III-1.12: 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. The following report analyses the last part of the volume and concludes on it.

Xiaoke Zhang describes in Global markets, national alliances and financial transformations in East Asia how East Asian countries, most specifically Taiwan and Malaysia adapted to the liberalization and globalization of financial markets over the past two decades. The authors suggests that East Asian countries, traditionally bank-based systems, have encountered the exponential growth of stock markets, especially because of equity finance which has fuelled incentives for industrials firms to rely on stock markets rather than on banks for external financing[1]. As previous contribution in this volume, the author recalls that the securities market orientation taken by East Asian countries differs from the Anglo-Saxon conception market model, both regarding corporate governance as well as regulatory regimes.

The first reason for such divergence given by the authors is due to input-side issues. Indeed, the international financial architecture did not balance policy imperatives with national configurations of power and interests, whereas effectiveness requires the articulation of national preferences on the input side, and policy space on the output side. Without legitimate input-side mechanisms, national systems will react against the architecture proposed. Faced with the potential yet real tensions between harmonizing liberal market and national institutions legacies and political imperatives, the author’s main argument is that complex interplay of external and internal factors characterize financial reform which encourages that “global governance standards consider input legitimacy in order to make them fit better with national political conditions” (p.205).

In this view, large-scale convergence of national systems on a particular model of financial governance is therefore unlikely in the near future, as it was demonstrated for the Basel II standards, and how the study of financial development in Taiwan and Malaysia proposed by the author suggests.

Indeed, the author describes the political process which led to financial transformations in Taiwan and Malaysia. For example, Zhang describes how “The political incentive to facilitate market-oriented changes derived in part from politicians’ desire to use the stock market to privatize state-owned enterprises (…) In Taiwan, effort to promote a financial market economy have geopolitical significance as well (…).They hoped pro-market policies would promote the overseas profile of the island and render it more admissible to multilateral institutions and processes” (p.209).

However, Zhang underscores how such financial transformations have diverged significantly from typical cases of financial liberalism. For example, although both countries’ financial development led to exponential capital market based stock market growth, the western model of corporate governance was not adopted, banks have acted as market markers[2] and regulatory agencies have operated under the direct influence of state and societal actors to pursue their policy interests. In this view, the author agrees with the volume main proposition, that market-oriented model of financial governance does not transfer well from one national context to another, while domestic dynamics will almost certainly mediate the impact of systemic pressures on patterns of market reform.

The author’s empirical findings lead to conclude that “international policy makers must adequately recognize the ways in which common external stimuli for national market change unleashed by global market integration are mediated by the incentives, preferences and strategies of domestic political actors” (p.218). The author therefore recommends finding the right balance between legitimate national political processes and systemic pressures for institutional change as this need for greater attention to the diversity of national political structures is what underpins financial markets as well as the need for more policy space than what is currently allowed in the international financial architecture. The latter recommendation were clearly ignored during the 2002-7 “period of calm” during which the EU and the US focused and spread their own notion of market-based financial governance, certainly creating transatlantic convergence but letting aside other parts of the world, and more importantly imposing to them standards which will soon appear to be flawed since their own market conception was too.

Indeed, in Changing transatlantic financial regulatory relations at the turn of the millennium, Elliot Posner describes EU-US relations in regards to regulatory regimes during the 2002-2007 “period of calm”. The author highlights the role of political authorities and institutions in amending transatlantic regulatory cooperation. The authors’ main argument is based on several diplomatic transatlantic accords, such as the “EU-US Regulatory Dialogue on Financial Services”, or the “Framework for advancing transatlantic economic integration, as well as on several “disputes” between regulatory authorities on regulatory matters, such as the Sarbanes-Oxley Act, the accounting norms[3], the Market in financial services Directives etc.. Based on the evolution of such cooperation, dialogues and dispute management reflecting either US preferences or EU preferences, the author proves that relations between transatlantic authorities (such as SEC-CESR) have changed, in particular in terms of “rule makers” and “rule takers”, but also how it ended for most of them in mutual accommodation. 

Posner suggests that notwithstanding the traditional American hegemony over financial regulation, which for a long time meant that the USA did not need to adjust its own policies in response to external pressures, the structural power of a regional policy such as the EU, with a “centralized “ regulatory authority, has led the US to compromise and modify its legislation in order for regulatory cooperation and coordination to be truly effective for markets actors involved in transatlantic relations. Indeed, regional cooperation as well as EU effort to harmonize rules and centralize rule-making (through the Financial Services Action Plan and the Lamfalussy Process) increased EU influence. Moreover, the SEC had responded largely to the lobbying of American investment banks, concerned about the possible negative implications of the new EU financial architecture, such as the new conglomerates directive, to their European businesses. The author’s interviews on both sides of the Atlantic confirm the role of lobby groups in convincing US authorities to make adjustments, end regulatory disputes and institutionalize transatlantic regulatory dialogue. “The US made concessions because Wall Street firms argued that making no adjustments would place them in a precarious positions and would jeopardize the role of the SEC as their primary regulator” (p. 236).

Yet, such private sector influence on public authorizes is no case of capture. The chapter demonstrates that private influence was a necessary but not a sufficient condition for the observed changes, since it was also the internal EU regulatory centralization which changed the market opportunities and expectations of US-based multinational firms, the breakdown of which was deemed unacceptable by US officials. In Posner’s words, US officials therefore had to find ways to accommodate EU positions.

The author therefore concludes that the EU’s role as a global rule-marker improved regulatory effectiveness. Yet, Posner tempers his finding based on the current financial crisis. Indeed, although transatlantic regulatory coordination is deemed by the author a success in term of mutual concessions, such coordination only accelerated and intensified the convergence and spreading of the “orthodox” market model, which is deemed by the volume as one of the cause of the crisis. In this view, it is left to the EU, with its acquired international role and interdependency with the US, to use its influence today in the area of financial governance and to put on the transatlantic table certain issues, such as the most important one in the author’s view: cross-border prudential supervisory arrangements.

Indeed, without proper common standards and supervisory mechanisms, no regional nor global financial governance will be efficient. This is what Heribert Dieter’s contribution called monetary and financial cooperation in Asia: improving legitimacy and effectiveness? recalls as the authors demonstrates how southeast and east Asia have been embracing regional cooperation and integration in monetary and financial affairs ever since the turn of the century, in order to flee western countries orthodox view of the market.

Indeed, the 1997-8 Asian crisis, demonstrating the lack of option for emerging economies in financial crisis –therefore creating doubts towards the IMF-, as well as the recent collapse of the Anglo-Saxon model, have both encouraged such process. Because Asian countries started doubting both the input side of global financial governance (its legitimacy) and well as its output (its effectiveness), monetary regionalism[4] and other bilateral agreement have increasingly received attention in Asia.

The author first describes the rationale for monetary regionalism, seeing in the 1997 Asian crisis the most important reason for pursuing monetary cooperation in Asia. First, because countries affected by the IMF’s provision of liquidity, which was much too slow in 1997, felt as they had little to say in the formulation of its policies. Second, because regionalism aims to increase the ability of countries to pursue domestic objectives while encouraging intraregional capital flows, an impossible thing to do with a global financial architecture the input-side of which has proved to be deficient in terms of legitimacy. Moreover, “the frustration of Asia-policy-makers with the slow reform of the international financial architecture and the dominance of Washington in regional and global affairs is equally important” (p. 243). Therefore, understanding that such reform would unlikely happen quickly, whereas national regulation had become insufficient, the region appeared as better able to provide solid structures. 

The author subsequently describes the evaluation of Asian regionalism since 2000 and how Asia’s regional monetary cooperation is currently four leveled: the networking of currency swaps under the Chiang Mai Initiative (CMI) ; the monitoring of short-term capital flows and other surveillance measures ; initiatives to strengthen regional bond markets ; and the emergence of cooperation on exchange rate.

Whereas Asian regionalism seems to be on the right track, the author raises two obstacles which could hinder its development: the regional capacity to be sufficiently integrated economically, and the capacity of countries to cooperate politically, especially China and Japan which seem to struggle for superiority and are the main problem to today’s progress in monetary regionalism. The authors notes that currently, “there has been very little debate [on exchange rate cooperation]: exchange rate policies in the region are set unilaterally, and the trend is towards managed or independently floating rates rather than a cooperative exchange rate arrangement” (p.250).

 To cope with such issues, the author suggests four paths for successful monetary integration: first, to develop a single currency ; second to agree on a regional exchange rate mechanism similar to the Exchange rate mechanism in Europe ; third, countries could abandon their dollar pegs and jointly agree to peg their currencies to a single currency from the region (yen or yuan) ; fourth, peg their individual currencies to a basket of currencies. Finally, the author recommends an enhanced regional surveillance for deeper cooperation in monetary affairs, not only to further integration but to combat the risk of contagion.

The author therefore concludes that Asian countries may, through regionalism, “enhance the input side legitimacy by strengthening cooperation and participation of Asian countries in determining their destiny in the global monetary order, and simultaneously enhance output-side legitimacy and policy effectiveness by better aligning policy output and results to their interests and normative preferences” (p.255). Such input-side improvement is necessary to stop the trend to expand globally standards which are not appropriate to all countries’ national characteristic. Such is the case of the pro-cyclicality of financial governance induced by skewed input-side mechanisms.

José Ocamp and Stephany Griffith-Jones focused on pro-cyclicality in the international financial architecture. In Combating pro-cyclicality in the international financial architecture : towards development-friendly financial governance, the authors mainly focus on the negative impact of pro-cyclicality on developing countries. As already mentioned in the volume, developing countries have had relatively little influence on the development of the existing international financial architecture, whereas the latter have much been under policy capture, indicating a lack of input-side legitimacy within the current international financial architecture, thus in turn limiting the out-put side legitimacy (or effectiveness) of global governance. The authors take the example of the highly pro-cyclical and market-based nature of the system to point out such limited output legitimacy as well as its limitation of policy space for developing countries. Authors suggest that the major function of an effective international financial architecture should be to “mitigate the pro-cyclical effects of financial markets and to open “policy space” for counter-cyclical macroeconomic policies in the developing word (…). The input-side governance of the system should give developing countries sufficient representation reflect their growing role in the world economy, while more attention should be paid to avoiding policy capture by private interests” (p.270).

Authors first describe how financial governance is tainted with the pro-cyclicality of the contemporary market-based order, enhancing highly pro-cyclical volatility in developing countries’ external financing. Authors describe the danger of volatility as following: “Volatility is associated with significant changes in risk evaluation, involving alternating period of “appetite for risk” (more precisely underestimation of risks) and “flight to quality” (risk aversion). (…) Furthermore, due to information asymmetries, different assets tend to be pooled together in risk categories viewed by market agents as strongly correlated. These practices turn such correlations into self-fulfilling prophecies. These problems have been dramatically evident in 2007-8, particularity in the United States.” (p.273).

Due to such volatility, authors maintain that developing countries therefore lost their policy space to adopt autonomous counter-cyclical macroeconomic policies and had much trouble creating deep financial markets which participate to economic development. As Cassimon et al. had already underscored, “a vicious circle emerged involving pro-cyclical financing, underdeveloped financial markets and institutions, and external constraints on macroeconomic policy autonomy” (p.273). Indeed, while developed countries can counter pro-cyclical effects of credit and asset prices by implementing counter-cyclical macroeconomic policies, developing countries are on the contrary forced to adopt pro-cyclical macroeconomic policies that reinforce the movements of financial markets. Such pro-cyclicality is unfortunately also encouraged by the private financing sector during booms since unstable external financing distorts incentives that private agents and authorities face throughout the business cycle. “Increased exposure to financial market risks has replaced Keynesian automatic stabilizers with automatic de-stabilizers. Contrary to the view that liberalized financial markets would play a disciplining role, dependence on financial swings has encouraged the adoption of pro-cyclical monetary and fiscal policies” (p.275). In such view, pro-cyclicality of financial markets increased growth volatility, efficiency gains from financial market integration having been swamped by the negative effects of growth volatility, and have not encouraged growth in the developing world.

Therefore, the origin of the problem comes from prudential regulation (through Basel Standards), which focus too much on microeconomic risks and exacerbates such pro-cyclicality, whereas risks often lies at the macroeconomic level. “In particular, by failing to consider the benefits of international portfolio diversification, capital requirements for loans to developing countries will be significantly higher than is justified on the basis of actual risk”. The introduction of counter-cyclical elements within prudential regulation and supervision should be a central concern for the Basel Committee and developing countries should also adopt specific regulations aimed at controlling currency, maturity mismatches and at avoiding the overvaluation of collateral generated by asset price bubbles.

As a remedy, authors suggest counter-cyclical instruments for developing countries such as GDP-indexed bonds or local currency bonds. They also suggest counter-cyclical guarantee facilities put up by financial institutions (IMF, Multilateral development banks) to cope with the fact that financial markets overestimate risk in difficult times and underestimate it in good times. Authors also suggest that appropriate facilities for international provision of counter-cyclical official liquidity include a liquidity provision in order to cover large capital flow reversals and volatility in real export earnings (in order to cope with the fact that recent crises in emerging markets have been triggered by self-fulfilling liquidity runs). Finally, authors conclude that while the IMF has facilities to compensate for terms of trade shocks, they are too limited, and should be significantly expanded to compensate the too much larger proportion of losses caused by temporary shocks.

The volume’s last contribution deals with Public interest, national diversity and global financial governance. Suggested by Geoffrey R. D. Underhill and Xiaoke Zhang, the chapter first describes how the input-side influence on the design of the international financial architecture of the very private financial interests which stood most to benefit from the facilitation of cross-border market integration and activity is directly associated with the causes of the crisis. Indeed, the crisis was not just a market failure but a policy process problem (such policy based on liberal order and market-based approach). In this view, authors argue that a more effective and legitimate governance of global finance lies in explicit consideration and incorporation of essential political and normative prerequisites.

Authors recall that legitimacy in governance is premium and can only be created if norms are elaborated in a manner that their policy makers will be accountable for them towards their constituencies. “Legitimacy is about satisfying enough of the people enough of the time” (p.289). Such legitimacy is difficult to achieve at the global level since in a parallel manner, financial integration intensifies while domestic governance is undermined, therefore creating sovereignty –legitimacy- issue. Legitimacy is however enhanced if states and transnational actors could be held accountable for their decisions and if the output-side of the process would descript a certain consensus on norms while representing the interested of the ruled. In such view, more representative and transparent input could lead to output perceived as legitimate. Institutions therefore need to be more inclusive and responsible for their impact in order for their policy output to satisfy a broader range of interests.

The chapter focuses on two prerequisites for global financial governance. The first one is that “the international financial order be predicated upon an appropriate and politically sustainable balance between private and public forms of authority, which should include the interests of emerging market and low-income countries”. In other words, the governance of the system should not reside completely in the private domain of the market. Indeed, it has been showed that unaccountable private actors participate in a somewhat closed policy community which has led to policy capture. Such trend is due to the broader reconfiguration of the role of states as both promoters of market-based global integration and managers of its consequences. “This trend (…) does not imply that states are in retreat or could not implement alternative options. With financial globalization has come a change in the balance of power between public authority and private interests and an accompanying transformation in the notion of the public interest that defines the financial order, posing problems to input and output legitimacy and to accountability” (p.293). Indeed, with financial globalization the influence of private market actors have increased within policy process, leaving aside broader sets of interests and obliging public authorities to respond by adopting market-based approaches to regulation, supervision and corporate risk management.

In the end, private firms managed to have their own risk assessed and managed through complex mathematical models implemented under the approval of supervisory agencies. Such firms achieved to have very close relationships with regulatory agencies, with frequent delegation of oversight to self-regulatory processes (authors cite the example of the Basel Committee, a public-private think-tank which consecrate a “Group of thirty” market based vision of financial governance). Such self regulation and public/private relation were enhanced by common professional norms within G7 economies’ firms. Slowly, “clear definition of the public interest distinct from the particularistic claims of private market actors had thus become increasingly difficult” (p.294), and the transnational financial system became more and more regulated by agencies constituting regimes that were more responsive to private interests than providers of collective goods. Yet, as the crisis demonstrated, “allowing those with pecuniary interest in lowering the costs of supervision to define the system is surely a flawed public policy process on both the input and output sides, and there appears to have been a very low level of accountability until the crisis struck” (p.293).

Authors therefore underscore how the financial governance is flawed in terms of input-side legitimacy and argue that encouraging private sector involvement is problematic if its fails to represent broader social constituencies and align notions of the public interest “with reducing risks and losses for those who profit most from financial markets” (p. 295) –which is precisely what seems to have caused the subprime crisis. Inevitably, the flawed input-side of financial governance polluted its output, as it is recognized that policy failures which led to the crisis originally laid in the G7 reforms that had encourage such financial governance to be overly responsive to private sector preferences.

The second prerequisite for the legitimate governance of global finance is that, in the same way as the previous chapter argues, the global financial architecture needs to be more compatible with legitimate national economic development aspirations, political processes and distributive justice. “A major plank in the reform process was the promulgation of a range ‘global’ standards in the domains of macroeconomic policy, financial stability, accounting and corporate governance” (p.296). And while regulatory change in financial system is a source of convergence, US and European institutions have long claimed for deregulation while developing countries were caught in deliberative forums (Basel Committee, IOSCO) in which their vote was either non existent or undermined. Such trend led to developing cross-borders market-oriented standards, whether they were appropriate for developing countries or not. Indeed, as the authors note, convergence could not have worked since historically, few paths to capitalist development have converged for long. “Where tensions between harmonizing liberal market structures and local contexts and institutions become overwhelming, capitalist development and market-based society may prove politically unsustainable or simply ineffectual” (p.298). Moreover, even though convergence to market oriented practices may be beneficial in an aggregate and long-term sense, it necessarily involves important short-term costs for more vulnerable players (financiers over workers, rich over poor).

Therefore, although convergence is indeed necessary for cross border finance to be efficient, the standards and practices which base it must be perceived as legitimate. In such view, the input side flaws of the current financial architecture as described by the authors can only produce outputs that conflict with certain norms of domestic governance. If norms which are bound to be global are actually only shared and agreed with by a narrow group of actors, international cooperation may only be ineffective.

To conclude, authors argue that the ongoing potential for capture suggest that a clear definition of the public interest distinct from the particularistic claims of private market actors is the key to ensuring the predominance of the public good in the financial system. In this view, the “policy implication once again is that input legitimacy could be substantially enhanced through better and broader representation based on a range of principles, thus increasing the likelihood of embedding a more acceptable spectrum of norms in global financial governance. (…) in order for the reform agenda to become more legitimate and therefore more achievable, developing countries and broader publics in the developed world will have to be given a major say in the setting agenda.” (p.301-303). 

Daniel Mügge, Jasper Blom and Geoffrey R. D. Underhill conclude the volume on the same stream of ideas: governance should not be one watertight set of rules but a much looser framework of cooperation that consciously acknowledges the needs and legitimacy of national idiosyncrasies. “Such an order would come much closer to what Keynes had in mind when negotiating Bretton Woods: a financial and monetary regime that bolsters rather than constrains governments’ ability to make financial policy in the public interest”. Moreover, broadening input may strengthen the legitimacy of global agreements; while at the same time decreasing the change the agreed rules proved as inappropriate (as for example Basel II), thus in turn ultimately enhancing the effectiveness of an emerging multilevel pattern of governance. Authors also add that “even with successful regional arrangements, the contemporary financial order also exhibits seriously global patterns of integration and imbalances, so better governance will need to be a multi-layered governance” (p.311).

As for the notion of financial order and governance which should prevail and underpin the process of reform, and the interests of whom should be protected, authors agree that the interests of the broad public will need to be those in front and centre in any system of financial markets and governance, as they are those who will remain the guarantors of the risks taken by financiers with other people’s money. “Our financial order should first and foremost serve these needs because these are the very people on whose modest resources financiers and the economy in general ultimately rely when they take risks that may or may not pay off, the end costs of which are potentially collectively to be borne. (…) Finance must take place in ways which are compatible with the broader and mostly simpler needs of this wide range of “publics”, spread as they are across a range of poor, emerging market and developed countries” (p.315).