now on obvious: supervisors and market agents must put into place better macroeconomic tools to assess financial systems as a whole in order to prevent bubbles or reveal that banks have taken too much risk relative to capital requirements.

The authors’ main conclusion is therefore that notwithstanding the mandatory or efficiency of Basel Standards, the most urgent objective is to improve institutions and the tools they need to participate to market stability. A similar argument on institutions is made on a whole other matter by Eelke de Jong and Koen van der Veer in their analysis of The catalytic approach to debt workout in practice: coordination failure between the IMF, the Paris Club and official creditors. Indeed, they observe how, in order to obtain a certain effect, such as market stability or reinserting growth in crisis-hit countries economies, international institutions need to improve the methods employed. Authors illustrate their argument based on the study of “the catalytic approach”. The latter is a strategy of the International Financial Institutions (IFIs) to involve private creditors in solving a country’s balance of payments difficulties (i.e. the belief that IMF intervention triggers renewed private capital inflows) in times of crisis resolution in order to restore market stability. Indeed, by signing an agreement, official creditors signal that a country has sound financial institutions and follows sensible policies, which attracts private investors. The catalytic effect arises if private sector inflows successfully complement official creditors’ contributions to fulfill the gross financing requirement.

The authors suggest that the catalytic approach, the goal of which is to involve private creditors in crisis resolution, which is necessary to prevent moral hazard and because official creditors generally lack the resources to fully meet the financing needs of the crisis-hit country, is not as effective as proven by 1990s crisis in emerging countries and therefore requires the reform of the international financial architecture. Indeed, their study show that a catalytic effect is at best present only under certain specific conditions, as it is only triggered by bilateral loans or precautionary IMF programs.

The authors suggest two reasons why the catalytic approach is not always efficient: first because in 25% of cases, the total amount provided by official creditors exceeded the debtor’s financing needs, which facilitated private sector withdrawal (bail out) rather than incentives for additional capital inflows. Moreover, a core concept of all IMF programs is the country’s “financing gap”, which is the difference between what a country needs to raise to pay its maturing debts, IMF payments and ongoing deficits, and what it is projected to be able to raise from private creditors. For the catalytic approach to work, the total sum of the official financial package must fall short of the financing gap, so that additional capital can fill the remaining gap. However, the IMF projection of the amount it can loan to a country is always too optimistic, including the availability of private capital, in order to get large programs approved by the Executive Board of the IMF. IMF estimations are thus unreliable for estimating financing gaps.

Second, the catalytic approach requires a coercive instrument to first bail in private creditors, such as the bilateral creditors assembled in the Paris Club[4]. However, this coercive instrument, based on the Paris Club debt restructuring, contains a condition held in the “comparability of treatment” clause according to which the debtor country must seek debt restructuring with other bilateral and private creditors on comparable terms. Failure to do so involves losing the Paris Club agreement and therefore the bailing in of private creditors. The authors findings suggest that unfortunately, in order to counter such clause, which excludes short term debts[5], the private creditors actually bailed in are in for short terms debts which does not help the country’s overall balance sheet and therefore do not structurally improve its situation. Such coercive instrument is therefore inefficient as it does not encompass all types of private capital flows. “In addition, even if the Paris Club through the clause is successful in involving private creditors with outstanding accounts, private capital markets may more generally shy away from investing in countries where they perceive they may be forced to agree to less advantageous interest and repayments conditions in the future” (p.145). In such view, the study led by the authors concludes that the Paris Club clause generally did not have the intended effect on net total private capital flows. The Paris Club agreements only “gave rise to additional inflows of private capital only in low-income countries that had signed a PRGF and where the Paris Club had decided to reduce bilateral debt” (p.148).

The authors therefore conclude that such coordination failures among official creditors (IMF, Paris Club) have not contributed to efficient catalytic effect. Authors suggest that a more coercive instrument to bail in private creditors be implemented, encompassing all types of private capital flows (including short term debt), such as debt standstills. Because international catalytic effect is still not efficient due to IIFs flaws, the reputation and efficiency of international financial governance, along with its institution, have decreased in Asia after Asian countries’ 1990s crisis. They have therefore embraced other financial governance mechanisms.