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Not Making the Grade: Report Card on Global Financial Reform

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Despite a host of reforms in the right direction, the financial structures that were in place before the global crisis have not actually changed that much, and they need to if the global financial system is to become a safer place.

Although the intentions of policymakers are clear and positive, the system remains precarious.

Our new study presents an interim report card on progress toward a safer financial system. Overall, there is still a long way to go.

How we measure progress

In our study, we first tried to pay attention to those features of financial systems related to the crisis--the large dominant, highly interconnected institutions, the heavy role of nonbanks, and the development of complex financial products for instance--features that need to be addressed in some way.

To do this we needed to construct measures of these features in a way that would allow us to gauge how well the reforms are working toward changing them. We looked at a lot of data, but we focus on three types of features.

  • The extent to which financial intermediation is market based--the hallmark trait of the United States, with a big nonbank financial sector, active capital markets and banks conducting activities other than borrowing and lending.
  • Features related to the size and scope of different financial activities within a country--like the size and concentration of its banking system and how connected certain parts of the financial system are, through say, interbank markets.
  • Measures about how connected the financial system is to the rest of the world through banking systems and the importance of the country in global markets.

The next thing we did is try to tie the reform agenda to how it could reasonably be expected to alter these chosen financial structures.

Good effort, but requires follow through

So, are the reforms moving the structures in the right direction--to a safer financial system? Our answer so far is: "somewhat, but not enough." We do not yet see the impact of the reforms; they have long implementation lags and the crisis is ongoing.

There are elements, such as new international banking rules known as Basel 2.5 and the market's anticipation of the Basel III implementation that are promising: many banks hold more capital and have begun to divest themselves of activities they view as less profitable.

However, the basic financial structures that we found problematic before the crisis are still with us: financial systems are still overly complex, banking assets are highly concentrated, with strong domestic interlinkages, and the too-important-to-fail issues are unresolved.

As some activities become costly, some banks will get out of those businesses, but others with enough scale economies will stay in, making these activities even more concentrated--the fixed income, currency, and commodities trading business line is one such activity.

The good news is that globalization has not been seriously harmed, except for in crisis-hit economies in Europe. But this also means that in the absence of proper policies, bad outcomes from one country can easily affect the financial system in another.

What to do?

So why do we see so little progress and what should we do about it? We have to recognize that some regions are still in a crisis and measures to prevent deeper financial system distress, and those to bolster nascent economic growth, remain in place. The recent introduction of further central bank efforts along these lines--QE3 from the U.S. Federal Reserve, the European Central Bank's buying of government bonds through outright monetary transactions, and similar quantitative easing from the Bank of Japan--attests to the need for ongoing crisis-fighting efforts.

While these need to be in place, this is also the time to think about their inadvertent side-effects on financial stability. Some of the cleansing of the financial system has not yet taken place, preventing a reboot to safety.

Even if the needed restructuring had taken place, financial structures tend to move slowly and the reform agenda has built in rather generous implementation schedules, in part to allow the economy to recover. So we want to emphasize that while we cannot definitively say financial systems are safer than four years ago, we want to emphasize the "somewhat" part of the answer.

By taking stock of all the regulatory reforms to date we can see some areas that still need to be addressed. These areas include:

  • More discussion on what it takes to break the "too-important-to-fail" conundrum, including a global level discussion of the pros and cons of direct restrictions on business models. We can already see that both the Volcker Rule in the United States, which aims to force banks to divest their trading businesses, and the Vickers commission proposals in the United Kingdom, which would ring fence retail banking from investment banking activities, will have effects beyond their respective jurisdictions and a global perspective is sorely needed
  • Further progress on recovery and resolution planning for large institutions, especially cross-border resolution.
  • Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector; and
  • Careful thought about how to encourage simpler financial products and simpler organizational structures.

The success of the current and prospective reforms depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer.

Policymakers need to press ahead. We are not encouraging a sprint, but simply a brisk, purposeful walk toward the goal of a safer financial system.

from iMFdirect blog