financing globalization: lessons ... - university of oxford

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 1

FINANCING GLOBALIZATION:LESSONS FROM ECONOMIC HISTORY All Souls College19 June 2012

www.bsg.ox.ac.uk

Globalization and Finance Projectsupported by the Ford Foundation

List of participantsCyrus Ardalan:Vice Chairman:Barclays

Hugo Banziger:former Chief Risk Officer:Deutsche Bank

Jaimini Bhagwati:Indian High Commissioner to the United Kingdom

Amar Bhide:Thomas Schmidheiny Professor, The Fletcher School of Diplomacy: Tufts University

Patricia Clavin:Professor of International History & Fellow: Jesus College, Oxford

Rui Esteves:University Lecturer in Economics, Brasenose College:Oxford

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

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

CONTENTSForeward

» Ngaire Woods 2 Summary of Proceedings

» Kevin O’Rourke and Philipp Hildebrand 3 Historical Lessons

» Hugo Banziger 5 » Rui Esteves 9 » Marc Flandreau 12 » Harold James 15 » Catherine R Schenk 17

Contemporary Challenges

» Cyrus Ardalan 20 » Charles Goodhart 22 » Rob Johnson 23 » Pierre Keller 25

Policy Recommendations

» Amar Bhidé 27 » Peter Kurer 30 » Roberto Jaguaribe and

Augusto Cesar Batista de Castro 33 » Vijay Joshi 36


FOREWORDProfessor 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.”

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.

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.


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.

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 cross-border banking such as what the western world witnessed between the mid-1990s and the outbreak of the Great Financial Crisis in 2007 are essential

Professor Kevin O’Rourke Dr Philipp Hildebrand


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 on-going regulatory reform efforts should be to reinstate the largest global banks to anything near their pre-crisis 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


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 self-liquidating 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

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


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 Glass-Steagall 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

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 re-insurance, 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


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

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 cross-border 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 de-levering, 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


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.

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


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

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 pre-1914 levels almost to this day.


Figure 1: Average Capital Account Openness, 1890-2004

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.

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 un-democratic regimes around the World.

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 short-term 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


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.

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.


Professor Marc Flandreau

Graduate Institute, Geneva

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

Do markets provide discipline? This used to be one of the basic tenets of Globalization.1 (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

Some Ideas on Financing Globalization: Lessons from Economic History Marc Flandreau, Graduate Institute, Geneva

Drawing lessons from the past is always a perilous exercise. One strong view I have about the study of economic history is that it mostly helps understanding how things are different today. In the following note I illustrate four areas where historical thinking can provide valuable perspective.

• 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. 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.

Figure 1: Financial Globalization and Market Risk 1880-1914

• 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

Figure 1: Financial Globalization and Market Risk 1880-1914

Table 1: Determinant of Government Bond Spreads (1880-1914)

2 1 5 8 91.Structural factors :

Int.serv./Rev. - 9.308 (7.96) 9.037 (7.12) 8.776 (6.52) 7.677 (5.35)

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)

2.Reputation factors :

- Default - 4.944 (16.10) 4.982 (15.79) 5.087 (16.20) 4.917 (15.48)- Memory - 0.966 (2.62) 0.913 (2.40) 0.872 (2.26) 0.667 (1.62)

3.Policy/political variables:- Franchise - - -0.040 (-0.80) -0.053 (-1.07) -0.072 (-1.39)

- Political crises - - - - F=1.889 (*)4. Gold Standard:

-1.546 (-5.13) 0.012 (0.06) 0.302 (1.19) 0.099 (0.38)

Constant - - - - -SBIC 564.056 427.741 432.928 435.307 466.732Log L. -539.174 -397.329 -396.987 -388.307 -369.967Adj. R2 0.310 0.774 0.773 0.784 0.798

Number of Observations : 252. Not shown are the country-specific constants. Numbers in parentheses are heteroscedasticity consistent Student t statistics (corresponding 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 5%. Source: Flandreau and Zumer (2003)


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).

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 market. Now, the important issue historically is that there has been a change in the role of underwriters. They used to have more “skin in the game” through a form of moral liability with foreign government debt (Figure 2). A consequence of this is that there is 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 financial integration inside globalization (Davis and Huttenback 1988, Cain and Hopkins 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 countries in the British formal or informal Empire and in effect, their impact of result is, by 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). However, such arguments downplay an important cross-sectional 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 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

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 market. Now, the important issue historically is that there has been a change in the role of underwriters. They used to have more “skin in the game” through a form of moral liability with foreign government debt (Figure 2). A consequence of this is that there is 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?

Figure 2. Successes and Failures of Gatekeeping (since 1815)

This shows Lorenz curve for failure rates. Underwriters are ranked from the smallest to the largest and their market share are added accordingly (x-axis). On the y-axis, the chart shows the share of the same group in the total volume of foreign government debt failures.

This shows Lorenz curve for failure rates. Underwriters are ranked from the smallest to the largest and their market share are added accordingly (x-axis). On the y-axis, the chart shows the share of the same group in the total volume of foreign government debt failures.

Figure 2:Successes and Failures of Gatekeeping (since 1815)

Figure 3. Speculative Grade and Investment Grade in Foreign Government Debt Markets (Interwar/Now)

Source: Flandreau et al. (2009).

• 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 (Flandreau 2006). Of course historians and economic historians have long recognized the special position of imperial financial integration inside globalization (Davis and Huttenback 1988, Cain and Hopkins 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 countries in the British formal or informal Empire and in effect, their impact of result is, by 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 of indebtedness (interest service as a share of budget)

Source: Accominotti et al. (2011).

Figure 3:Speculative Grade and Investment Grade in Foreign Government Debt Markets: (Interwar/Now)

Source: Flandreau et al (2009)

Figure 4. Surplus from Empire?

S2 : Colonies

S1 : Sovereign

S

Qs

iUK+si

iUK

D : Demand

Q : amount of capital borrowed

Figure 4:Surplus form Empire?


liquidity at once (See Accominotti et al. 2009 and 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 infra-structure 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.

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.

Figure 3. Speculative Grade and Investment Grade in Foreign Government Debt Markets (Interwar/Now)

Source: Flandreau et al. (2009).

• 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 (Flandreau 2006). Of course historians and economic historians have long recognized the special position of imperial financial integration inside globalization (Davis and Huttenback 1988, Cain and Hopkins 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 countries in the British formal or informal Empire and in effect, their impact of result is, by 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 of indebtedness (interest service as a share of budget)

Source: Accominotti et al. (2011).

Table 2:Evolution of indebteness (interest service as a share of budget ) Most indebted governments ratio ≥ 2.5

Source: Accominotti et al (2011)


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 cross-border 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.

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.


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 far-sighted 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.

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.


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

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.

* 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-062-23-2423. http://www.bank-reg.co.uk

http://eprints.gla.ac.uk/54496/



http://eprints.gla.ac.uk/view/journal_volume/Corporate_Finance_Review.html


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

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).


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:

» 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


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

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:

» 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


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:

» 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?

» 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.


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 on-going.

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.

This suggests that states hit by an asymmetrically bad shock would benefit from having a large proportion of their financial intermediation undertaken by cross-

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 begger-thy-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 cross-border 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?


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.

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


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 See David Tuckett’s The Mind of the Market for a treatment of psychological process of unanchored financial expectations.

4 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.

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.


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

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


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.

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 taxpayers 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

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.


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 mid-2008.

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 model-based 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.

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.


Global Ramifications

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.

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.

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.

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.

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 mega-banks triggered a global bank run.

The sovereign debt malaise

The 2008 debacle has now morphed into a protracted sovereign debt malaise centered in Europe. Here too mechanistic practices have played a leading role.

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.

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.

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.

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 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.


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 risk-taking 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.

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 short-term 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.)

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 case-by-case judgment, not a watered-down international consensus.

7 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?


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 transaction-oriented 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?

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.


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. Trade 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.

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 on-going 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.


» 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 growth-oriented 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.


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.

Brazil’s experience in reforming its financial system

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 mid-1990s. 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.

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

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.

The underlying international economic order

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.

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


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 diverse-minded 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.

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 long-term 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.


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.

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.

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.


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)

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.


expensive or dry up altogether during crises, when they are most needed. So greater capital mobility has increased, not reduced, the self-insurance 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 ‘export-led 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.

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.

financing globalization: lessons ... - university of oxford

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