Download financing globalization: lessons from economic history

Globalization and Finance Project
supported by the Ford Foundation
www.bsg.ox.ac.uk
FINANCING GLOBALIZATION:
LESSONS FROM ECONOMIC HISTORY
All Souls College
19 June 2012
CONTENTS
List of participants
Cyrus Ardalan:Vice Chairman:Barclays
Foreward
»»
Ngaire Woods
Hugo Banziger:former Chief Risk Officer:Deutsche Bank
2
Amar Bhide:Thomas Schmidheiny Professor,
The Fletcher School of Diplomacy: Tufts University
Summary of Proceedings
»»
Kevin O’Rourke and Philipp Hildebrand
3
Patricia Clavin:Professor of International History & Fellow:
Jesus College, Oxford
Rui Esteves:University Lecturer in Economics, Brasenose
College:Oxford
Historical Lessons
»» Hugo Banziger
»» Rui Esteves
»» Marc Flandreau
»» Harold James
»» Catherine R Schenk
Contemporary Challenges
5
9
12
15
17
»»
»»
»»
»»
20
22
23
25
Cyrus Ardalan
Charles Goodhart
Rob Johnson
Pierre Keller
Jaimini Bhagwati:Indian High Commissioner to the United
Kingdom
Marc Flandreau:Professor of International History:
The Graduate Institute, Geneva
Macer Gifford:Visiting Research Fellow, Globalization & Finance
Project:Blavatnik School of Government, Oxford
Charles Goodhart:Professor:London School of Economics
Philipp Hildebrand:Senior Visiting Fellow, Globalization & Finance
Project:Blavatnik School of Government, Oxford
Roberto Jaguaribe:Ambassador of Brazil to the United Kingdom
Harold James:Claude and Lore Kelly Professor in European
Studies:Princeton University
Rob Johnson:Executive Director:
Institute for New Economic Thinking
Vijay Joshi:Emeritus Fellow:Merton College, Oxford
Pierre Keller:former Senior Partner:Lombard Odier & Cie, Geneva
Policy Recommendations
»»
»»
»»
»»
Amar Bhidé
Peter Kurer
Roberto Jaguaribe and
Augusto Cesar Batista de Castro
Vijay Joshi
27
30
33
36
George Kounelakis:Managing Director:
Morgan Stanley Principal Investments Group, Europe
Peter Kurer:former chairman:UBS, Zurich
Walter Mattli:Professor of International Political Economy &
Fellow:St John’s College, Oxford
Kevin O’Rourke:Chichele Professor of Economic History and
Fellow:All Souls, Oxford
Catherine Schenk:Professor of International Economic
History:University of Glasgow
George Soros:chairman:Soros Fund Management and
chairman Open Society Institute
Sir John Vickers:Warden of All Souls College and Professor of
Economics:Oxford
Ngaire Woods:Dean:Blavatnik School of Government, Oxford
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 1
FOREWORD
Professor Ngaire Woods
Dean of the Blavatnik School of Government
As regulators across the world consider how to
constrain and regulate global banking, an equally
important question is being neglected. What forms
of global finance best serve global growth and
development? This question is being probed by the
Ford Foundation Globalization and Finance Program at
Oxford University’s Blavatnik School of Government.
Economic history provides several insights.
Specifically, by analyzing previous periods of
successful globalization, we can attempt to identify
what kinds of finance made them work. This
report includes an overview of important themes (by
Professor Kevin O’Rourke and Dr Philipp Hildebrand)
and a set of memos prepared for the workshop by
participants. An overall finding of the meeting is eloquently
summarized by participant Macer Gifford: “The earlier
periods do not necessarily support the argument
for global banks. Rather, that global rules written
with a clarity of purpose (such as Bretton Woods)
and requiring bankers having ‘skin in the game’ (such
as Rothschilds and JP Morgan in the early twentieth
century) can foster prolonged periods of global
growth.”
Sincere thanks
to those who made this workshop possible, and in particular:
the support of Leonardo Burlamaqui at the Ford Foundation;
the intellectual leadership of Philipp Hildebrand and Harold James;
the terrific research and organization of Rahul Prabhakar,
Taylor St John, and Emily Jones; and the design expertise
of Toby Whiting.
Globalization and Finance Project, University of Oxford
Two particular policy ideas are provoked for further
investigation by the Ford Foundation Globalization and
Finance project:
1. Focus on the link between global finance and
real resources, and investment for development.
Trade finance and mechanisms which allocate
investment to areas where it can be most
productive are vital elements of a global financial
system which supports growth and development.
Yet these elements of global finance risk being
neglected in the contemporary international debate
about regulation.
2. Reinstate unlimited liability in banking? When
owners of banks have unlimited liability, or “skin
in the game” they have a sharper and more
immediate interest in prudence, scrutiny and
the sound management of the operations of
their enterprise. Historically, when the liability of
owners of banks was limited, this was in return for
accepting accountability and transparency about
their operations. But that deal is looking tattered.
Syndication, securitization, financial engineering,
implicit government guarantees, evermore
detailed and incremental regulation, and rapidly
evolving accountancy practices have all rendered
accountability and transparency extraordinarily
difficult. Perhaps instead of continuing down
this path, regulators across the world should be
reinstating unlimited liability among the owners of
banks.
19 JUNE 2012 / 2
SUMMARY OF PROCEEDINGS
Professor Kevin O’Rourke and Dr Philipp Hildebrand
On 19 June 2012, the Globalization and Finance
Project at the Blavatnik School of Government held a
workshop on Financing Globalization: Lessons from
History. The workshop brought together a unique
combination of eminent economic historians, bankers
and finance practioners to discuss what lessons might
be drawn from the history of finance to inform today’s
challenge of reforming the post-crisis global financial
system.
There are two periods since 1870, but prior to the
1990-2007 period, which are typically regarded as
success stories: the nineteenth century, and the period
from 1950 to 1972.
The nineteenth century was a period of impressive
globalization, which was genuinely worldwide in
scope thanks to the combined effects of steamships,
railroads, telegraphs, and empires.
»»
According to Angus Maddison (1995, p. 38),
merchandise exports accounted for just 1 per cent
of world GDP in 1820, but 8 per cent in 1913 – a
substantially higher share than in 1950. In Latin
America and India the 1913 levels of openness
had not been recouped as late as 1992 (in the
case of India they had not been recouped as late
as 1998) (Findlay and O’Rourke 2007, p. 510).
»» International labour migration was much more
extensive in relative terms than today. Roughly
60 million Europeans migrated to the New World
between 1820 and 1914, and there were also
sizable outflows from China and India.
»» Net international capital flows, as measured by
current account imbalances, were extremely large
even by today’s standards. British capital exports
averaged 4.5 per cent of GDP between 1870 and
1914, and reached 8 to 10 per cent during lending
booms. A third of British wealth was held overseas
in 1913. Countries like Argentina and Australia
were extremely reliant on capital inflows: in 1913,
foreigners owned almost half the Argentine capital
stock, and a fifth of the Australian capital stock
(O’Rourke and Williamson 1999, Chapter 11;
Obstfeld and Taylor 2004; Taylor 1992).
These developments were inter-related: capital
and labour flowed from Europe, chasing resources
elsewhere in the world – primarily, but by no means
exclusively, land on the frontiers of the New World.
Capital financed massive investments in transportation
and other infrastructure, making it possible to bring
these resources into productive use, and hence
generating flows of income which borrowers could use
to repay their debts. Most of the capital flows involved
bond finance.
Globalization and Finance Project, University of Oxford
Professor Kevin O’Rourke
Dr Philipp Hildebrand
The period from 1950 to 1972 saw the gradual
reconstruction of the international economy, although
this was only partial in two respects. First, while the
OECD economies moved to reintegrate their markets,
Communist economies were moving in the opposite
direction; and much of the developing world adopted
inward-looking industrialization policies, following the
end of European imperialism. Second, the Bretton
Woods settlement prioritized domestic monetary policy
autonomy and fixed (but adjustable) exchange rates,
meaning that capital controls were ubiquitous.
Despite these limitations, world trade grew extremely
rapidly during this period, as the figure makes plain:
more rapidly than at any other time since 1870.
This was in part because of the extremely rapid
economic growth of the period, but trade grew more
rapidly than GDP, implying an impressive period of
“reglobalization”.
World exports, 1855-2010
Source: Findlay and O’Rourke (2007, p. 506), updated using data from WTO
Overall, what is striking is that history provides little
evidence that extreme developments towards crossborder banking such as what the western world
witnessed between the mid-1990s and the outbreak
of the Great Financial Crisis in 2007 are essential
19 JUNE 2012 / 3
to support inclusive and sustainable growth. This
certainly does not mean that a fragmentation of the
global banking system along national frontiers would
be a desirable development. It does mean, however,
that it is deeply flawed to argue that in an effort to
support growth and employment, the aim of the ongoing regulatory reform efforts should be to reinstate
the largest global banks to anything near their precrisis size and prominence. Banks will continue to
play a crucial role in any well functioning economy.
Nonetheless, fundamental changes in the risk profile
and the business models of word’s largest banks are
urgently needed in a much broader effort to lead the
world economy out of near five-year state of permanent
crisis. History provides to evidence to the contrary.
References
Findlay, R. and K.H. O’Rourke. Power and Plenty: Trade, War, and the
World Economy in the Second Millennium. Princeton: Princeton University
Press.
Maddison, A. 1995. Monitoring the World Economy 1820-1992. Paris:
OECD.
Obstfeld, M. and A.M. Taylor. 2004. Global Capital Markets: Integration,
Crisis, and Growth. Cambridge: Cambridge University Press.
O’Rourke, K.H. and J.G. Williamson. 1999. Globalization and History: The
Evolution of a Nineteenth Century Atlantic Economy. Cambridge MA: MIT
Press.
Taylor, A. M. 1992. ‘External Dependence, Demographic Burdens,
and Argentine Economic Decline After the Belle Epoque.’’ Journal of
Economic History 52: 907– 936.
Clockwise from top: Tea in All Souls
between sessions: Patricia Clavin, The
Old Library, George Soros in conversation
with Ngaire Woods, Pierre Keller
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 4
Dr Hugo Banziger
former Chief Risk Officer, Deutsche Bank
Information Technology, modern communication
and the liberalization of markets were the primary
forces, which drove the globalization of finance and
integration of financial markets over the last 30 years.
As a result, the financial industry is today the biggest
spender on IT and the majority of data pumped around
the globe relates to finance. Indeed, financial markets
are truly global and integrated. It is thus no surprise
that the crisis of 2007, which had its origins in the US
residential mortgage market, spread across the globe.
It will not be the last one to do so either. The question
this paper tries to answer is whether the globalization
of finance contributed to financial instability. By looking
at several waves of financial integration, I try to analyze
what it meant for the people at the time, whether
it affected financial stability and when it did, how
societies responded. That domestic imbalances can
lead to financial instability is obvious. The collapse of
the German Mortgage Banks in the late 1990 resulting
from a government sponsored real estate bubble after
the fall of the Berlin Wall is a less well known but good
example. Given the magnitude of the question, my
answers are summary in nature.
Trade Finance – Netting The Risk
As we know from archeology, long distance trade in
metals, grain, wine, olive oil and spices started during
the Sumer Empire and the early Pharaoh kingdoms.
We know from fragmented records that these early
traders employed their families to conduct their
business. So far, no evidence survived as to how these
trading activities were financed. The first clues date
from the grain trade in the Roman Empire, even though
the records are few. To manage and finance the import
of wheat from Sicily and Egypt, traders maintained a
large network of agents, which were mostly relatives.
These agents not only purchased and shipped grain,
they also acted as clearers in order to minimize the
risk of payment loss (pirates, loss of ship, fraud).
Receivables were netted within the widespread family
framework.
After the collapse of Rome, trade and related
financing disappeared from the western part of the
Mediterranean but survived in the Byzantine Empire
from where it re-emerged with the crusades first
in Venice and Genoa, later in Renaissance Italy.
Banking families like the Medici were organized along
family lines with their branches in Europe typically
run by family member. Even Germany’s Fugger
who started with manufacturing and trading textiles
before becoming bankers, were a family bank. Whilst
both houses, the Medici and the Fugger, eventually
collapsed because of excessive lending to Emperor
and Kings, their trade finance business was as selfliquidating as it remains today. It reduced the risk to
the system by using gilts thereby netting payments
and drastically reducing the amount of money, which
had to be physically shipped. The invention of gilts
Globalization and Finance Project, University of Oxford
introduced the risk of bank failure to society but with
equity typically making up 1/3 to ½ of the balance
sheet, this risk was well buffered and affected only
wealthy families. Albeit bank runs did happen at the
time, they were usually caused by government defaults
on bank debt.
Joint Stock Companies – pioneers of foreign
investments
In the 17th century, Europe started the long process
of transformation from an agricultural to a modern,
monetized society. Some important steps were the
creation of the first stock exchanges in Antwerp, the
establishment of Joint Stock companies such as the
Dutch and the English East India Companies and of
Government Debt Offices (Bank of England). At the
exchanges, which spread quickly to Amsterdam and
London, physical commodities, government debt and
the shares of the few stock companies were traded. It
was this innovation that made the South Sea Bubble in
England and the Mississippi Bubble in France (Banque
Royale) possible. Based on hyped-up promises of
future trading profits in South America and Louisiana,
the companies issued stock or bank bills beyond
their asset capacity. Some of the proceeds went
invested abroad. But most were used to purchase
government debt to finance the perpetual wars
between Spain, France and England. In 1720, both
companies spectacularly collapsed leaving the equity
and notes holders with huge losses. Before joint stock
companies came into existence, banks were owned
by a few rich families. The combination of joint stock
structure and exchange trading broadened ownership
and transferred risk to the wider society. There were
now merchants, scientists (Newton!), middle ranking
government officials, town mayors and village elders
among the investors. Not surprisingly, the collapse of
these two companies had wider political ramifications.
To restore confidence in markets and the value of
money, both the French and the English government
had to intervene and resolve these companies. The
public registration for stock companies became
mandatory. For the first time, the public demanded
proper accounting and disclosure standards. It was
also a novelty that a paper currency (bank bills of the
Banque Royale) had to be depreciated. Joint stock
companies were established to reduce the risk of
individual investors and mostly achieved this goal.
However, it is fair to say that the concept of a public
company promising future cash flows added a new
systemic risk to the financial system. Over the next
200 years, there were several more bubbles, which
had their root cause in hyped-up investment schemes,
manipulation of accounts, missing or misleading
disclosure and lack of governance/supervision. By
and large, the world had to wait for the Securities
and Exchange Act in 1934 until these issues were
fully addressed. Regrettably, the SEC framework did
19 JUNE 2012 / 5
not keep pace with the financial innovation over the
last 30 years. The disclosure rules of 1934 proved
inadequate for modern banks, derivatives and
securitized products. A regulatory framework, which
does not remain in sync with market development and
innovation, will become ineffective.
Savings Banks – Unexpected Contributors to
Systemic Risk
The industrial revolution in the 18th century not only
transformed the way we manufacture and consume,
it also profoundly impacted the use of money. In an
agricultural, self-subsistent society, the circulation
of money was limited. Farmers did not need a lot of
money. All this changed with large concentration of
industrial workers in towns. They got a salary and
had to buy their food and clothing in the market.
Society was monetized. In the absence of a safety
net, delaying consumption was the only way to protect
against rainy days. The safety of the resulting savings
thus became of paramount importance. Within a few
years of factories being built, savings associations
emerged everywhere in Europe. Traditional banks
were neither present in these new industrial centers
nor capable of handling small deposits. As traditional
banks failed in economic downturns, so did savings
banks. But the consequences were different. Suddenly,
large numbers of less well off people were affected,
losing their protection against the avarices of life.
Thus, protection against individual risks created a
new systemic risk. Also, since the rise of savings
banks coincided with the development of capital
markets, savings associations also invested in bonds
of large foreign infrastructure projects. We are well
aware of the losses resulting from large infrastructure
projects such as the Suez and Panama Canal,
various railway schemes in Africa and the Americas,
or even the Gotthard tunnel in Switzerland. That the
emancipating working class demanded corrective
political action is thus no surprise. Indeed the first,
albeit timid investment restrictions for savings banks
emerged in the middle of the 19th century. In many
European countries, these restrictions (“investment
rules for widows and orphans”) were a nascent form
of banking supervision. The safety of our citizen’s
deposits remains of paramount importance to this
day. Both the collapse of the Swiss “Spar & Leihkasse
Thun” in the mid 1990 or the more recent failure of
“Northern Rock” illustrate the point. The debate of how
to best protect a nation’s deposits has been re-opened
more recently in the UK by the Vicker Commission’s
recommendation to segregate deposit-taking activities
from other banking operations. Before the GlassSteagall Act was suspended in 1999, the United
States not only separated commercial, deposit taking
banks from investment banks but also went a step
further by establishing the Federal Deposit Insurance
Corporation to insure all deposits. Sixty years later,
the European Union followed with a Deposit Insurance
Scheme in 1994. With the exception of the US Savings
& Loan debacle, deposit protection and insurance
schemes worked reasonably well for domestic
Globalization and Finance Project, University of Oxford
institutions. However, the 2007 Financial Crisis cast
serious doubts as to whether these schemes also
work for large, globally active banks. Lehman Brothers
syphoned billions of deposits from Germany before it
collapsed in 2008. When it failed, losses in the range
of EUR 4bn almost bankrupted the private German
deposit insurance. Also, the German HypoReal Estate
needed around EUR 100bn of government support
since its “Schuldscheindarlehen” counted as deposits.
Re-thinking deposit protection and insurance is thus
mandatory, given the global dimension of today’s large
banks.
Modern Capital Markets
The 19th century saw a rapid expansion of
international credit extension, underpinned by the
fast integration of the world economy, which made
major progress with the Transcontinental Railway
in the USA and the opening of the Suez Canal in
1871. The demand for infrastructure financing in the
developing world was matched by much improved
fund raising capacity of “new” types of banks such
as Merchant Banks, Investment Banks and Credit
Mobilier Banks. They were the key agents of the
globalization of finance in the second half of the 19th
century. Whilst their specific business model differed,
all raised bonds and issued shares on behalf of other
companies. To minimize their risks, they formed large
underwriting syndicates, as we know them today.
Syndication was by and large the equivalent to reinsurance, which was “invented” by Sal Oppenheim
in Koln at around the same time. Without any doubt,
the syndication of underwriting risk minimized the risk
for the participating banks. It allowed them to diversify
their risks and to underwrite larger transaction than
they could do on their own balance sheet. On the other
hand, listing large numbers of shares and bonds on
exchanges introduced a new risk to financial stability:
the psychology of bullish and bearish investors.
The period from 1870 to the First World War saw an
increase in stock market panics with considerable
decline of liquidity. Domestic stocks dominated the
exchanges at that time (rail, shipping, infrastructure,
later hydro electric power). But international stocks
were often amongst the most volatile. For a while, the
financial strength of large institutions could stabilize
the markets. JP Morgan’s intervention in the 1907
panic is legendary. However, even the resources of
large banks became too small and in 1913, the United
States had to establish the Federal Reserve Bank
system as “Lender of Last Resort”, a concept now
widely adopted throughout the world. In a nutshell,
the development of modern capital markets reduced
the syndication risk for banks but it also increased the
instability of financial markets and eventually required
the creation of modern central banks.
Steps to Global Banks
The last decade of the 19th century also witnessed
the beginning of a development, which became
important one hundred years later. To support their
national industrial champions, big banks began
19 JUNE 2012 / 6
to expand abroad by setting up foreign branches
and subsidiaries. A good example is Deutsche
Bank’s expansion into Asia and Latin America
where subsidiaries were set up in the 1890s. These
subsidiaries conducted wholesale banking operations
(Trade Finance, Lending) in support of German
business interests. They did not engage in domestic
or retail banking. As such, they helped to insulate their
multinational clients from financial volatility abroad
and provided a controlled mechanism for direct
investments into developing markets. Whilst severely
limited during the two world wars and with some
international operations even confiscated by the allies,
this business model survived and proved useful until
the early 1970.
With the process revolution in retail banking in the
1980s, things began to change. Many banks started to
acquire foreign retail networks. We have seen Spanish
banks expanding into Latin America, French, Italian
and Scandinavian banks into Eastern Europe, English
and American banks into developing markets. Whilst
many of these foreign assets were purchased when
they were distressed and the buyers were welcome at
the time, the Financial Crisis revealed some tensions
in this business model. The losses in the early stages
of the Financial Crisis affected the P&L of Italian,
French and Scandinavian banks noticeably and led to
a curtailing of lending in Eastern Europe. Also, without
the dollar liquidity from their Latin American operations,
the Spanish banks would be in worse shape.
Although no real accident has happened just yet, the
tensions inside global retail banks clearly need to be
addressed. Cross-border activities, even when done
within a global banking group, are not without risk as
the next section elaborates.
Cross Border Lending
There was a further development towards the 20th
century, which deserves our attention: the increase
in cross-border lending. Banks in nations with high
savings rates face a particular problem. They have
a structural liability overhang, in other words more
deposits than loans. With insufficient domestic credit
demand, such excess liabilities can be used either
to build up cross-border lending operations or make
portfolio investments. There are several examples in
history for both.
A good example is the Swiss-German cross-border
lending at the eve of the First World War. Assuming that
both Gold Standard and fixed exchange rates were a
permanent feature, Swiss Cantonal and Savings Banks
built large mortgage portfolios across the border in
southern Germany. Typically, they lent in Reichsmark
whilst the deposits were in Swiss Francs. The First
World War however shattered their assumptions. At the
outbreak of the war, the convertibility of the Reichsmark
was suspended. Within five years, the massive inflation
reduced the value of Germany’s currency to almost
nothing, resulting in staggering losses for the Swiss
lenders. Had the Swiss, for reasons which are beyond
the scope of this paper, not reduced their lending
Globalization and Finance Project, University of Oxford
before the war, the losses may well have exceeded
their absorption capacity. Managing their asset and
liability mismatch, the Swiss unknowingly imported
systemic country and currency risk into their financial
sector.
Another good example of the dangers of crossborder operations can be found in the time between
the two world wars. After the Dawes plan settled the
questions of German reparations in 1924, American
and British banks began lending short-term dollars
and pound sterling again to Germany and Eastern
Europe. However, with the crash of 1929, the American
banks called these loans back triggering a delevering, which eventually resulted in 1931 in the
failure of Creditanstalt-Bankverein in Austria and Danat
Bank in Germany. From 1930 to 1931, the supply of
international short-term credit dropped by a staggering
36%. The shockwaves from the collapse of these two
institutions heavily damaged the European banking
system and also reached across the Atlantic. Whilst
the banking crisis in the United States had mostly
domestic causes, the foreign dimension contributed
to the loss of confidence. To summarize, events in
the inter-war period showed that systemic risk in
cross-border operations can arise from both maturity
transformation and un-hedged currency exposure1.
Since financial institutions on both sides of the Atlantic
were involved, the systemic risk travelled both ways.
The challenges to the international financial system
and the solvency of states were eventually addressed
with the creation of the IMF in Bretton Woods in 1944.
But a good thirty years later, the system was under
stress again. The sharp increase in oil prices after
the Yom Kippur war in 1973 created the Petro and
Eurodollar market. Banks were swamped with cheap
dollar deposits from oil producers, which they used
for extensive cross-border lending primarily to Latin
America and Africa. Both US and European banks
were involved. Borrowers were primarily governments.
It took not too long until the bubble burst. Once the
Federal Reserve Bank started to sharply increase
fed fund rates in 1979 to combat inflation, troubles
started. Already in 1982, Mexico declared that it was
unable to service its debt. But Mexico was not alone.
Other nations followed. In a few years, Latin America
quadrupled its foreign currency debt to around
50% of GDP. The losses for the US and European
banking system were so severe that the intervention
of the IMF and the US government was required. A
permanent solution was eventually found in 1989
with the exchange of defaulted loans for new Brady
bonds. Investors accepted discounts of up to 50% in
exchange for collateralized new debt. Whilst the losses
for the banking system could thus be stretched over
several years, the debt crisis was a serious blow to
Latin America’s economic development. Between 1980
and 1985, per capita GDP dropped by almost 9%. It
took Latin America almost 30 years to recover.
1
In 2010, there was almost an identical replay of this scenario. When
the US money market funds reduced their USD lending by about one
third, French, Belgian and Italian banks had to significantly reduce their
balance sheet
19 JUNE 2012 / 7
The debt crisis in Asia in 1997 followed similar patterns
albeit portfolio investors and capital markets were
the key drivers this time. Also, due to the strength
of their export sector, the Asian countries recovered
faster. Whilst the IMF framework was a useful start,
it also showed its limitation. Asian countries started
to horde foreign exchange reserves in order to
never again become dependent from the IMF. Whilst
their motivation is understandable, it created a new
imbalance. The large holdings of US Treasuries by
Asian countries contributed to lower USD interest
rates. It was thus one of the factors that made the
high consumer leverage in the USA possible. Clearly,
the IMF framework needs to be strengthened and
modernized. It must address structural financial
imbalances. Global asset and liability mismatches and
large maturity transformation create global bubbles
and systemic risk. Recognizing and managing them
in a globally coordinated fashion is vital for Financial
Stability2.
Systemic Risk from Portfolio Investments
Earlier, this paper mentioned that excess liquidity might
also result in the building of large investment portfolios.
This was indeed one of the transfer mechanisms for
the Financial Crisis in 2007. For different reasons,
banks such as UBS, ING, Dexia, ABN AMRO (later
acquired by RBS), the German Landesbanks or IKB
all created large, un-hedged investment portfolios
with a significant share of securities related to the
performance of the American mortgage market
(RMBS, CMBS, REITs). There are still no reliable
figures available, but it is fair to estimate that the
European banking sector bore about 20% of the
total US mortgage losses of USD 2.3tr. The collapse
of the US real estate bubble thus directly translated
into the Eurozone and forced government to bail out
their insolvent banks with support packages in three
digit billion numbers. At the time of the build-up of
these portfolios, they were seen as safe and profitable
alternatives to risky lending. They also attracted less
capital. In the end, it became evident that they were
the very channels through which systemic risk reached
Europe!
2
The European sovereign debt crisis also puts its fingers on the
limitations of the IMF when dealing with weaknesses in a currency union.
Globalization and Finance Project, University of Oxford
Central Liquidity Management
Without spending time on the systemic risk of financial
innovation 3, there is one management innovation
of significant importance. The rapid progress in
technology and communication makes today group
wide liquidity management possible. For most banks,
which operate only in one country, this is not relevant.
But there are a few global banks, which could trigger
serious disturbances if they transferred liquidity
unconstrained from one country to another. The
example of Lehman Brothers Germany has already
been mentioned. The transfer of prime brokerage
cash from London to New York on the eve of Lehman’s
collapse was another. It is a well-known fact that the
deposit base in Germany is larger than in Italy. Thus,
Italian banks with subsidiaries in Germany are always
tempted to transfer excess liquidity to their home
country. In effect, within a group, cross-border lending
takes place. Whilst global management of liquidity
increases the efficiency of the financial system, in
times of crisis some safeguards are necessary to keep
the liquidity where it belongs.
Conclusion
Many innovations in finance started with the idea
of risk reduction or risk diversification. However, as
this paper illustrates, there are often unintended
consequences, which are overlooked and create new
systemic risks at a later stage. The risks of what we
now call globalization, has been with us for the longest
time. The ever changing interconnection amongst
institutions around the world poses risks which are
difficult to perceive and even more difficult to manage.
The individuals who head our public and private sector
institutions and are responsible for the management
of such risks are often the victims of their own limited
vision and aspirations. An experience I can confirm
from the many weeks I spent at the EU in Brussels
without finding people willing enough to listen to
serious concerns. The contribution of globalization to
systemic risk is probably neutral with benefits and new
risks keeping a close balance. What we need to learn
from history is that every innovation has unintended
consequences and thus new, unknown downside
risk we need to explore before it is to late and that no
regulatory framework survives intact without permanent
adjustments to new market realities.
3
Derivatives were rather beneficial during the Financial Crisis. Without
derivatives, the volatility in foreign exchange, interest rates, equities and
commodities would have overwhelmed several institutions
19 JUNE 2012 / 8
Dr Rui Esteves
University Lecturer in Economics,
Brasenose College, University of Oxford
This memo focuses on the political processes behind
the first wave of financial liberalisation during the
nineteenth and early twentieth century and its demise
after World War I. As we live through a renewed period
of financial integration, the question of its sustainability
naturally arises, while it is pertinent to know whether
we can draw lessons from history.
Not everyone gained from the process of globalisation
–of trade, labour, and finance–, which brought about
important changes in the structure of the economy
and the distribution of income in nations across the
world. This idea of this memo is how the economic
incentives generated by these dislocations translated,
through the political system, into choices about
openness to foreign capital and financial integration.
In this type of study, the logic of political economy is
especially useful in cognate contexts, particularly the
attitude of countries towards protectionism (Frieden
and Rogowski 1996) and the choice of exchange rate
regimes (Eichengreen 1992, Gallarotti 1995).
The history of financial openness and liberalisation
has been less studied, although there is a vibrant
literature on the political drivers of the current process
of financial integration (Quinn and Inclán 1997, among
many). Despite Frieden and Rogowski’s (1996: 27)
claim that “movements of services and capital are
analogous to those in goods and can be subjected
to similar tools of analysis,” the former have attracted
much less attention in the historical literature than the
latter. Apart from data limitations, this is probably due
to the relatively small cross-country variation in the
explained variable. Indeed, up to 1914 there were
very little limitations to unfettered capital movements
between nations, while most countries converted to
controlling capital flows between the wars, albeit with
varying intensity. Contemporary empirical studies are
mostly cross-section and cannot be easily transposed
to an historical setting with considerably less between
variation.
Nevertheless, the within variation is sufficient to identify
the causes of the reversal in policies toward capital
openness in the interwar period. World War I
looms large in this reversal, as suggested by the
Globalization and Finance Project, University of Oxford
speed with which this transformation occurred.
Before the war there was a broad consensus across
the political spectrum about the advantages of not
tampering with capital mobility. Only at the far left was
there an uncompromising critique of capital exports
as instruments of the extension of imperialism, the
‘highest stage of capitalism’ (Hilferding 1920, Lenin
1916). The following picture illustrates this reversal by
tracing the de jure degree of capital account openness
over more than a century.
The overall story in this picture can be described in
three stages. Financial integration was highest prior to
World War I (a 100 value means full capital openness),
with hardly any variation across nations; the War put
a stop to this state of affairs, despite some attempt
at reintegration in line with the re-establishment of
the gold standard until 1928. However, the Great
Depression elicited an even more autarkic reaction
from most countries. Substantial variation across
groups of nations also emerged in this period. A 1938
study from the League of Nations classified countries
in three groups according to their exchange rate
policy since the demise of gold in the 1930s: ‘gold
bloc’ countries that persisted in their pegs to gold
until the second half of the decade; ‘devaluers’ that
more quickly dropped their pegs and allowed their
currencies to devalue; and ‘exchange-control’ nations
that kept their pegs but only through imposing very
severe exchange and capital controls. This ordering
is reflected in the average indices of capital openness
for the three groups of countries up to 1931, with
‘devaluers’ restricting financial openness less than
‘exchange-control’ nations. Relative capital market
restrictions persisted throughout the Bretton Woods
period, and were only reversed since the late 1960s.
Interestingly, there is persistence in attitudes toward
capital controls among groups of nations. The previous
members of the gold bloc were the first to liberalise
after the war and mostly persisted on that track since,
while ‘exchange-control’ quickly reverted to greater
capital restrictions after the collapse of the Bretton
Woods system in 1971. On a de jure basis, capital
mobility is censed to have remained below the pre1914 levels almost to this day.
19 JUNE 2012 / 9
Figure 1: Average Capital Account Openness, 1890-2004
Depending on the stability properties
of the system, a small shock might be
enough to disturb the prewar equilibrium.
The two shocks of World War I and the
Great Depression were not ‘small’ in
any sense and triggered a course of
economic and political disintegration that
forms a mirror image of the years before
1914. These trends reduced and then
reversed the distribution of economic
gains from international liberalisation,
which was then quickly reflected in the
political fights of the period and the
dramatic turn toward autarkic policies,
especially after 1929. The extension of
the franchise certainly helped in making
this possible, although identical policies
were taken up in democratic as in undemocratic regimes around the World.
The widespread support for capital openness before
1914 was attributed to the complementarities between
trade and factor flows, as well as to the network
externalities from monetary coordination. In this sense,
international financial liberalisation is best understood
in the context of the other aspects of the globalisation
process prior to the War. Countries that opened up
to trade gained in terms of easier access to foreign
finance, which gave them the means to invest in
transportation and communication infrastructure that
would enhance their comparative advantage. The
connection also operated for countries with excess
savings, since previous trade relations alleviated
the informational asymmetries in investing in exotic
investment projects or securities. Capital further
chased labour toward countries abundant in natural
resources but hardly in anything else. Finally, access
to foreign capital facilitated a credible adherence to
stable exchange rates (in the gold standard) and was
made easier by the reduction of the currency risk of
foreign investors. This in turn made it possible for
countries to specialise in an unprecedented degree,
because they were assured that specialisation would
not imply a current account constraint in bad times.
Although emerging economies were not immune to
financial crises and exogenous volatility their openness
to foreign finance paid off in faster convergence and
higher levels of income. Of course, globalisation
if beneficial in aggregate also generates losers,
who can block the process for lack of a credible
redistribution mechanism of ex-post gains. However,
the complementarity between trade and factor flows
alleviated these distributional tensions, perhaps helped
by the concentration of effective political power in
elites that stood to gain more from the process.
The multiple positive feedbacks described meant that
only a shock to integration could disturb the system
from a path of increasing economic integration.
Globalization and Finance Project, University of Oxford
And yet, systemic crises were not new,
which begs the question of why they
hadn’t endangered the liberal status
quo before the war. There are several candidates for
an answer. Kindleberger (1986) and Mundell (1999)
emphasise the role of the UK in preventing the most
serious crises of the prewar period (1890, 1907)
from threatening the stability of the system. This is
a straightforward application of a model of multiple
equilibria, selected by the focal points provided by the
hegemonic nations. The uncompromising isolationism
or inept policies of the US provided the wrong focus.
Eichengreen (1992) prefers to stress the cooperation
between the authorities of the leading nations as well
as the limited franchise that insulated them from shortterm political pressure before the War. Cooperation
and policy independence were in short supply while
the world economy descended in the throes of the
Depression. But we might also ask, with O’Rourke and
Williamson (1999), whether War and Depression can
really be construed as exogenous shocks to which
an inept world leader could not react in a stabilising
way. The work of these two authors and others has
uncovered the latent political tensions from the
distributional consequences of prewar globalisation. It
is possible to imagine a counterfactual world, without a
World War starting in 1914, where these tensions could
have lead to a backlash against globalisation anyway.
Much harder is to test it though. Compared to tariff
policies and immigration restrictions, capital mobility
was relatively spared by these anti-globalising forces,
which may be a reflection of the less adversarial
consequences of capital openness alluded to before.
Or it may be that we do not fully understand the
connection between economic incentives and political
outcomes around financial integration. The example
of the literature on the political economy of financial
liberalisation in the late twentieth-early twenty-first
centuries shows the path for the further research
necessary to uncover the historical perspective on
this topic. More and better data on capital market
19 JUNE 2012 / 10
frictions and capital flows is a good starting point
here. The literature has been arguing perhaps too
much from the reconstituted series of capital exports
from Britain before 1914 and the US after, without
much consideration for the significant differences in
the patterns of investment of other capital exporting
nations (France and Germany). Only then will we be
able to follow on Frieden and Rogowski’s (1996) “plea
to eschew impressionistic generalisations, instead
attending consciously to the interests and incentives
facing all relevant individuals and working up from that
point to expectations about behaviour” that can be
tested empirically.
Globalization and Finance Project, University of Oxford
References cited
Eichengreen, B. (1992) GoldenFetters. The Gold Standard and the Great
Depression, 1919-1939, New York: Oxford University Press.
Frieden, J. and R. Rogowski (1996) “The impact of the international
economy on national policies,” in R. Keohane and H. Milner, eds.,
Internationalization and domestic politics, New York: Cambridge
University Press, pp. 25-47.
Gallarotti, G. (1995) The Anatomy of An International Monetary Regime:
The Classical Gold Standard, 1880-1914, New York: Oxford University
Press.
Hilferding, R. (1920) Das Finanzkapital: eine Studie über die
jüngste Entwicklung des Kapitalismus, Vienna: Verlag der Wiener
Volksbuchhandlung, 2nd ed.
Kindleberger, C. (1986) The World in Depression, 1929-39 (Revised and
Enlarged Edition), Berkeley: University of California Press.
Lenin, V. (1934 [1916]) Imperialism: The Highest Stage of Capitalism,
London: Martin Lawrence.
Mundell, R. (1999) “A Reconsideration of the Twentieth Century,” Nobel
Prize in Economics documents 1999-5, Nobel Prize Committee.
O’Rourke, K. and J. Williamson (1999) Globalization and History. The
Evolution of a Nineteenth-Century Atlantic Economy, Cambridge, Mass:
MIT Press.
Quinn, D. (2003) “Capital Account Liberalization and Financial
Globalization, 1890-1999: A Synoptic View,” International Journal of
Finance and Economics, 8: 189-204.
Quinn, D. and C. Inclán (1997) “The Origins of Financial Openness: A
Study of Current and Capital Account Liberalization,” American Journal
of Political Science, 41(3): 771-813.
19 JUNE 2012 / 11
international financial integration. An illustration is provided by the following graph, which
shows the evolution of an indicator of international financial integration during the “Belle
Epoque” of the late international financial system. The graph outlines this relation by showing
the co-movements of an indicator of “Emerging markets risk” and the indicator of global
financial integration. The effect of the Argentine crisis is very perceptible. This is a reminder
of the relevance of crises and their handling for international financial integration. Now,
different crises have different effects and it is important to unpack the logic of the
international financial system in order to be able to provide meaningful insight.
Professor Marc Flandreau
Graduate Institute, Geneva
Figure 1: Financial Globalization and Market Risk 1880-1914
Figure 1: Financial Globalization and Market Risk 1880-1914
Crises and globalization
The international financial system is a place that
may have governance, but lacks a government. As
a result, its historical evolution has been haphazard,
confused, chaotic. One thing that has been striking
across history is the two-way relation between crises
and international financial integration. An illustration
is provided by the following graph, which shows the
evolution of an indicator of international financial
integration during the “Belle Epoque” of the late
international financial system. The graph outlines this
relation by showing the co-movements of an indicator
of “Emerging markets risk” and the indicator of global
financial integration. The effect of the Argentine crisis
is very perceptible.
Exchange Rate Regimes
In their quest for a Holy Grail of international
financial stability, economists and historians
have put their stethoscopes on the
international gold standard. In the interwar,
many observers blamed contemporary
problems on the world not being the nice
place it used to be. Because the War had led
to the suspension of the gold standard, lack
of a “gold standard discipline” was made
responsible for the evils at work. There has
been some debate on that matter (Bordo
and Rockoff’s gold standard as “Good
Housekeeping Seal of Approval Hypothesis”)
but contrarian minority view illustrated by
Table 1 (from Flandreau and Zumer 2004)
is becoming majority view (See e.g. Alquist
and Chabot 2012 for recent corroborating
evidence).
Market Discipline
• Exchange Rate Regimes
In their quest for
a Holy Grail ofBond
international
financial
stability, economists and historians
Table 1: Determinant
of Government
Spreads
(1880-1914)
have put their stethoscopes on the international gold standard. In the interwar, many observers
2
1
5
8
9
blamed contemporary problems on the world not being the nice place it used to be. Because
1.Structural
the factors :
War had led to the suspension of the gold standard, lack of a “gold standard discipline”
Int.serv./Rev.
9.308at
(7.96)
9.037 (7.12)
8.776
(6.52)
was made responsible-for the evils
work. There
has been
some
debate7.677
on (5.35)
that matter (Bordo
Res./bankn.
-
-
-
-0.518 (-1.14)
-0.402 (-0.83)
Exp/Pop
-
-
-
2.575 (2.38)
2.279 (1.95)
Deficit/rev.
-
-
-
0.723 (2.20)
0.747 (2.21)
Exch. rate vol.
-
-
-
23.906 (2.17)
13.104 (1.05)
- Default
- Memory
-
4.944 (16.10)
0.966 (2.62)
4.982 (15.79)
0.913 (2.40)
5.087 (16.20)
0.872 (2.26)
4.917 (15.48)
0.667 (1.62)
3.Policy/political variables:
- Franchise
-
-
-0.040 (-0.80)
-0.053 (-1.07)
-0.072 (-1.39)
-
-
-
-
F=1.889 (*)
0.012 (0.06)
0.302 (1.19)
0.099 (0.38)
432.928
-396.987
0.773
435.307
-388.307
0.784
466.732
-369.967
0.798
2.Reputation factors :
- Political crises
4. Gold Standard:
Constant
SBIC
Log L.
Adj. R2
-1.546 (-5.13)
564.056
-539.174
0.310
427.741
-397.329
0.774
Number of Observations : 252. Not shown are the country-specific constants. Numbers
in parentheses are heteroscedasticity consistent Student t statistics (corresponding
Do markets provide discipline? This used to
standard errors are computed from a heteroscedastic-consistent matrix (Robust-White)).
In all cases, F-tests choose Fixed Effects versus simple pooling. (*) F-test significant at
be one of the basic tenets of Globalization.1
5%. Source: Flandreau and Zumer (2003)
(i.e. the Washington Consensus). Probably out
of laziness, many problems were outsourced
to “markets”. This was done without due
diligence, that is, without investigation of the specific
conditions of individual markets. It is quite remarkable,
in particular, that this was done in a way that was
totally ignorant of history. An excellent example of this
complacent and inadequate attitude has been the
European Union. Europeans have turned to a reliance
on “market forces” each time they could not agree
on something, as was the case for the stability pact.
The stability pact did not have teeth, and the theory
was that market forces would take care of delinquent
borrowers. For instance, in the late 1990s research had
showed that “markets” could be quite
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 12
happy with large public accumulation of debts during
upswings (e.g. late 19th century) but they suddenly
became debt intolerant when the cycle reversed (see
Flandreau, Le Cacheux and Zumer 1998).
Figure
2. Successes
and ofFailures
of Gatekeeping
Figure
2:Successes
and Failures
Gatekeeping
(since 1815)
(since 1815)
Gatekeeping
More careful focus on international financial
intermediation, and its history, should be a primary
research topic. There is substantial work on defaults,
committees etc. but research needs to realize that
the whole purpose of an effective governance of
globalization is to prevent such things from happening.
One theory is that the solution to international financial
problems has much to do with resolving moral hazard.
If “adequate” costs and penalties are inflicted to
debtor when debtor defaults, then there should not be
any default in the first place. I find this line of thought
somewhat misleading. At the limit, if there is no default
(say because the dominant power always sends the
gunboats) then the moral hazard problem becomes
bigger, not smaller. My own research has led me to
uncover the crucial role of intermediaries in the debt
This
shows
Lorenz
curve
failurerates.
rates.
Underwriters
are ranked
from the
This shows
Lorenz
curvefor
for failure
Underwriters
are ranked
from
market. Now, the important issue historically is that
the to
smallest
to the largest
and their
market
shareare
areadded
added accordingly
accordingly (x-axis).
smallest
the largest
and their
market
share
thechart
y-axis,shows
the chart
of thegroup
same group
there has been a change in the role of underwriters.
On the(x-axis).
y-axis,Onthe
theshows
sharethe
of share
the same
in theintotal volume
the total volume of foreign government debt failures.
of foreign government debt failures.
They used to have more “skin in the game” through
a form of moral liability with foreign government debt
Figure 3. Speculative Grade and Investment Grade in Foreign Government Debt Markets
Figure 3:Speculative Grade and Investment Grade in Foreign
(Figure 2). A consequence of this is that there is
(Interwar/Now)
Government Debt Markets: (Interwar/Now)
evidence suggesting that the international financial
system has more “built in” risks than it used to
(Figure 3). Does it signal the fact that we have better
institutions today? And in which case, which are they?
Or is the message that we are heading towards a
major disaster and need to be careful?
Empire and Contracts
A little recognized contribution to the “high financial
integration” shown by Feldstein-Horioka based
measurements before WWI is that of the British
Empire. Of course historians and economic historians
have long recognized the special position of imperial
Source:
Flandreau
et al. (2009).
Source: Flandreau
et al (2009)
financial integration inside globalization (Davis and
Huttenback 1988, Cain and Hopkins 1993). However,
• Empire and Contracts
it worth bearing in mind that the “folk sample” (Bordo
Figure 4.
Surplus from
Empire?
A little recognized contribution to the “high
financial
integration”
shown by FeldsteinHorioka
and Flandreau 2003) used to compute coefficient
of based measurements before WWI is that of the British Empire (Flandreau 2006). Of
Figure
Empire?
course historians
and4:Surplus
economicform
historians
have long recognized the special position of
financial openness before WWI has 25% of countries
D : Demand
imperial financial integration inside globalization (Davis and Huttenback 1988, Cain and
in the British formal or informal Empire and in effect,
Hopkins
their impact of result is, by construction of the F-H
test, 1993). However, it worth bearing in mind that the “folk sample” (Bordo and
Flandreau 2003) used to compute coefficient of financial openness before WWI has 25% of
enormous. The contribution of Empire to globalization
countries in the British formal or informal Empire and in effect, their impact of result is, by
has been noted by authors who have emphasized
construction of the F-H test, enormous. The contribution of Empire to globalization has been
the reduction of default risk (Davis and Huttenback
iUK+s
noted by authors
who
have emphasized the reduction of default riskS (Davis
i
: Sovereign and Huttenback
1988, Ferguson and Schularick 2006). However,1988,
such
Ferguson and Schularick 2006).
iUK
arguments downplay an important cross-sectional
S : Colonies
Table 2. Evolution of indebtedness (interest service as a share of budget)
dimension of formal “Empire”, namely the difference
between self-governing and dependent colonies. As
shown in Figure 4, elimination of default risk when it
takes the form of control creates apolitical economy of
Qs
S
Q : amount of capital borrowed
capture that turns “globalization” into something rather
disastrous. On the other hand, as the experience of
self-governing suggests, substantially higher level of
international integration, even with high debt levels,
can be sustained provided that adequate institutions
are created enabling to cope with solvency and
1
2
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 13
construction of the F-H test, enormous. The contribution of Empire to globalization has been
noted by authors who have emphasized the reduction of default risk (Davis and Huttenback
1988, Ferguson and Schularick 2006).
Table
2. Evolution
ofofindebtedness
as aa share
liquidity at once (See Accominotti et al. 2009 and
Table
2:Evolution
indebteness (interest
(interest service
service as
share of
of budget)
budget
)
Most
indebted
governments
ratio
≥
2.5
Accominotti et al. 2011 for a discussion). Table 2
right shows that “surprisingly”, self-governing Empire
countries were the ones that accumulated the largest
levels of debts. This is also a time of high infrastructure building and economic success.
References for readings:
Accominotti, Flandreau, Rezzik, Zumer, 2010: Black man’s burden,
white man’s welfare control, devolution and development
in the British Empire, 1880–1914: European Review of
Economic History.
Accominotti, Flandreau, Rezzik, 2011:The Spread of Empire;
Clio and the Measurement of Colonial Borrowing
Costs:Economic History Review.
Flandreau, 2006: Home biases, 19th century style:Journal of the
European Economic Association.
Source:
Accominotti
et et
al.al(2011).
Source:
Accominotti
(2011)
Flandreau and Zumer, 2003:The Making of Global Finance:OECD,
Paris.
Flandreau, Le Cacheux and Zumer, 1998:Stability without a pact?
Lessons from the European Gold Standard:Economic Policy.
Flandreau, Flores, Gaillard, and Nieto-Parra, 2010:The End of
Gatekeeping; Underwriters and the Quality of Sovereign
Bond Markets, 1815-2007”, NBER International: Seminar on
Macroeconomics 2009.
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 14
Professor Harold James
Claude and Lore Kelly Professor in European Studies, Princeton University
The assumption of policy-makers at the 1944 Bretton
Woods Conference was that cross-border capital
movements would be restricted and controlled. They
followed Keynes, and Ragnar Nurkse, in believing that
short term or hot money flows had been responsible
for the destabilization of the world economy in the
1930s. They thought a resumption of private flows
unlikely; if there were to be large international capital
movements, they would be official, and they might best
be managed through the World Bank.
By the 1960s, there were already substantial crossborder flows of money. Notwithstanding extensive
capital controls, there could be substantial short term
movements – occurring, for instance, through channels
intended for trade finance, with early or late foreign
exchange payments (leads and lags). An offshore
bond market (Eurobonds) developed, and some big
U.S. banks helped to redevelop London as a financial
center for offshore finance. But banks remained largely
national (and old-fashioned or unadventurous or “retro”
in Amar Bhide’s terminology) in their orientation.
The 1970s was the decade when internationalization
really took over banking. That revolution can be
thought of as an outcome of
1. Changes in domestic finance, above all in the
U.S. The development of a capital market made
bond financing available for large corporations.
As a consequence, U.S. bank lending to industry
diminished, and banks felt a need to look for
alternative or new borrowers.
2. An international imbalance issue, in the aftermath
of the two oil price shocks, with oil producers
unable to spend the greatly enhanced revenues
that followed the oil price rises.
3. Encouragement by Western governments (in
particular the U.S.) for oil producers to “recycle”
the surpluses through the banking system (rather
than say through the official sector: though the
IMF came up with an Oil Facility that was intended
to allow the funds of oil producers to ease the
adjustment in non-oil developing countries).
On occasion, National Security Adviser Henry
Kissinger spoke directly about how the inclusion of
Middle Eastern oil producers into an economic and
political “West” through the international banking
system was a better way of securing an alignment
of their interests with those of the large industrial
countries than any sort of openly confrontational
course.
Globalization and Finance Project, University of Oxford
4. A belief by some bankers that the encouragement
of their governments of the recycling process
amounted to an implicit guarantee on the part of
governments. In the case of U.S. banks, bankers
when asked about the security of their syndicated
lending to Latin America referred to views in the
State Department about the desirability of political
and economic stability in the western hemisphere;
German banks that lend considerable amounts
to Warsaw Pact (Soviet satellite) countries, in
particular Hungary and Poland, also liked to
refer to their government’s interest in the new
phenomenon of Ostpolitik.
5. A lack of any detailed knowledge about the
extent of total exposure of banks through loans to
developing countries, and a general regulatory
failure. Both the Federal Reserve System and
the BIS tried to collect statistical information, but
largely failed because of bank resistance. It is not
even clear that individual debtor countries had
information about the total indebtedness of their
public sector (because a multiplicity of state and
para-state institutions was involved in the lending
process).
6. The low interest rate environment prevailing until
the dramatic shift in the policy orientation of the
Federal Reserve in October 1979. With often
negative real interest rates, debt service appeared
unproblematical.
7. Nearly ubiquitous cross-default clauses in
syndicated loan agreements made an isolated
individual default impossible, and a collective
default triggered by such clauses would have such
impossibly dangerous consequences that it was
also unthinkable.
8. Competition within different national banking
sectors for the lucrative activities associated with
recycling or relending oil surpluses and other
deposits. Newcomer institutions that wanted to
expand quickly would be prepared to take greater
risks.
9. Competition between national banking sectors,
with Japanese and continental European banks
gradually displaying increasing eagerness to catch
up with British and American lenders.
10.Within the lending banks, there may also
have been agency problems. The individuals
responsible for making loans saw their (highly
profitable) activity as a channel for rapid career
advancement, and assumed that if there were to
be problems regarding borrowers’ capacity to
pay in the future, they would no longer in their old
positions.
19 JUNE 2012 / 15
The outbreak of a debt crisis in August 1982 with the
possibility and threat of Mexican default created the
threat of a repetition of a 1930s style contagious and
general debt and banking crisis. A Mexican default
alone would have wiped out almost all the capital of
almost all the substantial New York lending banks.
What followed was a seven year play for extra time.
The initial approach was to link policy improvement in
the borrowing countries with help from international
institutions, but also extra lending from the banks. The
latter element seemed to defy the most elementary
canons of sensible bank behavior. The aftermath
of the Latin American debt crisis produced the
first systematic attempt at international regulatory
coordination, culminating with the 1988 Basel
Agreement (with its notorious weighting system, under
which OECD country debt was assessed as risk free).
Three years after the outbreak of the Latin American
crisis, Treasury Secretary James Baker announced
a systematization of the initial response. It was not
very imaginative. Banks and multilateral development
institutions should all lend more, and the debtors
should continue their efforts to improve their policy.
The Baker Plan was a universal disappointment.
Growth faltered again, and the IMF actually reduced its
lending.
More than three years passed before a new Treasury
Secretary, Nicholas Brady, set out a more satisfactory
program, in which banks would be given a menu of
options that included lower interest rates on the debt
and selling back the debt to the debtor at a hefty
discount. If the banks were unwilling to accept some
form of restructuring, they would have to put in new
money. The lending of the international institutions
might also be used for buying back discounted debt.
The Brady plan was a great success. Confidence
returned, capital flight from Latin America was
reversed, and the capital markets began to be willing
to lend again.
Why did it come so late? The most obvious answer
is that at an earlier stage in the Latin American
saga, the banks simply could not have afforded to
take such losses on their capital. They needed the
seven years of faking the position in order to build up
adequate reserves against losses. It is also important
to recognize that the initiative for the Brady Plan really
did not come from the official sector at all. It was the
willingness of some big financial institutions to trade
in discounted debt that established a market that
would clear out the legacy of past policy mistakes. In
particular, two institutions took a lead: Citicorp in the
US, and Deutsche Bank in Europe. Their CEOs at the
time presented their actions as motivated by a farsighted benevolence and a concern for the well-being
of the world as a whole. That may have been plausible,
but these two banks also were playing in a competitive
field and wanted to demonstrate very publicly that they
had a better balance sheet than their weaker rivals. In
Germany, the Dresdner Bank and the Landesbanken
could not afford to take such a hit.
Globalization and Finance Project, University of Oxford
Moreover, despite the obvious “reform fatigue” of
Latin American electorates, the debtor countries had
engaged in a substantial measure of reform. Before the
Brady Plan was announced, Mexico had accepted a
wide-ranging Pact of Economic Solidarity and Growth
which had an immediate effect in restoring confidence
and reducing the very high domestic interest rates.
The aftermath of the Latin American debacle was quite
long-lived in the sense that an immediate lesson about
bank exposure to developing country debt was learnt.
When capital movements start up in the second
globalization wave after 1945, they come in a rather
different order than that of the nineteenth century wave.
1. FDI was the first type to assume a major
importance after the Second World War. It is
associated with major flows of skills, technology
and management. It often responded to trade
protection and closed off good markets, in that
production moved to markets that would otherwise
have been inaccessible. The MNC was thus a
major bearer of the initial dynamic of the second
globalization wave. MNCs play a large part in the
transformation of European production, but also in
development in Latin America.
2. Bank lending flourished in the 1970s, and then
appeared to lead the world to near-catastrophe
and to more coordinated agreement on regulation
and especially on capital adequacy.
3. Bond markets are a relatively late development
both for the official and the corporate sector (in
contrast with the nineteenth century experience).
Indeed the bond market – and with it securitization
- was given a decisive impulse by the policies
resolved to resolve the developing country bank
debt crisis of the 1980s (Brady bonds). The
internationalization of bond debt, and the breaking
down of insulated or isolated domestic markets
(financial repression), is thus a relatively late
development that took off in the intensive wave of
financial globalization in the 1990s and 2000s.
19 JUNE 2012 / 16
Professor Catherine R Schenk*
Professor of International Economic History, University of Glasgow
The eruption of the global financial crisis in 2007 has
been blamed on many guilty parties: greedy bankers
seeking bonuses rather than sustainable growth,
complacent bank board members, financial engineers
that created inscrutable products, poor home-owners
borrowing beyond their means, savings ‘gluttons’ in
China and debt-dependency in the West. Over-arching
these actors in the drama, however, is the general
governance and supervision of the international
financial system. How did things get so far out of line,
the system so fragile, as to generate the ricochet of
panic and collapse across the globe? The effects of
the crisis certainly seem to warrant a reassessment of
how a more robust international financial architecture
might be built in order to support recovery and
renewed growth. How do we maintain the benefits of
financial innovation while managing risk? Realistically,
we will be unable to regulate away all bubbles and
their inevitable bursting, but minimising the impact of
these bubbles and restraining their size and scope
should be within the realm of possibility. Current efforts
in Basel, the IMF and in the G20 have a long legacy
of experience on which to draw, and a considerable
reputation for failure to overcome.
What is particularly vexing for those with a longer term
view is that the underlying factors that contributed
to the latest crisis have long been recognised. While
there has been considerable commentary on the
lessons from the Great Depression, we don’t need to
go back so far to identify financial crises that revealed
failures in regulatory oversight. Although the process
of regulating banking and financial systems began
much earlier, the current structures of international
regulation were shaped by key episodes since the
Second World War: this brief addresses the innovation
of the Eurocurrency market in the 1950s and 1960s
and the advent of a new risk environment in the 1970s
culminating in the sovereign debt crisis of 1982.
The post-war international economic system was
designed to achieve stable exchange rates and
promote freer trade in goods to give the best
prospects for economic growth and full employment;
the two main goals of most industrialised states.
International financial markets were blamed for
contributing to damaging flows of ‘hot money’ in
the inter-war period, which were believed to have
contributed to the contagious spread of the Great
Depression. In order to sustain policy sovereignty
and stable exchange rates, international capital flows
were tightly controlled and national banking systems
were insulated from competition. This complacent
environment, particularly in the City of London, allowed
informal networks between the Bank of England
*
This brief draws on C.R. Schenk (2010) Are we bad students or do
we have poor teachers: why don’t we learn the lessons from previous
crises?, Corporate Finance Review, 15 (2) and C.R. Schenk (2010) The
Decline of Sterling; managing the retreat of an international currency,
Cambridge University Press. Research funded by ESRC Grant RES-06223-2423. http://www.bank-reg.co.uk
Globalization and Finance Project, University of Oxford
and the banking system to remain the foundation
for regulation and supervision. Personal contact,
moral suasion, and the Bank of England’s practice of
informal ‘words in the ear’ of bankers who might be
engaged in imprudent behaviour was the model for
regulation and supervision. This cozy atmosphere
was soon challenged, however, by the Eurodollar
market. Initiated in the mid-1950s by Midland Bank
to overcome the restrictions on bidding for sterling
deposits, the development of an offshore market in
dollar deposits and loans in London quickly prompted
an invasion of US and other international banks into the
City to take advantage of this opportunity. Moorgate,
where many US banks found premises, became known
as ‘America Avenue’ and the Eurodollar market was
quickly dominated by American banks in London.
In the process, the City changed from a cozy and
uncompetitive haven to a much more dynamic and
rapidly growing sector. Regulators, however, were slow
to adapt.
The Bank of England continued its personal approach,
insisting that the market could not be regulated
without imposing unreasonable reporting burdens on
banks, and that it should not be driven out of London.
Nevertheless, fears about an excessively risky term
structure of liabilities and assets in the market, lack of
transparency about ultimate borrowers of funds and
the ‘pyramiding’ of inter-bank lending encouraged
central banks elsewhere in Europe to refuse to host
similar markets in their jurisdictions. Imposing taxes
on interest payable to non-residents or higher reserve
requirements on Eurodollar deposits were the most
common ways to ensure that an offshore foreign
currency market did not develop. The distrust on the
Continent prompted considerable private discussion
in the BIS where European and American central
bankers debated what could be done to improve the
supervision of this new market, even while it grew
exponentially. Suggestions to improve transparency
by collecting data from participating banks were
resisted by many central bankers who viewed the
confidentiality of their relationship with their national
banking systems as sacrosanct. Some jurisdictions
did not collect such data and were not willing to begin
doing so; others refused to share confidential market
information. In 1963 the collapse of a fraudulent
scam in the USA generated a series of defaults
on Eurodollar loans. This sent a shock through the
market and brought monetary authorities back to the
question of regulation and supervision, but plans for
an International Risk Centre were rejected in 1965.
Instead, after much debate, the BIS began to publish
consolidated data on the size of the market from the
mid-1960s.
The failure to enhance supervision or to regulate
the Eurodollar market signalled several issues that
were to have echoes in the global crisis of 2007.
19 JUNE 2012 / 17
First, financial innovation surprised regulators and
they were caught on the back foot. Second, the
innovation was considered highly complex at the time;
prudential standards should be set and monitored by
banks themselves rather than civil servants or other
independent parties. Third, the confidentiality of bank
information was a barrier to transparency. Regulators
were also clearly aware of the dangers of regulatory
competition and the Bank of England argued that if
London closed its market the business would merely
shift to some less experienced financial centre, thereby
adding to systemic risk. The Fed appreciated how the
market relaxed pressure for loans from its domestic
capital markets at a time of tight money. In addition,
the problem of identifying and enforcing common
international standards across a range of different
banking systems and cultures was clearly identified.
Finally, as in the 2000s, the economic benefits of
providing global financial services were not to be
endangered by restraining profitable new market
opportunities.
The undisputed success of the market endorsed the
norms that were established when supervision and
regulation were debated. Whether the enhanced
capital mobility that brought down the Bretton Woods
system between 1967 and 1973 was primarily due to
the Eurodollar market is open to debate – at the time,
experts at the BIS did not blame the Eurodollar market
per se. Indeed, the market was lauded for solving the
problem of global imbalances by ‘recycling’ OPEC
surpluses into loans for LDCs.
The new floating exchange rate regime from 1974,
coming at the same time as commodity and asset
price volatility, ushered in a new risk environment for
which many banks and regulators were unprepared.
The result was a series of bank collapses that
threatened cross-border contagion in an increasingly
integrated international banking system. The rash of
bank failures in the summer of 1974 exposed failures
of internal and external supervision in international
banks and the dangers of inconsistent national
prudential supervision. In almost all cases there
was evidence of fraud or rogue trading that had not
been captured within rapidly expanding international
banks. The crisis also exposed confusion over which
jurisdiction was responsible for supervising and bailing
out the increasingly global international banking
market. The Fed bailed out the National Franklin Bank,
the Bundesbank let the Herstatt Bank fail and the
Bank of England partly bailed out the Anglo-Israeli
Bank ex post. In Germany and the USA the national
banking system contributed to bail-outs through
separate contributory institutions (in the UK this was
limited to bailing out domestic fringe banks through the
‘lifeboat’).
In 1975 the Basle Committee on Banking Supervision
was set up to consider the establishment of an ‘early
warning system’ that would allow national regulators
to step in to nip potential systemic bank failures in
Globalization and Finance Project, University of Oxford
the bud. But this required sharing information across
borders, and there was no consensus among the
members of the committee that this should be done.
In the end, George Blunden as Chair submitted a
personal report to the BIS Governors suggesting
that members of the committee might share gossip
informally at their regular meetings and they
exchanged phone numbers. The Committee instead
focussed on making sure that all banks were at least
supervised by one jurisdiction – although the Bank of
England did not adhere to the eventual Concordat.
Any effort to standardise the rules of supervision and
enhance risk management were hampered by the fact
that control of national banking and financial systems
was a jealously guarded element of each state’s
national sovereignty. As the chairman of the Basle
Committee, George Blunden of the Bank of England,
stated in 1977:
The banking system of a country is central to
the management and efficiency of its economy;
its supervision will inevitably be a jealously
guarded national prerogative. Its subordination
to an international authority is a highly unlikely
development, which would require a degree of
political commitment which neither exists nor is
conceivable in the foreseeable future.1
Thirty years later, it is unclear that central bankers’
views had changed.
A further question was how to increase the flow of
information on lending and borrowing to enhance
transparency, but little progress was achieved in
collecting and publishing the sovereign debt exposure
of borrowers and lenders until the late 1970s.
The distribution of the loan portfolios of individual
banks was considered private valuable commercial
information and there was resistance by banks and
also by regulators to publish this data. Meanwhile the
Fed began to collect and publish country exposure
for US banks, the IBRD collected and published
sovereign borrowing by state and the IMF also began
to collect its own data and began a regular and
frequent round of visits to international banks in various
financial centres in Europe and North America to gain
market intelligence. The BIS data was considered most
comprehensive, but it included only members of the
BIS and there was a long delay before publication so
that it was not very useful for market purposes.
In the end these efforts were too little too late to
prevent the crisis of 1982.
There was a range of market factors that shifted the
assessment of risk in international lending in the
1970s. First, increased syndication allowed groups
of banks to share the risk burden of a loan. As each
individual bank appeared less exposed to default this
encouraged larger and more risky lending overall.
Secondly, the loans were to governments rather than
businesses and it was difficult to price the default risk
1
Bank of England Quarterly Bulletin, 17, 3 (1977).
19 JUNE 2012 / 18
of states, partly because lenders have expectations
that international organizations such as the IMF or
World Bank will assist states in default to repay their
debts. The expectation that the losses might be shared
ex post with another body introduced moral hazard
and encouraged more risky lending. Thirdly, the
dramatic expansion in international financial activity in
the 1960s and 1970s drew new lenders into the market
over the decade. A loan in 1970 might have been
rational for the individual bank at the time, but it was
made more risky by subsequent lending from other
banks that increased the prospect of an overall default.
In this way the rapid accumulation of lending reduced
the security of existing loans.
The fundamental causes of the 2007 crisis can
be clearly identified in previous rounds of turmoil.
This is not merely hindsight; these problems were
carefully deliberated over by governments, central
banks and bankers themselves for over forty years. It
wasn’t that policy-makers, bankers and stakeholders
were unaware of the problems, but rather that they
could not conspire to resolve them. More historical
work is needed to identify the turning points and
motivations that prevented comprehensive and
innovative responses to dynamic market processes.
Understanding how lessons were not learned from
one crisis to another is fundamental to creating a
sustainable framework for international banking and
finance for the future.
Some of the key issues highlighted by 1950s-1970s:
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Importance of information/transparency for efficient
markets: role of trust
Resilience to new risks: from financial innovation
and changes in the external environment
Supervision is national; market is international
Effectiveness of internal vs external prudential
supervision
Need to ensure market compliance/engagement
without regulatory capture in a competitive and
dynamic market environment
Skills gap between regulators and market
Too many actors? national, international,
multinational: regulatory competition
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 19
Cyrus Ardalan
Vice Chairman, Barclays
Many of the characteristics of the 2008 financial crisis
are found in previous economic crises. History has
an important role to play in helping us understand
and deal with existing problems and avoid making
the same mistakes in the future. On the other hand,
circumstances change and the lessons of the past
must be carefully aligned to the realities of today.
It is only through this careful synthesis of our past
experience with the continuously changing world we
live in, that we can help improve our decisions.
Financial markets have in the past few decades
undergone dramatic changes. Much of this has been
made possible as a result of the huge breakthrough in
computer science and communications. These change
have greatly increased the range and complexity
of financial instruments, the size and importance of
the capital markets, the inter-connectivity of financial
markets, response times and transparency.
Alongside this, there have been important structural
changes in the financial markets. The role and range
of institutional investors has grown sharply as has
the diversity of their motivations and behavior. These
changes have been partly driven by the changes in
financial markets and partly by demographic trends.
As a result, the nature and motivation of market
participants too has undergone significant change.
These changes inevitably impact the way financial
markets work. In the past few decades both the mode
of travel and its driver have undergone dramatic
changes. As a result, financial intermediation, risk
management and the speed and the way in which
financial markets and flows respond to changing
economic conditions and news are different. The
feedback loops are similarly impacted. All these will
have significant implications for the lessons we can
draw from history and their relevance to us today in
crafting a new regulatory framework.
The current crisis has elements that have been
common to previous crisis. For example, the impact
of rigid and fixed exchange rates as a source of
economic instability has a long history. The current
crisis has its roots in the large global imbalances
between the US and Asia driven by rigid exchange
rates. Similarly within the Eurozone, fixed exchange
rates have led to diverging economic performance
creating over time large disparities in productivity, high
cross-border debt and credit bubbles that have been
brought to the fore with the global crisis.
Similarly the perils of excess leverage have also
been a common theme throughout history. Monetary,
regulatory and tax policy across the West in recent
years encouraged the continued growth of leverage
across the private and public sector. In the 2008 crisis,
the regulatory apparatus did not identify and react to
the credit bubble around housing until too late. At the
Globalization and Finance Project, University of Oxford
same time the interplay of macro and micro prudential
considerations were not adequately addressed by
regulators. The consequences of excess leverage
seem to have been forgotten and overlooked as
markets believed that we were operating in a new
paradigm.
To understand the relevance of history we also
however need to identify the important ways the
markets and its participants have changed. Let’s
consider some of the significant changes we have
seen in recent years:
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Markets are significantly more complex: in the past
three decades the derivatives markets have grown
from a negligible size to dwarfing the market in
real financial assets. Derivatives markets provide
highly efficient means of taking market views, low
transactions costs, leveraged and in many cases
more liquid than the cash markets. They are also
opaque, have created huge interconnectivity
between market players and have led to the
creation of highly complex financial products that
require sophisticated models to value; models that
in themselves are based on a view on how markets
behave.
Markets are far more transparent: information is
available instantly and globally. At one level this
has been a very positive development allowing
investors to make better and more informed
decisions. On the other hand it has in times of
crisis adversely impacted liquidity and led to
gapping in pricing and vicious downward price
spirals.
The role of capital markets by comparison to banks
has grown in the intermediation process: this
has been a positive development in fostering the
growth of non-bank lending and helping diversify
sources of funding and improve the efficiency of
the intermediation process. On the other hand it
has added to the transparency of markets, the
speed financial markets respond, reduced in some
respects accountability and amplified market
movements. The transmission mechanism for
monetary policy has changed. The differing impact
on financial markets of the Latin American crisis
compared to the current EU crisis is noteworthy.
The role of shadow banking has grown
significantly. The securitization market has
until recently played an important role in the
intermediation process and has the growth of
the repo markets and money market funds. The
impact of these developments has not been fully
understood and need to be considered.
Trading behaviour has changed – Modern capital
markets are characterised by low latency, high
transparency, and complex algo trading strategies.
MiFID I and the development of genuinely high
19 JUNE 2012 / 20
speed computer trading happened in parallel in
the years immediately leading to the crisis. Market
participants are now able to internalise market data
at unprecedented speed, which has contributed
to atomisation of trade sizes. Participants are now
able to spread capital across a huge number
of small scale trades maintaining a very small
risk exposure. The result has been a significant
reduction in depth as liquidity has increased. Some
institutional investors have felt excluded from the
market, which has contributed to their looking
to dark pools and other less transparent trading
venues. Equally, speed of data internalisation led
to events like flash crash.
»» The role of institutional investors has grown
sharply: This has changed in important ways the
key players in the market. The growth of pension
funds, insurance companies and hedge funds has
potentially important consequences for the way in
which markets operate.
These developments have been important factors in
understanding what is arguably the worst financial
crisis in history. The new fully globalised economic
system brings challenges of scale, regulatory
arbitrage, and cross-border impact risks which are
quantitatively new. This having been amplified and
fueled by the transition of economic influence from
the developed economies to the BRICs and other
emerging markets.
The regulatory response therefore needs to address
both the historical lessons which may have been
ignored, and have therefore contributed to crises and
on the other hand the many aspects of the crisis which
are new, and require new thinking.
In doing so, it would also be useful to consider the
appropriate regulatory response for each of the key
elements of the regulatory agenda:
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Resilience of banks: What are the appropriate
requirements for capital, liquidity, and leverage
and maturity transformation? How do we deal with
global interconnectivity of systemically important
banks?
Structure of Banks: what is the appropriate
structure of banks? Should there be a separation
of banking and capital markets operations, ring
fencing (ICB) or prohibition (Volcker) of some
activities?
Market Structure: should some of the structural
aspects of the capital markets be modified
to improve oversight, transparency and risk
management e.g. central clearing of derivatives?
Market Practice: what is the right balance between
transparency and liquidity? Impact of transparency
and real time data on market psychology? What
steps can be taken to deal with the negative
feedback loops?
Globalization and Finance Project, University of Oxford
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Consumer protection: How can we best protect
consumer interests? What is the tradeoff between
complexity and consumer interests?
»» Recovery and Resolution: what steps need to be
taken to be able to resolve banks without the need
for tax payer money and avoid systemic risk and
contagion?
»» Systemic risk: How do we monitor and manage
systemic risk in an increasingly interconnected
world with large systemically important institutions?
»» Regulatory oversight: what is the right structure
for enhancing macro prudential regulation, micro
prudential oversight of individual institutions and
oversight on conduct?
It is important that all of these questions are answered
and more important that they are answered in a way
that ensures we do not end up being a hostage
to the past by addressing the weaknesses of the
previous system and in doing so creating new risks or
neglecting likely future developments.
There is only one lesson from the history of financial
crises that it is difficult to dispute. We are not living in a
new paradigm. We are never living in a new paradigm.
Crises will happen and what we need to try to ensure
is that their damage is minimised.
In today’s world that involves ensuring that our
reforms are as well coordinated as possible across
all jurisdictions. The G20 mechanism is not currently
able to manage the implementation of the regulatory
agenda agreed by its members, and as a result, there
is divergence between jurisdictions. There is scope for
a series of G20 working groups or colleges on each
issue where officials from each state work together to
maintain a harmonised approach.
It is also worth the respective jurisdictions taking
the time to reach consensus on the direction of
regulatory travel and a strong degree of agreement
on the specifics. While the momentum for change is
always greatest while a crisis is with us, coordinated
pro-cyclicality may be all we achieve from acting too
quickly. In today’s fast moving markets, it can be a
case of the more haste the less speed.
19 JUNE 2012 / 21
Professor Charles Goodhart
Financial Markets Group, London School of Economics
I am currently trying to do a research exercise
examining three states which were all particularly
badly hit by an asymmetric shock in, and after, the
crisis of 2007/8. These states are Arizona, Latvia and
Spain. I have not attempted to quantify the degree
to which these states were asymmetrically adversely
affected, but it is reasonably clear that they all three
suffered more from the shock than other states in
the same system. There was, however, no apparent
problem for Arizona in remaining comfortably within the
monetary union of the United States. Latvia appears to
be an example of a country which, although suffering
a brief but intense downturn, nevertheless managed to
achieve an internal devaluation and adjustment while
remaining pegged to the euro. Spain on the other hand
has found the adjustment to be difficult, slow and ongoing.
My work so far, although it is far from complete,
suggests that the nature of the banking systems in
each of these three countries played a major role in
determining whether the adjustment process would
be more, or less, difficult and extended. The key point
is that the domestic banks in Spain did almost all the
intermediation in that same country, and only the two
biggest, (Santander and BBVA), were international.
Accordingly the downturn in Spain, particularly in the
housing market, fed directly through into weakness in
the Spanish banks, notably and particularly the Cajas.
And the fiscal position of the Spanish government,
although initially relatively good, soon deteriorated to
a point at which it could not bail out the banks by itself
without weakening its own fiscal position excessively,
(as with Ireland and Iceland). In turn the weakness
in the Spanish banks made them less able to extend
credit domestically, thereby amplifying the initial
downturn.
By contrast, the greater amount of financial
intermediation in Arizona was done by the large
federal US commercial banks, e.g. JP Morgan Chase
and Citi. As a result, these banks were not particularly
devastated by their Arizona results, a small proportion
of their overall book, and were therefore able to assess
demands for new borrowing in Arizona on a much
stronger basis than if they had been focussed entirely
on that one state. By the same token, the main banks
in Latvia, by size, were Swedish rather than Latvian.
With Sweden getting through the crisis relatively well,
this meant that the Swedish banks in Latvia were not
dragged down by their Latvian exposures, though they
were, in practice, severely damaged by them at one
stage in 2008; and they were able again to avoid the
amplifying cycle between local economic weakness
leading to local bank weakness leading to less credit
expansion leading to yet more local weakness.
border banks. On the other hand, and more commonly,
most host countries fear that, if there is a shock in the
home country of the cross-border bank, that they (i.e.
the host country) would find that the home country
puts pressure on its own bank to lend at home, rather
than in the host country. There is certainly evidence,
particularly in Europe, that a great deal of this has
been happening. The crisis has led to a considerable
amount of financial protectionism, whereby the
politicians in the home country put pressure on their
‘own ‘ banks to give priority to private sector lending
at home, rather than abroad. In some ways, the
Vickers Commission Report is an indication of the
increasing tendency towards fragmentation back into
national banking systems, and away from cross-border
banking.
So, in response to a symmetric adverse shock, there
is some advantage in having banks headquartered
in your own country, because you can put such
protectionist pressure on them. But this is a beggerthy-neighbour policy. Which, though understandable,
is not socially optimal. The implication is that in any
economic system, such as a federal country or
a monetary union, that banking should be crossborder across all the states in that system, with the
responsible authority being at the federal or European
level, rather than at the level of the constituent state.
Nevertheless there are considerable obstacles to
doing this in the European Union, because supervision
implies control of resolution and resolution can be
fiscally expensive. He who pays the piper chooses the
tune. If resolution of a bank remains the responsibility
of the nation state, then the nation state is going to
want to be in charge of supervision, to be assured that
it is not so lax as to cause it additional expenditure.
The problem with moving control over banks to the
European level, much less to the world level, is that
there is not sufficient European (much less world)
political and fiscal management and control at that
level.
So, at the moment, when financial crisis strikes and
fiscal costs loom large, the European, and the global,
financial system rapidly starts to fragment. In order
to reverse this, if so wanted, there would need to be
much greater centralisation of fiscal, and political,
powers at the EU level than seems immediately likely,
though many would like to move in that direction. But,
even if the continent should be willing to move in that
direction, would the UK be happy to do so?
This suggests that states hit by an asymmetrically bad
shock would benefit from having a large proportion
of their financial intermediation undertaken by crossGlobalization and Finance Project, University of Oxford
19 JUNE 2012 / 22
Dr Rob Johnson
Executive Director, Institute for New Economic Thinking
1. The immediate objective of the workshop is to
examine to what extent historical insights about the
evolution of global banking can and should affect
the ongoing banking regulatory reform debate.
2. Arguably, not enough emphasis is put on the
question of what an ideal global financial system
would look like.
3. Globalized finance is said to enhance trade in
goods and services, the global allocation of
investment capital, and the diversification of risk.
4. But what kind of global finance and what kind
of global financial institutions best serve these
purposes?
5. What does the historical record suggest?
6. What kind of global financial system will ultimately
render globalization more inclusive?
Key questions and the role of historical evidence
The relative importance of alternative visions of
financial process should not be left to the Darwinist
process of intimidation by vested interests through
repetition and amplification via marketing budgets.
Theories adopted as conventional wisdom through
repetition and intimidation might just as well be filed
under fiction. Historical evidence can, and does,
shed light on different financial system structures and
their costs and benefits for society as a whole. The
relative reliance on the role of banking versus capital
market finance, the role and impact of central banks in
system stabilization, and the impact of short term cross
border capital mobility can be studied as comparative
experiences through the examination of different
historical institutions and examples. (Questions 4 and
5 above)
Studies like Robert Shiller’s 1981 seminal article in the
American Economic Review 2, which addressed the
relative explanatory power of fundamental and rational
financial theories in accounting for the variation in
equity asset prices, are illuminating. He found that less
than 20 percent of the variation in equity prices can
be accounted for by orthodox theories. This finding,
and the long history of what Charles Kindleberger
aptly called Manias, Panics and Crashes are, in
my mind, sufficient evidence to embark upon this
important historical empirical inquiry regarding the
nature of global financial systems and the alternative
perspectives and findings for future design that it might
reveal. Said another way, there is a great deal that our
orthodox framework does not account for. It provides
insufficient basis for confident system and regulatory
design. Recent experience and the profound
damage that our current architecture has inflicted on
humankind suggest that we have a lot to learn and
2
See “Do Stock Prices Move Too Much to Be Justified by Historical
Changes in Dividends?” By Robert Shiller. American Economic Review,
June 1981, pages 421-436.
Globalization and Finance Project, University of Oxford
potentially a lot to contribute to in both understanding
and system design. It may also be a legitimate basis
for recommending much larger capital buffers as
testament to our lack of precise understanding which
is, of course, also characteristic of market participants
who are reliant upon the accepted state of knowledge
about financial processes.
The global financial system design of recent years
has proceeded along the lines of the logic of perfect
markets. In such a vision of a system no entity has
market power and no external diseconomies between
one financial institution and another, or between
financial institutions and the real economy, exist in a
way that can do harm to those who are not directly
responsible for actions. All constraints in such an
ideal system constitute inefficiencies, and should
be removed if the logic of this vision is followed
strictly. These constraints interfere with the wisdom
of market allocation of capital. We can refer to this as
the question of the presence or absence of incentive
misalignments where the social value of financial
market activity is, or is not, equivalent to the private
value of that system’s activity.
A second question pertains to the ability of financial
markets to act as the conduits of value over time. They
become the social mechanism to bridge between
present and future values. Expectations of future
developments are the key determinant of asset prices.
Modern financial theory works from the premise
that an equilibrium point that anchors the system
in the distant future is knowable and well defined.
This presupposition is not empirically derived, it is
assumed.
The fixed anchor in the future is not often modeled with
certainty (what economists call perfect foresight) but
with a certainty equivalent that is one step away from
certainty. It is represented with a statistical distribution
whose parameters (moments as statisticians call them:
Mean, Variance, etc.) are known. What statisticians
refer to as the “ergodic axiom,” is assumed to hold.
The ergodic axiom assumes that past is prologue. It
assumes that statistical distributions that are derived
from past experience are an adequate representation
of the future. This presupposition is to be contrasted
with the notion of radical uncertainty that has been
identified with the thinking of Frank Knight, John
Maynard Keynes, F.A. Hayek and more recently,
Hyman Minsky and George Soros.
This presupposition has profound implications that
result in a vision of the inherent stability of financial
markets. If ergodicity is valid then market participants
can work backwards from the anchored future to
understand the price of assets in the present and the
trajectory of their migration to that future “terminal
condition. If financial markets are not so solidly
anchored then the question of the psychological
19 JUNE 2012 / 23
process employed by investors to achieve success in
a very competitive world is reopened3. In addition the
notion of the interaction between expectations, asset
prices, incentives for the real economy and future
expectations becomes potentially indeterminate.
The combination of these two questions; the first
related to the alignment of incentives within the
financial sector and between finance and the real
economy; and the second related to the inherent
stability financial markets, are vital ingredients to the
design of the financial system architecture and the
regulatory regime that is best suited to serve the well
being of mankind. (Questions 2,3 and 4 above)
It is here that historical experience and evidence from
previous vivid episodes in the history of globalization
can shed light. While these issues are important to the
design of a national financial system, the additional
complexities associated with balance of payments
adjustment, and with international regulatory harmony
increase the sensitivity of the vision of global financial
markets to the two fundamental questions of financial
process raised above4.
Using the logic of perfect markets and the anchor of
stability in the future one is hard pressed to articulate
a reason for capital buffers or cross border restrictions
of short term capital mobility. On the other hand, if the
spillovers from one financial firm to others (sometimes
referred to as contagion) or from finance to the function
of the real economy are in fact large, then systems
design to maximize the mobility of capital might be
in actuality a design that amplifies the propagation
of disturbances occurring at any node in the system.
Furthermore, either as a cause, or as a consequence,
of the propagation of a shock to the financial system,
a system where a certainty equivalent anchor in the
future is absent, (a world of radical uncertainty) is not
a world that can count of the stabilizing tendencies
to grab hold and help the financial system exhibit
resilience and restorative properties.
A system that exhibits this unstable nature may
be better modeled as an analogue to a network or
biological system where disturbances (epidemics)
should be quarantined to diminish the propagation
of the disturbances to attenuate their impact on the
economic system, and therefore enhance the system’s
resilience. Thus a different vision of financial process
leads to a different logic of regulatory and architectural
design leading to an ideal global financial system.
3
4
This design deliberately confines the spread of
damage within the financial sector, and/or confines the
damage of financial crises in ways that lessen to harm
to the real sector. In essence the vision of financial
process leads to vastly different designs of what is an
ideal global system should look like.
In addition, the work of Hyman Minsky has offered
a vision where risk in a system is not an exogenous
risk that is distributed through society by the financial
system. Rather, Minsky raises the specter that the
design of financial systems can be an endogenous
amplifier of the degree of risk that society will bear.
To the extent that the incentives of the system are
designed in a way that leads to the misalignment
of the interests between the financial system and
the economic system as a whole one can imagine
a financial architecture that generates unnecessary
levels of endogenous risk and unnecessary losses.
Financial system architecture is the creation of a
human political/social system. Question 6 above
speaks of the design of a system that is more
inclusive, implying in my interpretation of that question,
that the system leads to the betterment of more
people. Here it is important to examine the benefits
and costs to financial capital, and the agents of
financial capital in the financial sector, in relation to the
well being of humans who derive their livelihood from
labor income, or other sources of income. The relative
power of these different actors in society can over time
contribute to a distribution of power, and therefore
income, that impacts the distribution of cumulative
benefits of global financial system design. The
question is very important in the current context where
the social mechanisms for sovereign debt restructuring
are of acute importance. In fact when the stakes of
this dynamic interaction are examined through the
study of “vested interests” of various sorts one can
better comprehend the process of how society arrives
at the system designs that we have experienced at
various times in economic history and the various
institutional arrangements associated with each. The
logic of collective action likely illuminates some of this
process. The relations of institutional power to system
design is an important awareness to cultivate, both
historically and in the present circumstance. As is
demonstrated in many aspects of life, might does not
always make right. Seeing things in a comparative
historical perspective can perhaps illuminate how
various systems have come to be adopted and how
human interactions have influenced the distribution
of the burdens and the occurrence of unnecessary
losses resulting from a particular system during over a
variety of historical periods.
See David Tuckett’s The Mind of the Market for a treatment of
psychological process of unanchored financial expectations.
On the international consequences of short term capital mobility within
a system, particularly as they relate to the current design of the Euro
zone, see Paul DeGrauwe’s recent paper entitled, “The Governance of a
Fragile Euro zone.
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 24
Pierre Keller
Former Senior Partner Lombard Odier & Cie; Geneva
The key to a more stable international financial system
is to find a proper equilibrium between free market
forces and regulatory controls. Indeed, after the recent
economic and financial crisis we have experienced,
it would be difficult to defend the point of view that
markets alone are apt to preserve or restore an
acceptable degree of stability by themselves without
the need for some supervisory regulations and controls
by the authorities. The question therefore is really what
kinds of regulations and controls are necessary and
what authorities should be designated to apply them,
without hampering the necessary flow of financing
in our economies and above all without preventing
the adjustments or innovations in the system which
might be required to improve its efficiency or to adjust
it to changing conditions. In addition, there is the
very important issue of international cooperation or
integration within the global financial system itself. I
am a convinced defender of free enterprise, but I do
believe that the above considerations should always
be kept in mind.
In trying to devise the main elements of a future
international financial system, the Oxford Financial
Globalization Workshop has rightly decided to look
first at what history can teach us in that field. While we
are operating nowadays in a different economic and
technological environment - we are not anymore living
in the world of the gold or gold exchange standard,
but with fluctuating exchange rates, huge capital
movements, instant communications and a financial
sector which has grown out of all proportions - there
are still undoubtedly lessons to be drawn from past
experience. In a wider perspective, I would assume
that such an analysis will deal with the numerous
financial crisis which occurred over the years and
which are so well described by Reinhart and Rogoff.
For other more specific or technical aspects, one will
probably have to look at more recent periods and
sometimes even to some very near to us. Furthermore,
one cannot overlook matters of economic and
monetary policy which are, of course, very closely
linked to any financial system. But this exercise should
certainly increase our understanding of the workings
of an international financial system and contribute to
a reflection on the essential factors needed to make it
both more stable and more efficient.
Then we should always try to relate this research to
some of the specific questions on the organization
and functioning of a financial system as we conceive it
today. For convenience purposes, I list the main points
in this regards below:
»»
The organization and shape of the international
banking sector (capital and liquidity requirements,
size, scope and extent of its activities, systemic
implications (too big too fail) on which various
attempts have been made to find an adequate
Globalization and Finance Project, University of Oxford
solution but no absolutely satisfactory method has
yet been found),
»» The supervision of non-banking financial
institutions (assets managers, investment trusts,
insurances, pension funds, etc),
»» The functioning of financial markets (transparency,
derivatives, protection of investors, high speed
trading, etc.),
»» Fiscal conformity and capital movements,
»» The organization of the respective supervisory
authorities,
»» The role of Central banks,
»» International governance in the financial field.
Being a practitioner, I can only make a very limited
contribution to this historical debate. I will therefore
restrict myself to a few brief comments on three
specific cases where recent history has, it seems to
me, clearly indicated the direction in which one should
go: hedge funds, derivatives and financial instruments
and proprietary trading of banks.
Hedge funds
Originally, they were meant for sophisticated investors,
who were conscious of the risk they were assuming.
While these funds are intended to achieve good
performances in rising markets and less unfavourable
ones in declining markets, their overall record is
actually mixed. Many have been created and many
have disappeared. Still, they represent, at this stage, a
very substantial asset class that cannot be overlooked.
But what is important for our discussions is that beside
the case of Long Term Capital Management - which
was skilfully dealt with by the Federal Reserve of New
York - hedge funds have not been a significant factor
of systemic risk in the recent crisis. This does not
mean that some improvements are not called for, such
as a greater transparency towards the supervisory
authorities, the prohibition of naked short selling and
the possibility to limit leverage. As is well known, there
are some attempts underway to tighten the rules for
hedge funds, which in several cases seem to me to go
too far, but that some additional rules are needed is
clear.
Derivatives and financial instruments
Their use has developed considerably in the last
few decades and they have become a major way
to control risk or balance portfolios, but conversely
they have also contributed to creating a new and
significant element of potential instability into the
financial system. Without adhering to Warren Buffet’s
famous remark, recent experience shows clearly
that the use of derivatives and financial instruments
should be better organized and controlled. I fully
share George Soros’ view that they should, above
all, be standardized, more transparent and that their
19 JUNE 2012 / 25
transactions should be centralized in a regulated
exchange with proper guarantees of collateral and
joint responsibility for counterparty risks. With regard
to financial instruments – some of which have become
so complex that they are difficult to understand by
ordinary people - one could envisage the creation of
an international board granting certificates of quality
for new instruments sold to the public.
been achieved in this regard through central banks
cooperation, the multilateral financial institutions and
hopefully some regional institutions, but there is still
a long way to go towards a more integrated world
financial system.
Proprietary trading of banks
If there is one case where there is clear evidence
that something has to change, it is that of proprietary
trading of banks, which has produced huge losses
in recent times and about which former Chairman
Paul Volcker has proposed new rules restricting such
operations. At the same time, it must be admitted that
these restrictions are not so easy to carry out, because
it is not always simple, in practice, to dissociate
operations of market making which are legitimate from
those which represent a real bet on the part of the
bank itself (although the huge existing trading desks
are certainly not necessary for mere market making).
It would probably not be practical to go back to the
old Glass Steagall Act, particularly on an international
basis, but other methods of limiting at least retail
bank’s trading activities or setting “ring-fencing”
around them have been envisaged, such as those for
instance suggested in the Vicker’s report. It seems
to me absolutely essential to restrict the trading
activities by bank which are basically financed by
public deposits, are systemically important and in
case of failure would have to be bailed out by the
States, i.e. with tax- payers money.
To revert to the broader context in which financial
systems operate, I would like to call the attention of
participants to four more general comments. The
first concerns the use of monetary policy, which has
led in the past to periods of very high liquidity and
very low interest rates, and which is undoubtedly
responsible, to my mind, for the extravagant level of
credit creation we have experienced during the past
30 to 40 years and has contributed to a number of
destabilizing financial bubbles. Secondly, there is the
question of the economic and societal usefulness of
the enormous increase in size of the financial sectors
in our advanced economies which has occurred in
recent times, with all the excesses that this evolution
has entailed. As Lord Turner has mentioned a number
of times, one cannot face such an extension without
questioning whether it has really contributed to our
general welfare. Thirdly, the current vicissitudes or the
European currency have, of course, a very serious
impact on the international financial system and can
therefore not be completely absent of our reflections,
but that opens a subject which might go far beyond
the scope of the workshop. And above all fourthly,
there is the crucial question of how one can arrive at
a proper system of international governance in a field
where globalization has reached an extraordinary
high degree but where national governments are
still the deciding authorities. Some progress has
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 26
Professor Amar Bhidé
Thomas Schmidheiny Professor, The Fletcher School of Diplomacy, Tufts University
The globalization of finance5 supposedly enhances the
allocation of capital and the distribution of risk. I argue
that it actually tends to misallocate resources and
destabilize the world’s economy. I also suggest that
the problems are better addressed by radical reforms
within existing regulatory jurisdictions than by new
global rules.
The dysfunctions of mechanistic finance
In my 2010 book, A Call for Judgment I offered the
following critique of modern finance:
Funding requests (e.g. a homebuyer seeking a
mortgage, an entrepreneur venture capital, or a small
business a line of credit) originate in idiosyncratic
forward-looking judgments. Financiers in turn need to
make judgments-about-judgments. They must have
‘on-the-spot’ knowledge of the specific circumstances
and engage in a dialogue to understand the
assumptions and reasoning behind the financing
request. On-going relationships are also valuable
because they facilitate adaptations to unforeseen
contingencies.
Although venture capital and small business lending
remains decentralized and based on judgment and
relationships, the vast expansion of finance in the last
three decades has been mainly through instruments
such as asset backed securities and OTC derivatives
created through a mechanistic, arm’s length process.
In fact computerized models are as essential for
modern finance as the assembly line was for the
automobile industry. Without such models derivatives
outstanding could not have increased nearly sixfold
from $95 trillion to $ 684 trillion between 2000 and mid2008.
The mechanization is lauded for reducing costs
and increasing lending. But, in finance, more isn’t
necessarily better -- how well bankers discriminate
between responsible and reckless borrowers matters
a great deal. And in this, mechanization offers a false
economy.
Central planners misallocate resources, Hayek
pointed out in 1945, because they have to rely on
highly abstracted statistics that ignore the unique
circumstances of time and place. Automated modelbased lending based on a handful of variables suffers
from this very problem. Moreover models extrapolate
from historical data, whereas an essential feature of the
modern economy is unceasing human effort to make
the future different from the past.
5
I use this term to refer to the purely financial cross-border transactions
that don’t directly originate from trade in goods and services or the
transfer of knowhow. Examples include German banks buying Greek
sovereign debt and UK fund pension funds buying the stock of
Brazilian electricity companies. I exclude finance necessitated by “real”
commerce, such as trade credit and investments in joint ventures. In
other words my analysis of the globalization of finance does not cover the
financing of globalization.
Globalization and Finance Project, University of Oxford
The technology also tends to channel resources to
activities that at least on the surface can be easily
automated and modeled, such as housing finance and
derivatives trading and away from those, such as small
business lending, where human judgment seems more
obviously indispensible. Like Willie Sutton, the chief
executives of banks tend to follow the money. Yet the
capacity of banks to lend to small businesses remains
crucial to the economy.
The new finance, said to improve risk bearing, in fact
makes economies less stable. Humans are fallible
whether they are making case-by-case lending
decisions or constructing a model. With traditional
lending however mistakes don’t imperil the economy
unless there is a mania afoot. But when all lending
is based on a few models, mistakes can trigger a
widespread collapse without any mania.
Arm’s length financing through standardized,
liquid securities does allow easy diversification but
that doesn’t necessarily reduce risks. Effortless
diversification in fact creates free-riding problems with
every security holder relying on the others to provide
monitoring and oversight. Collective action problems
also make ongoing adaptations (whose need is
inevitable in a dynamic economy) difficult: the diffused
holders of mortgage backed securities cannot easily
renegotiate a delinquent loan.
Model based finance undermines the ability of
regulators to monitor the solvency and liquidity of
banks. A typical bank exam once included scrutiny
of every single business loan and a large proportion
of consumer loans. Capital adequacy was secondary
and a matter of judgment: examiners would figure out
how large a buffer a bank ought to have, taking into
account its specific risks. As examination of individual
risks became infeasible, regulators came to rely
primarily on standardized capital requirements. The
requirements were supposed to be risk weighted, but
the risks were defined in terms of broad categories,
not case-by-case. For instance under internationally
agreed upon Basel rules, all business loans were
deemed to be five times as risky as all investment
grade mortgage backed securities.
The new technology has legitimized unmanageable
mega-banks. The difficulty of managing individuals
making judgments once limited the size and scope of
financial institutions, especially in contrast to industrial
firms. The belief that mechanistic finance is amenable
to by-the-numbers control, has justified the creation
mega-banks such as JP Morgan whose 250,000
plus employees now outnumber Dow Chemical’s
by about five to one. In reality the sprawl has made
effective oversight impossible even for the banks’ own
managers.
19 JUNE 2012 / 27
Global Ramifications
The sovereign debt malaise
Mechanization has spurred an unprecedented
globalization of finance especially in activities that
have nothing to do with real cross border commerce
such as mortgage lending or speculating on the
default of government bonds.
The 2008 debacle has now morphed into a protracted
sovereign debt malaise centered in Europe. Here too
mechanistic practices have played a leading role.
Traditional finance, based on on-the-spot judgment,
required a local presence. Venture capitalists rarely
made investments further than they could drive.
Banks that did business outside their home markets
focused on multinational clients and the financing of
international commerce. If they did seek domestic
business abroad they established a local capacity to
make case-by-case decisions.
This continues in activities and institutions that retain
the traditional approach. U.S. venture capital firms
for instance have set up offices in Israel, China and
India. Sweden’s Handelsbanken (that now operates in
Britain and the Baltics) still follows the church steeple
principle of branches lending to businesses visible
from the church steeple in the middle of their town.
As Edmund Phelps and I have argued, countries
cannot get overly indebted on their own: excessive
borrowing by governments requires lenders who
overlook the fact that sovereign debt is in many
ways worse than unsecured private debt or junk
bonds. Governments provide no collateral and offer
no covenants to restrain profligacy. As Greece
has shown, governments do not pay penalties for
fraudulent accounting. There is neither a legal process
for forcing a state to pay off creditors, nor a legal
venue for debt renegotiation.
Purchasers of sovereign debt, therefore, should be
extremely careful – either shunning spendthrifts or
demanding higher interest rates to offset greater risk.
Making excessive borrowing expensive or impossible
would cap deficits.
Transactions in derivatives or asset backed securities
created by mechanistic finance however can be
done from afar. All the risks and returns are thought
to be captured by a few variables whose values are
available to anyone with a computer terminal. Indeed
claims whose values depend on what happens in
some remote place are thought to provide the kind
of diversification free lunch celebrated by Markowitz.
They elevate portfolios to a more efficient frontier.
Unfortunately, banks enabled excessive borrowing
by reckless governments by accepting interest rates
that were only a bit higher than the rates that more
cautious governments had to pay. The 2008 crisis
should have served as a sharp reminder of the need
for careful credit analysis. Instead, banks increased
indiscriminate purchases of government debt; their
financial engineers and derivatives traders also
turned to this debt as raw material after new subprime
securities became unavailable.
The new technology, not just the products it created,
proliferated globally. Unlike traditional practices that
are hard to codify and embedded in organizational
traditions, the techniques of model based finance can
be easily replicated; and, because they are based on
principles that are supposed to universal, they can be
applied anywhere. Mechanization also offers financial
institutions everywhere the promise of rapid growth
in profits – and compensation for top executives. It
makes no difference whether a chief executive is
based in Frankfurt, Zurich, London or New York when
quantified risk metrics constitute the sole control
mechanism.
Banks had been burnt by sovereign borrowers before
but regulators apparently forgot and helped bankers
to forget. As mentioned, top-down rules required
banks to hold capital against broad categories
of assets. Very little capital was required against
holdings of sovereign debt, because it was ruled to
be virtually risk-free. In fact, holding government debt
helped banks to meet their liquidity requirements. Not
surprisingly, they loaded up on the highest-yielding
bonds, ignoring whether the extra interest justified the
risks. Blind bond buying in turn allowed governments
to accumulate debts and deficits on a scale that
virtually ensured defaults.
Therefore even if many financial practices were
pioneered in the U.S., like the flap of the proverbial
butterfly’s wings they set off tornadoes afar in 2008.
As house prices in Las Vegas collapsed, subprime
mortgages owned by Norwegian municipalities north of
the Arctic circle plummeted. The once staid Deutsche
Bank was as exposed to financial losses, lawsuits and
regulatory sanctions arising from its underwriting and
derivative operations as Citicorp and J.P. Morgan.
Uncertainty about the solvency and liquidity of megabanks triggered a global bank run.
Unilateral reform
It seems natural to look for international solutions to
the problems of globalized finance but the realities
are daunting. If coordinated international action
cannot stop brazen piracy off the Somali coast, how
effectively could it control the covertly risky behavior
of financiers? Moreover while the international
standardization of weights and measures is a good
thing, one-fit-all banking rules such as the Basel
capital requirements often do more harm than good.
Reforms tailored to domestic conditions 6 offer a more
promising solution.
6
Globalization and Finance Project, University of Oxford
Or more precisely, to conditions in the same monetary authority. The
absence of Eurozone-wide deposit insurance – with complementary
bank-regulation -- poses a mortal threat to the common currency.
19 JUNE 2012 / 28
Reinstating and expanding the 1930s Banking
Acts (aka Glass-Steagall) in the U.S. would be a
great advance. Specifically I have argued for fully
guaranteeing all deposits – with tough limits on risktaking by banks to offset moral hazard problems and
make unlimited insurance credible. If losses are
thought to be unbearable, guarantees are useless.
Interest rate caps, indexed to T-bill rates, would
therefore be reinstated, ending the competition for
fickle yield-chasers that helps set off credit booms and
busts. Attracting yield-chasers impels banks to take
imprudent risks to pay higher rates and exposes them
to mass-withdrawals.
Limits on the assets and off-balance sheet exposures
would be stringent but simple. Banks would be
restricted a few enumerated activities, principally
making traditional loans and simple hedging
operations. A landmark charter granted to the
Commercial Bank of Albany in 1825 offers a good
model. It gave the bank specific powers to carry on
the business of banking—and excluded everything not
expressly granted.
The reforms could also dampen trade imbalances
and reckless excessive borrowing by governments.
Countries can import much more than they export
-- and their governments can spend more than they
raise domestically -- only if a foreign lender or investor
covers the shortfall. If banks weren’t allowed to lend,
many countries wouldn’t have large trade or budget
deficits.7
To conclude: mechanistic risk-taking by banks -be it through the securitized mortgages, complex
derivatives or dodgy sovereign debt -- is not just
a problem for bank stock or bond-holders. Like
drunk driving it is a public menace that must be
proscribed, not merely discouraged through taxes or
cushioned through capital buffers. And, it will take
radical country-by-country reforms to restore caseby-case judgment, not a watered-down international
consensus.
No model-based risk-taking would be allowed; banks
would be required to document their credit analyses
for every borrower. And the terms of loans and hedges
would have to be comprehensible to a regulator of
average education and intelligence. If the average
examiner couldn’t understand an instrument or
contract, it wouldn’t be allowed.
The rules would apply to any entity taking shortterm deposits, terminating the shadow banking
system. Banks would have to shed their derivatives
business and end their involvement in asset
securitization – no financing of warehouses of
loans awaiting securitization, no lines of credit
backstopping securitized assets and no buying of
the securities. And without the involvement of banks
the mass-production of derivatives and securitized
assets would likely cease. (Five mega-banks, led
by JP Morgan, now account for more than 90% of
derivatives outstanding in the US because transactions
with a too big to fail institution are regarded as
having no counterparty risk. Concerns about the
creditworthiness of non-bank derivatives dealers,
whose liabilities weren’t guaranteed, would naturally
limit the size of the market.)
7
Globalization and Finance Project, University of Oxford
The U.S. is a special case: purchases of U.S. Treasury bonds by the
Chinese government have contributed more to financing the U.S. trade
deficit than private lending. That bond buying, attributed to a “savings
glut” in China, is said to have forced down interest rates and triggered
a consumer borrowing binge in the U.S. Now try the following thought
experiment: would consumer borrowing have exploded if lenders in the
U.S. had been more prudent? And without credit-fueled consumption
in the U.S., would China’s trade surplus and savings glut have been as
large?
19 JUNE 2012 / 29
Dr Peter Kurer
former chairman, UBS, Zurich
Politicians, policy makers and regulators around the
globe dream of a global bank model which runs at
a low level of systemic risk but, at the same time,
supports and fosters economic growth. In contrast, I
would like to argue that there exists neither in reality
nor in history a uniform or at least prevailing model of
a global bank which could meet these criteria. As a
matter of fact, in real life there is no standard model at
all. There are about ten banks in the world which one
could call “global banks” but, upon closer scrutiny,
each of them follows a special and distinct strategy
which distinguishes itself very much from the one of
its global competitors. A few of them are transactionoriented investment banks which concentrate on
trading, underwriting and corporate finance advice.
Others are universal banks, often with a bias for
a particular product such as retail, commercial
lending, infrastructure finance, trade finance or wealth
management. Still others essentially are a transnational
string of local retail banks, loosely held together by a
common roof of some limited corporate functions.
This absence of standardization makes it very hard
to define an optimal model which would support
globalization and growth at low risk. By the same
token, I reckon it will be difficult to find a historical bank
model which would serve as a lodestar for a more
efficient and, at the same time, more secure global
banking paradigm. Would it be the early merchant
banks, established by the trading companies and run
by partnerships? Or the extension of a colonial retail
and commercial bank bureaucracy which assures
a multitude of commercial banking transactions
including lending to private households and small
businesses but which shies away from capital markets,
wholesale lending or financial innovation? Or huge,
highly efficient trading utilities which serve as reliable
brokers around the globe but are carefully ring-fenced
from any deposit taking or proprietary trading activities,
following in the footsteps of the houses of Morgan or
Nomura? Or super-smart corporate financiers who
put together the perfect deal, epitomized by firms like
Lazard or Rothschild?
I do not believe that history will yield such a model.
Nonetheless, historic analysis is important here.
But it should not centre around the search for a
defining model. Rather, I propose to make a kind of a
functional-structural analysis of globalization, banking
history and present day reality of global finance.
The key questions in such an analysis are: what
functions have to be fulfilled in a globalizing world
and which financial structures are required to meet
such functions? And which structures can act as a
substitute for another; and if the functions develop and
differentiate over time how will the structures adopt;
and which policy supports fast adaption at lowest risk
possible?
Globalization and Finance Project, University of Oxford
Since its beginning, presumably the active trade going
on in the vast Roman empire, globalization evolves
along the same trajectory: It starts with single trade
over long distances, then goes on to more organized
export and import structures such as operated, in the
ancient world, by the Nabataeans or other trading
tribes in the Middle East or later by the Dutch, Scottish
or Swiss trading companies; as a next step in the
evolution comes local manufacturing by foreigners
and general foreign direct investments in real estate,
infrastructure or technology; even later, investments
start to flow in both directions; and finally, global
integrated structures are created, be it in technology
(Google), transportation (Star Alliance), finance (the
global banks), global supply chain management or
even fashion brands.
A phenomenon closely attached to this evolutionary
concept of globalization is the rise of the middle class
in emerging markets. It also has a close association
with some aspects of our analysis, though not on first
sight but upon closer observation. Globalization is
about bringing poorer countries into the flow of goods
and services of the broader world and thereby allowing
them to grow their economy and erase poverty. You
can measure the stage of this evolution by many
development parameters. But for this discussion,
there are some simpler means to gauge the rise of a
middle class. Look, e.g., at three things in a particular
country: first, production and use of cement; second,
the existence or absence of supermarkets; third, the
development of the retail banking system. In some
of the poorer countries of Africa, you will hardly find
any cement production. But if you go to Nigeria or
Thailand, some people have made huge fortunes by
running big cement factories. By the same token, in
Ethiopia you will rarely find a supermarket, and retail
trade is confined to street markets or mom and pop
stores at best. By contrast, in southern Africa or South
East Asia, you will find supermarkets which are at the
same level as here (and sometimes higher). Again,
in lower developed countries, there are hardly any
retail banks, a minimal distribution of bank bills and
transfers often assured by the central bank, whilst,
to take an example, Namibia or the Philippines have
sophisticated retail banking groups. All this has to
do with the rise of the middle class. If people leave
subsistence agriculture, earn money beyond their daily
needs, start to save and can make some economic
choices, they need cement to build houses, they want
to go to supermarkets to buy branded products and,
finally, they need retail banks to keep their savings and
help them to finance their house.
19 JUNE 2012 / 30
If you travel along this continuum of globalization,
increasingly you will have very particular needs of
finance as the example of retail banking has shown.
For the purpose of this discussion and by way of
simplification, we can distinguish the following of such
financial functions:
1. T
rade requires the ability to settle accounts over
long distances.
2. Export/Import will need a more elaborate system of
trade finance.
3. Foreign direct investments demands a multitude
of financial services such as corporate finance
advice, cross border and wholesale lending,
creation of local capital markets and sophisticated
forms of project finance and infrastructure funding.
4. Global integrated systems will lead to global
capital markets.
5. The rise of a middle class needs, as shown, a
functioning retail banking system which, in line
with the development of the middle class, has to
add ever elaborate products such as new forms of
mortgage, credit cards, or saving instruments.
6. Once the top of the middle class gets wealthy,
it first requires functioning and internationally
versatile retail brokerage and then, at the top end,
a full-fledged wealth management.
7. Along the lines, the exporting emerging markets
will build up currency reserves, create sovereign
wealth funds and need institutional asset
management services.
8. An important aspect of globalization is bringing
innovation from highly innovative countries of the
old world to the emerging markets where they
will be used in cheap mass production. This
transformation of innovation to manufacturing and
sale needs risk financing, commonly called venture
capital.
Most of these services can be provided by a global
bank. And some of the global banks try to render
almost all of these services. But this is only part of
the story. Many of the functional requirements of a
globalizing world are met by players other than global
banks. There are many reasons for this. The global
banks are too weak to guarantee market efficiency
over the whole specter. Fortunately, there are many
structures who can substitute: Settling accounts over
long distance can be done by money transfer outlets
or credit cards; corporate finance can be rendered
by boutiques; wholesale lending can be replaced by
efficient debt capital markets; private equity or family
equity in Asia can step in for equity capital markets;
hedge funds can help non-performing loan or capital
markets to work; fund managers and alternative
investment managers provide high end wealth
management.
Globalization and Finance Project, University of Oxford
Thus, even though global banks fall short of the
expectations we might have for their contribution
in a globalizing world, and even though they might
be further weakened in the ongoing crisis and the
regulatory response to it, there exist all the building
blocks for restarting global growth and further
globalization. But the bleak reality is that the global
finance system is dysfunctional in many respects. See
the following examples:
»» Lending has become an issue and credit crunch
a reality in many countries. Cross-border lending
is an even more serious issue in a fragmentizing
world where banks are called to the duty to
finance local companies. Central Eastern Europe
(CEE) was one of the fastest growing emerging
markets since the nineties. But the region
depended heavily on lending from Austrian and
other foreign banks. Now these banks have
to cut back on cross-border lending in view of
new regulatory capital requirements and ongoing loss absorption. As a consequence, a
local entrepreneur in, let’s say the Ukraine, has
to pay interest of 18 percent to its local bank
on a commercial loan which prevents him from
expanding his business. The same applies in
Poland, Serbia and most of the CEE which will
bring the region into a slump.
»» Trade finance was a traditional stronghold of
French banks which now leave this business; it will
take years till other players will be able to fill the
gap.
»» Capital markets, in particular debt capital
markets outside the U.S., are too weak to play
an efficient role in financing. Both in Europe and
all the emerging markets, debt financing is still
dominantly rendered through bank lending which
is dysfunctional in many respects: in a credit
crunch the whole economy is hit immediately;
bank lending is exposed to political pressures and
bargaining; and bank lending brings the heavy
concentrated risk which should be avoided as we
have learnt in the crisis.
»» Public companies increasingly become victims of
regulatory burdens, NGO attacks and over-zealous
investigations. In the old world, their number has
gone down and IPOs have become rare. This
weakens equity capital markets.
»» One of the early victims of the crisis were monoline
insurances. Since they are broken it has become
very difficult to finance complex infrastructure
projects through insured bonds in the absence
of government funds or guarantees which have
gotten rare over all the public debt issues.
»» Regulators around the world have increased
regulatory pressures on wealth management,
asset management and alternative investment
vehicles, often with the result that it gets more
difficult for the wealthy to have their wealth
managed on a multinational level.
19 JUNE 2012 / 31
»» And in many places, it has become extremely
difficult to open a bank account if one is not a
resident.
»» And to conclude with a brief, sad note on venture
capital: In a world awash of liquidity, it is difficult to
get finance for innovations so desperately needed
for growth.
Thus, a structural-functional analysis suggests that our
main worry should not be the global bank concept but
the stage of the global finance system. This system,
I think, is not on the way to help restarting the global
economy. Quite to the contrary, it loses ground and
strength because politicians, policy-makers and
regulators around the world fail to support it.
So what should be done? I see the following policy
requirements:
»»
»»
»»
»»
»»
»»
Establish a policy agreement that a growthoriented globalization needs a vibrant global
finance system. This can and should not be left
with the global banks. There are good reasons to
cut back on their often excessive risk appetite. But
then, policy-makers should do something positive
about the rest of the finance world with a view to
allow appropriate substitution. All this needs a
complex policy mix.
Deepen the capital markets with a view to make
debt financing more efficient and take some of
the concentrated risk off the shoulders of the big
banks.
Make the public company an attractive concept
again with the purpose to make equity financing
more efficient.
Abstain from heavy-handed regulation of wealth
managers, asset managers and alternative
investment advisers such as private equity and
hedge funds. These financial service providers
import limited systemic risks and many of the
regulatory efforts in this area are counterproductive
and promoted simply for political reasons. The
more we leave them freedom, the more they can
fulfill their role as fast moving gap fillers.
Support the creation of efficient retail banks in the
emerging markets and help international banks to
enter retail banking there.
Cut excessive risks of the global banks but allow
them to bring all their depth of knowledge and
superior systems to the table and make money with
this.
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 32
Roberto Jaguaribe and Augusto Cesar Batista de Castro
Ambassador of Brazil to the United Kingdom, and Economic and Financial Affairs Officer, Embassy of Brazil
Financial markets must support the development of the
real economy.
The ongoing economic crisis made dysfunctional
elements of the global financial system all the more
visible. These problems not only diverted the financial
system from achieving that goal but also set the
context for the worst crisis since the Great Depression.
In our perspective, any long-term solution to the
challenges posed by the recent crisis must necessarily
deal with three main issues:
»»
a full acknowledgement of the new international
economic order;
»» a thorough reform of the international financial
institutions (IFIs); and
»» a new institutional framework for the global finance
industry.
Brazil is fully engaged in the debate both at the
G20 and other international bodies on how to best
accomplish this agenda. In this paper, I would like to
start by briefly highlighting some aspects of Brazil’s
recent experience in reforming its financial system.
That may be useful to understand both our vision
of a fair and inclusive financial system and also our
standpoint at the international level. Secondly, I will
try to summarize the latter, with a special emphasis
on the requirements for the consolidation of a new
international economic order, the reform of the IMF and
the World Bank and the construction of an adequate
institutional framework for financial institutions.
risk-taking whilst promoting a culture of responsibility,
in which both managers and main shareholders are
effectively liable for bad management.
Under the right kind of incentives, Brazilian banks
are very profitable and very conservative at the same
time. Our regulatory capital requirement is 11% of
risk-weighted assets, already above Basel criteria, but
banks typically hold more than 16% of RWA. Around
90% of all transactions involving OTC derivatives
in Brazil are, furthermore, cleared through central
counterparties.
Another aspect of the Brazilian financial system, which
has proved to increase the resilience of our economy
to external shocks, is the existence of development
institutions. Created in a historical context of scarce
capital flows to savings-thirsty developing countries,
those institutions are key to channelling much-need
resources aimed at long-term investments - for
instance, in infrastructure projects -, providing, at
times of economic distress, a sound buffer against
herd behaviour and the pro-cyclical nature of financial
markets.
Although we are perfectly aware of our limitations and
the huge challenges that still lie ahead, we strongly
believe that a healthy combination of strict regulation,
transparency and disclosure, as well as an institutional
framework able to counter pro-cyclical bias and
other market failures, can make the interests of the
financial institutions more aligned with those of other
businesses, taxpayers and citizens in general.
Brazil’s experience in reforming its financial system
The underlying international economic order
After a long period of high inflation, Brazil had to make
important adjustments in its financial system after the
macroeconomic setting was stabilized in the mid1990s. Most banks and economic players struggled
to operate in the new economic environment, as they
were used to a short-term horizon of planning. In
addition, Brazil had many provincial banks engaging
in quasi-fiscal activities and thus creating an unstable
environment both for the financial system and for
public finances.
The Bretton Woods monetary and financial order
was somehow a compromise between economic
integration and the construction of the welfare state.
This ‘embedded liberalism’, in the felicitous definition
by John Ruggie, was then jeopardized by the
globalization of finance, especially from the 1970s
onwards.
Two governmental programmes, the so-called PROER
and PROES (Portuguese acronyms for Programme
for Restructuring the National Financial System and
Programme for Reducing the Participation of the State
in the Banking Sector), implemented at the time, laid
the foundations for a healthy, highly regulated and
balanced financial sector.
It is also worth noting that Brazilian banks and other
financial institutions have been strictly regulated for a
long period. Since at least the 1960s Brazil has had
institutional instruments to intervene in banks in the
case of misconduct or threats to the stability of the
financial system as a whole. Our system, moreover,
has always been careful in preventing excessive
Globalization and Finance Project, University of Oxford
The new mind-set, for which the opening of the capital
account became a new orthodoxy, supposedly found
its justification in the expectation that freer capital
flows would lead to a better allocation of resources.
Furthermore, financial markets would provide the
much-needed discipline to profligate governments.
As we now know, several aspects of this new order
have, however, been badly neglected by the new
orthodoxy, namely:
»»
»»
financial systems across countries show a great
variation not only in terms of depth and breadth,
but also in the nature of its connections to the real
economy (even within the G7, the so-called “Rhine
capitalism” is very different from the “anglo-saxon
model”);
there is no equivalent to a proper regulatory and
19 JUNE 2012 / 33
supervisory body at the international level – the
paradox of a single integrated financial market
and fragmented polities has not received due
consideration;
»» there is a considerable democratic deficit in
the way IFIs work and conceive of very invasive
policies to fight economic crises, which, up to the
2010s, were more common in emerging markets;
»» the mere harmonization of regulatory standards
of developed countries, therefore, might not be
enough to prevent future economic crises.
Although the prevalent mind-set has changed
considerably since the Asian crisis and, more notably,
since the 2007/8 crisis, we believe that a proper
reckoning of the mistakes and gaps in the previous
international economic order is still lacking.
The updates in the membership of institutions such as
the Financial Stability Board and the Basel Committee
on Banking Supervision; the consolidation of the
G20 as the main international forum for economic
cooperation as well as the ongoing reform at the
IMF are very important first steps in setting up a new
international economic order, but which still fall short of
completing the task.
Most likely, we currently find ourselves in a kind
of interregnum, between the end of the old order
and the rise of a new one. We believe that the most
important thing at moments of this kind is to keep
one’s mind open instead of resorting to old prejudices
and intellectual constructs. As Keynesianism
became the mainstream economic theory after the
turbulent 1930s, perhaps what we need now is a
new economic and political way of thinking, capable
of (i) reconciling the neoclassical school with the
contemporary requirements of a new paradigm
of sustainable development; and (ii) laying the
foundations for renewed cooperation among diverseminded countries, in a context of continued increasing
interdependence.
We are not likely to be successful just by re-fuelling a
model based on unrestricted credit for consumption.
At the same time, we shall not curb the fair aspiration
of billions of people that still do not have access to
basic material comfort. Striking a fair balance between
these seemingly opposite goals should be at the core
of any possible new economic model.
As far as the international monetary system is
concerned, we must not neglect the links between
the exorbitant privilege of issuing international reserve
currency and the build-up of global imbalances that
paved the shaky ground to the latest crisis. Brazil and
other large emerging countries support further work on
a possible enlarged role for the SDRs, notwithstanding
our recognition that a plain international currency
requires governance mechanisms that do not seem
feasible yet. As in the Chinese proverb, however, a
long journey always starts with one first small step.
In this regard, we should be very careful about narrow
assessments of the potential of forums like the BRICS.
Globalization and Finance Project, University of Oxford
The diversity of interests, of cultural backgrounds,
of geopolitical concerns is not its weakness but the
very core of its strength. There has been an excess
of the “like-minded” countries approach. No longterm solution to any global problem is feasible without
proper representation of diverse-minded countries in
global institutions.
Our common effort to reform these institutions should
be regarded as an auspicious sign or the prelude
of a more democratic and plural international order.
There has not been any strong revisionist impulse; no
completely alternative order has yet been proposed.
Instead, big emerging economies are struggling
to make the same old international institutions
more democratic and open to different – but not
incompatible – views on security, development and
other important issues on the international agenda.
For their own sake, Western countries must realize,
once and for all, that convergence will not be achieved
by emulation of a pretence moral superiority but by a
common endeavour by all actors to reach a shared
centre.
The reform of the IMF and the World Bank
The resuscitation of the reform processes of the
Bretton Woods institutions, after the 2007/8 crisis,
seems to have been motivated more by fear of
irrelevance than by a genuine desire of more plural
institutions. Self-insurance policies after the Asian
crisis came close to making those agencies financially
unviable.
Although some progress has been achieved recently,
those institutions are still far from representing not only
the economic weight of emerging economies but also
their plurality of views. The formula on the basis of
which the IMF quotas are allocated, for example, still
disproportionately values concepts such as ‘economic
openness’ - less precise and measurable than the
more objective ones such as GDP.
Another good example is capital controls. From hard
orthodoxy, which came close to being included in
the IMF Articles of Agreement in the 1990s, the Fund
has recently nuanced its view, recognizing the role of
managing capital flows under certain conditions. This
highly relevant intellectual reappraisal, however, has
not been translated into the political sphere.
At the G20, some countries seem yet reluctant to
assess the effects of expansionary monetary policies
on exchange rates, whereas the same countries do
not shy away from reiterating the desirability of full
commitments to the opening of the capital account. A
much more balanced approach is needed if we really
want to build confidence on the IFIs.
Emerging economies will never have an appetite to
fully commit to institutions that they perceive as mere
agents of developed countries’ national interests.
Needless to say, the selection of chairpersons
and managers for those institutions, as well as the
persistence of a sort of veto power that some countries
enjoy, are also part of this equation.
19 JUNE 2012 / 34
Development institutions such as the World Bank
must also wake up to the new reality. In the last
decades, the Bank reduced dramatically its loans to
infrastructure projects in favour of concepts such as
good governance. It has also been guided by the view
that it should only focus on the poorest countries in the
world. To a certain extent, the Bank has fell prey to aid
policies of developed countries.
Fortunately, for those countries where capital is scarce,
traditional development institutions and donors are
no longer the only source of resources. International
aid is not always conducive to development. The
latter involves a complex structural transformation of a
country and a society. The mere transposition of alien
institutions and notions of governance has already
proved to be counterproductive.
A new institutional framework for global finance
It is a big mistake to see prosperity and innovation
as the results of the free market forces exclusively.
The strength of capitalism resides as much in
strong institutions as in the freedom of the players.
Unrestricted freedom leads to abuses and to
institutional capture. We need, furthermore, decide
whether a financial market that is many times the size
of our real economies is really functional.
Economic development, moreover, is a complex
process that involves huge structural adjustments,
which are very unlikely to be achieved solely by the
invisible hand of the market.
In our view, these very simple assumptions must guide
the construction of a new institutional framework for
global finance. The globalization of capital flows,
especially from the 1970s onwards, has not delivered
all of its promises. Economic crises and disruptions,
many of which entail systemic consequences,
became a recurrent pattern of our economic system.
The question about the social desirability of such
phenomena has been eluded and a thorough reform
of the institutional framework for global finance has
been kept at bay by the action of vested interests
that benefit hugely from the paradox of an integrated
financial market and hundreds of jurisdictions.
For this to happen, much more progress is needed
in issues such as the shadow banking system,
international resolution of financial institutions
(especially the “too important to fail” problem) and the
regulation and transparency/disclosure of transactions
involving OTC derivatives as well as any other financial
products. Innovation in finance will only be a benign
process if we can at least assess its implications for
the real economy.
Conclusion
All we should offer, at this stage, as a sort of
conclusion is what we consider to be the necessary
foundations of a new international economic order in
which the globalization of finance is an asset and not a
liability.
1. Firstly, a renewal of economic and political theory
capable - as Keynesianism was after WWII of reconciling integration with development,
coordination and diversity.
2. Secondly, a full acknowledgement of the new
reality, upon which the new international economic
order should be built.
3. Thirdly, international financial institutions that
effectively translate that new order into proper
economic governance.
4. Fourthly, an institutional framework for global
finance that addresses the current fragmentation
and lack of transparency.
All of that is far from secure. The slower we adjust our
mind-sets and institutions to the new reality, the riskier
for the cohesion of global economic governance.
Unlike the disciplines of international trade, guarded
and coordinated by a single and elegant institution
like the WTO, global finance has been the subject of a
myriad of small fragmented agencies. Notwithstanding
the merit and technical expertise of those bodies, a
higher level of coordination is required to prevent future
crises. In this regard, Brazil supports the strengthening
of the Financial Stability Board, possibly at the core
of an international regime for global finance in a near
future.
Globalization and Finance Project, University of Oxford
19 JUNE 2012 / 35
Dr Vijay Joshi
Emeritus Fellow of Merton College, Oxford
1. It has long been understood that the international
monetary system has to address two main
challenges. The system must promote adjustment
of balance of payments disequilibria. It must also
ensure that international liquidity is adequate (but
not excessive) to enable countries to finance
deficits and surpluses in order to smooth the
process of balance of payments adjustment.
Before the recent crisis the dominant view was that
these challenges had been rendered obsolete by
financial globalization. We can now see that this
‘new view’ was mistaken.
Adjustment
2. Supporters of the new view thought that the
adjustment problem would go away if the public
finances were kept in good order. Excessive
current account deficits and surpluses would
not emerge because rational private agents
would respect their own inter-temporal wealth
constraints. But there have been many examples of
countries getting into trouble despite having sound
budgetary positions. This is not surprising. Markets
can and do fail; booms and busts driven by the
private sector are entirely possible. Moreover, the
world is not composed only of small private agents
but also of large government actors, which are in
charge of exchange rate arrangements that can
provide faulty signals to private agents.
3. Global current account imbalances were not the
main cause or trigger of the recent crisis but they
did play an important role in its build-up. It is
also worth noting that a continuation of the trend
of growing imbalances in the last decade would
have led to a severe dollar crisis if the housing
bubble had not imploded first. The fact that the
world dodged the imbalances bullet last time does
not mean that it will do so next time. A necessary
(though not sufficient) condition of avoiding
excessive global imbalances is an exchange rate
system that promotes adjustment. This point must
not be forgotten in the current focus on regulation
as the answer to the ills of financial liberalization
and financial globalization.
4. Exchange rate arrangements today are
characterised by a laissez faire approach, based
on the idea that each country should unilaterally
choose a regime that best suits its goals and
circumstances. This ‘non-system’ came into force
with the Second Amendment to the IMF Articles
that was enacted in 1978, a few years after the
breakdown of Bretton Woods. But this free-for-all,
especially as between the key countries, contains
a radical flaw from a systemic standpoint. Pressure
to adjust is felt neither by surplus countries
that practice ‘export-led growth’ on the back of
undervalued exchange rates (Germany, China)
Globalization and Finance Project, University of Oxford
nor by those countries (in particular the U.S.) that
benefit from their power to create global reserves
by running deficits. Thus, the system positively
encourages excessive imbalances. (Note that
some non-floaters, like China, which run balance of
payments surpluses are also able to sterilize their
monetary effects, which reinforces the imbalances
tendency.)
5. What then should be the shape of the exchange
rate system for key countries? A fixed exchange
rate would be inefficient and intolerable in the
face of asymmetric disturbances. A clean float
would occasionally produce insane exchange
rate misalignments. That leaves two options.
Exchange rates between key currencies could
float in unmanaged fashion most of the time but
with occasional coordinated intervention. (In
China’s case, this could only happen eventually,
with negotiated exchange rate changes in the
interim.) Or, as suggested by John Williamson,
reference rates could be periodically agreed,
intervention being allowed (but not compelled) only
if undertaken to influence market exchange rates
in the direction of reference rates. None of this is
going to happen soon. A rather crude, admittedly
imperfect, way forward would be to tax persistent
and excessive current account surpluses and
deficits. (The numerical specification of ‘excessive’
and ‘persistent’, and the rate of tax to be paid to
the IMF, would have to be agreed. The latter would
have to be big enough to affect behaviour.)8
International Liquidity
6. The ‘new view’ also downgraded the importance of
official provision of international liquidity. This was
on the basis of two presumptions. The first was that
the adoption of floating would reduce the demand
for reserves significantly. This has not happened.
Clean floating has been rare, confined to a few
advanced countries. Many governments have
exhibited ‘fear of floating’. They have maintained
intermediate regimes in order to damp down
exchange rate volatility. The second presumption
was that financial globalization would reduce the
need for reserves. External imbalances would be
financed, and reserves obtained, by borrowing
and lending on the world capital market, as and
when necessary. But many countries have learned
by bitter experience that the capital market is a
fair-weather friend. Loans become much more
8
Some clarification is called for on how these considerations affect the
euro-zone. The euro is a key currency that is highly relevant for global
imbalances; so it would be an integral part of any global exchange rate
arrangement for key currencies. Imbalances within the euro-zone are a
different matter. Intra-union real exchange rate changes are necessary
to deal with large intra-union imbalances. Real exchange rate changes
have to be effected via changes in inflation rates brought about by fiscal
contraction in deficit countries and fiscal expansion in surplus countries.
A symmetrical adjustment mechanism of this kind does not currently exist
in the euro-zone and is needed for its long-run viability.
19 JUNE 2012 / 36
expensive or dry up altogether during crises,
when they are most needed. So greater capital
mobility has increased, not reduced, the selfinsurance demand for reserves, especially owned
reserves. The sure-fire way to accumulate owned
reserves is to run current account surpluses. The
consequential scramble for owned reserves has
contributed to the excessive global imbalances.
Reserve hoarders run large current account
surpluses while the U.S., the main issuer, runs
large current account deficits. As regards the
latter, the underlying behavioural connection with
the current reserve system is psychologically and
empirically plausible: the ‘exorbitant privilege’
conferred by the power to issue reserves weakens
balance of payments discipline on the issuer
country and tempts it to overspend.
7. The reserves system also continues to suffer from
a long-standing problem. This is the potential
instability involved in national currencies serving
as international reserves: a modern version of the
‘Triffin problem’. If reserve issuers run persistent
surpluses, the world is starved of liquidity; if they
run persistent deficits, confidence in reserve
media is threatened as the issuers’ debts increase.
The number of reserve currencies is set to rise.
Optimists hope that competition between issuers
will discipline them. That may not happen. More
likely, there could be destabilizing switches
between reserve currency assets.
8. It is unlikely that the demand for reserves will slow
down. There would be a significant improvement
in global stability if a substantial portion (say a
half) of the expected annual growth in demand for
reserves were met by the creation of SDRs, rather
than by expanding reserve currency holdings. In
time, such a change would confer various benefits.
Firstly, it would reduce the need for countries
to earn reserves by running current account
surpluses. This would serve to counter one of
the two causes of excessive global imbalances.
(The other cause is the obsession with ‘exportled growth’. Countering that would require reform
of the adjustment process, discussed above.)
Secondly, it would constitute a move towards
a system in which international reserves do not
consist of national currencies. This would tighten
the balance of payments constraint on reserve
issuers and reduce ‘exorbitant privilege’. Thirdly,
it would begin to provide reserve holders with
diversification benefits, more conveniently than by
managing an equivalent portfolio of currencies.
Fourthly, it would reduce the danger of large-scale
switches between reserve currencies. Fifthly, it
would distribute the seignorage from reserve
creation more widely. Sixthly, it would reduce
‘reverse aid’ from developing countries to the
advanced countries, which arises from the large
spreads between the cost of borrowing reserves on
capital markets and the return on depositing them
with reserve issuers.
Globalization and Finance Project, University of Oxford
9. A more complete move towards an SDR system
would require further changes. The first is the
institution of a ‘substitution account’ to mop up
existing reserve currency holdings. This would
raise difficult issues such as the sharing of
exchange risk. The second is measures to increase
the appeal of the SDR by transforming it into an
asset that can be held by the private sector. This is
complex and will take time.9 But promoting greater
central-bank use of SDRs, as advocated above,
need not wait on such changes. Right now, it is
hard to think of any other improvements to the
world monetary system that could achieve so much
as such little cost.
9
Some visionaries have imagined the IMF becoming a full-fledged global
central bank, with the SDR as the principal, perhaps the sole, global
currency. This would require the world’s governments to put their fiscal
capacity behind the global central bank, just as a national government
stands behind a national central bank. This is a far cry from the modest
change advocated here.
19 JUNE 2012 / 37