Finance: Global Financial Crisis, its aftermath and policy response

The aftermath of the Global Financial Crisis (GFC) which began in 2008 is still with us. The widespread macroeconomic downturn which followed the GFC's outbreak has been contained and growth of GDP has been restored, though not at rates which have repaired earlier losses.

The post-crisis reform agenda is still being put in place but without a consensus as to the relative importance of different causes for the GFC and thus as to the importance of the different reforms required.

The seriousness of the crisis in the autumn of 2008 had several manifestations. Global credit markets were no longer functioning. GDP in the United States was falling at an annual rate of nearly 7 per cent. The S&P index of US stock prices had fallen by 40 per cent.

The Chairman of the US Federal Reserve, Ben Bernanke, in testimony to the US Financial Crisis Inquiry Commission, stated, "as a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure ... out of 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two." [Russo TA and AJ Katzel (2011), The 2018 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Washington DC., Group of Thirty: 1911: 11].

The effects of the GFC were also experienced in Advanced Economies (AEs) other than the US. Following a recession in the GFC's immediate aftermath and weakly positive economic growth in 2010-2011 the Eurozone experienced six consecutive quarters of negative growth until the second quarter of 2013, and in the first quarter of 2016 GDP was still below the 2008 level in Italy, Spain, Portugal, Greece, and Cyprus [Akyuz Y (2017), Playing with Fire: Deepened Financial Integration and Changing Vulnerabilities of the Global South, Oxford, Oxford University Press: 23-26].

The macroeconomic slowdown was accompanied by widespread weakness and failures amongst European banks. Emerging and Developing Economies (EDEs) were affected in more various ways. The downturn in AEs was not immediately associated with the corresponding movements in EDEs.

But the latter group of countries was eventually affected by unfavourable movements in commodity prices and capital inflows. Of a group of major EDEs only India achieved a growth of GDP in the period 2008-2017 higher than in 1998-2007 [Chandrasekhar CP and J. Ghosh  (2018), "Did developing countries really recover from the Global Crisis?", Business Line, 16 July 2018 (available at].

The initial international policy response to the GFC came from the G20 in November 2008. The Washington Declaration stated that the G20 leaders had reached a common understanding of the root causes of the global crisis; had reviewed initiatives which countries could launch in a coordinated way; had agreed on principles for financial market reform; had created an action plan to implement those principles; and reaffirmed a commitment to free markets.

Important parts of the new agenda were assigned to the Financial Stability Board (FSB), a body containing all member countries of the G20 as well as representatives of major financial and regulatory institutions.

The FSB's responsibilities were to include providing early warnings of macroeconomic and financial risks and reshaping regulatory regimes. In January 2010, the FSB published a Framework for Strengthening Adherence to International Standards.

Here it stated that FSB member jurisdictions had undertaken the following commitments: (1) to undergo an assessment under the IMF-World Bank Financial Sector Assessment Program every five years; (2) to disclose the extent of their adherence to international standards; and (3) to submit themselves to periodic peer reviews.

As will be described in more detail in a moment, the FSB has since launched and coordinated initiatives regarding best practices and harmonization of financial regulation. The agenda of the FSB has to a significant extent shaped the policy response to the GFC regarding financial regulation and governance.

Banks' financial positions and Basel Capital Accord

Observers were in agreement that the major features of the GFC in the banks of the principal AEs were excessive leverage and inadequate provisions of liquidity.

Leverage is a measure of financial institutions' exposure to risks in relation to protective layers of capital. The exposure consists not only of straightforward instruments like loans but also of derivatives and several financial services.

Liquidity refers to the ability of financial institutions to meet financial obligations as they fall due. Satisfactory liquidity denotes sufficient cash for this purpose from different sources.

Excessive leverage leaves financial institutions vulnerable to weakening of profitability and to zero levels of capital in the face of widespread defaulting.

These two processes call into question their capacity to attract deposits and commercial funding, and thus also their liquidity positions.

Thus unsurprisingly, a central role in the international agenda of financial reform is played by standards for banks for reduced leverage and improved liquidity management together with strengthened regulation and infrastructure for their operations.

The most important standards for this purpose are contained in the successive versions of the Basel Capital Accord, which has gone by the official titles of Basel I, Basel II and Basel III. These are parallelled by corresponding directives and regulations of the European Union.

The Basel capital framework is designed to control banking risks through requirements for capital levels and liquidity management combined with improved internal risk controls.

There are four key categories of risk in the Basel capital framework: credit risk resulting from the failure of borrowers or other parties to meet payments due to the bank; market risk due to losses arising from changes in market prices; liquidity risk due to bank's inability to meet financial obligations promptly; and operational risk due to losses resulting from failures of banks' internal systems and procedures or to external causes such as legal rulings, government actions, natural disasters, or criminal activity.

A bank's capital serves as a buffer against unidentified or unexpected losses.
Capital consists of equity and other financial instruments with the property of being available to support the bank in times of crisis through reducing the probability of insolvency.

The Basel capital framework initially addressed primarily credit risk. However, owing to developments in the financial markets and in banking operations, there was an extension of its scope from 1996 onwards - firstly to market or trading risk and then to operational and liquidity risk.

The initial versions of the capital framework had two principal objectives. One was microprudential, namely to help to ensure the strength and soundness of individual banks - and thus only indirectly of the banking systems of which they are a part.

The other was to help to equalise cross-border competition between banks (provide "a level playing field") by eliminating competitive advantages due to differences among countries in their regimes for capital adequacy.

Since the initiation of Basel III, the objectives of the capital framework now incorporate a macroprudential dimension.

This reflects more explicit acknowledgement than previously amongst regulators and other policymakers that many of the risks to banks targeted by regulation in crisis situations can spill over into risks affecting several institutions and thus threaten the essential functions of the financial system such as payments, lending and deposit-taking.

The 1988 edition of the Basel capital framework, Basel I, was originally designed for internationally active banks in the countries of the G10 (a group of AEs originally formed to assure that members would have access to IMF resources adequate to meet their needs for market intervention following liberalisation of controls over capital movements).

However, by the second half of the 1990s it had become a global standard and had been incorporated into the prudential regimes of more than 100 countries.

This was a source of problems in both the design and implementation of the framework since the rules apply, inter alia, to cross-border banks with constituent entities in several jurisdictions often subject to regulatory systems reflecting the different histories and different levels of financial sophistication of the countries involved.

Basel I became the subject of increasingly widespread dissatisfaction owing to its crude calibration of credit risks and to the growing importance of practices such as securitization as well as of new financial instruments such as derivatives and securitised assets, for which its rules were not well adapted.

Thus, a decision was taken to initiate what proved to be the much lengthier than anticipated process of drafting successor agreements. The first of the series of successors, Basel II, became available in 2004 [Basel Committee on Banking Supervision (BCBS) (2006), International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Basel, Bank for International Settlements].

Basel II consisted of three Pillars in a framework which has been retained in Basel III. Under Pillar 1, minimum regulatory capital requirements for credit risk are calculated according to two alternative approaches, the Standardised (based on externally determined indicators) and the Internal Ratings-Based (based to varying degrees on banks' own rating systems).

Pillars 2 and 3 of Basel II were concerned with supervisory review of capital adequacy and with the achievement of discipline in banks' risk management through disclosure to investors.

Partly on the basis of Quantitative Impact Studies of Basel II on banks' financial position, regulators in different countries became concerned that levels of capital under Basel II were not going to be sufficient. This concern was accentuated by the stress on banks evident since the outbreak of the GFC.

The initial resulting revision of Basel II, dubbed Basel II.5, concerned the rules for the market risk of exposures in the trading book. Since revision of the rules for the trading book is not yet completed, I shall not cover these rules here.

Agreement on major changes to the Basel II rules for the banking book followed in September 2010 (with a revised version in June 2011) [BCBS (2011), A Global Regulatory Framework for More Resilient Banks and Banking Systems; Basel, Bank for International Settlements, June].

The revised rules, now called Basel III, incorporate much of Basel II. But they have also been extended and changed.

* Basel III contains more stringent rules for the categories of financial instrument which are eligible for inclusion in different categories of minimum required regulatory capital.

* The capital is to include a conservation buffer. This consists of equity and is intended to absorb losses during periods of economic and financial stress.

* National authorities may also impose a countercyclical capital buffer as a way of countering rapid credit growth. This can be relaxed during periods of stress. The countercyclical buffer is intended to achieve the macroprudential goal of protecting the banking sector from periods of excess credit growth which can trigger economy-wide financial crises.

* For global systemically important banks (GSIBs), there is an additional capital charge in the range of 1 to 3.5 per cent. The capital surcharge for GSIBs also is to serve the objective of macroprudential stability.

* Moreover, GSIBs are to be subject to additional rules on absorption capacity, another extension of the capital framework designed to cover macroprudential risks. These rules specify Total Loss Absorption Capacity (TLAC) in the form of 16-20 per cent of a bank's risk-weighted assets. TLAC will consist of instruments meeting certain conditions as to their capacity for absorbing losses. The instruments will include some - but not all - of those which count towards Basel III capital minima. The rules are designed to facilitate the resolution of GSIBs during the process following insolvency, minimising the resulting costs to governments and to taxpayers.

* The correlation parameter in the formula for risk-weighted assets in the estimates of exposures to credit risk is now to be multiplied by the factor 1.25 (Asset Value Correlation/AVC multiplier) for selected large regulated financial institutions and for all unregulated financial institutions whose main business is in certain specified activities.

* As already mentioned, Basel III now includes rules for the management of banks' liquidity risk. It also includes overall restrictions on the leverage of banks' balance sheets in the form of limits on the ratio of common equity Tier 1 capital to the accounting measure of their exposures. There is a supplement to the leverage ratio for GSIBs. The leverage ratio is intended to be a non-risk based backstop measure, the need for which was indicated by banks' build-up of excessive leverage while still showing strong risk-based capital ratios.

The Basel Committee on Banking Supervision (BCBS), the body responsible for developing the capital standards, announced at the end of 2017 that Basel III was now complete.

However, this is questionable. The final capital standards for market risk have not yet been issued. There are indications that the standards for banks' exposures to sovereign risk (still not subject to minimum risk weights in the Internal Ratings Approach) are still being re-thought and may yet be the subject of further revisions.

And regulators are apparently still debating whether to include Pillar 1 capital standards for interest-rate risk in the banking book.

Revisions of the standards for the credit risk of securitised assets issued in July 2016 were not incorporated in the text of Basel III of December 2017, though this may be a drafting rather than a substantive matter.

Securitized assets are pools of financial assets, which are individually illiquid but after aggregation become marketable securities.

Securitized assets, particularly pools consisting of packaged mortgages, have often been of questionable quality. They played an important role in the illiquidity and insolvency of major parts of the banking sectors in the United States and Europe during the GFC.

The revisions to the framework for such assets published in July 2016 were designed to eliminate shortcomings highlighted by the GFC as follows: they seek to reduce mechanistic reliance on often misleading external credit ratings; they increase risk weights for highly-rated risk exposures and reduce risk weights for low-rated senior securitisation exposures; and more generally, they are designed to enhance the framework's risk sensitivity [BCBS (2016), Basel III document, Revisions to the Securitisation Framework, Basel, Bank for International Settlements, July].

The Basel Capital Accord has been the subject of much criticism even by those who believe that strengthened capital standards are an essential part of the post-GFC reform agenda.

On the one hand, the banking lobby would like to limit the stringency of the new standards, arguing that they have an unfavourable effect on banks' capacity to finance higher economic growth (an argument lacking proof).

On the other hand, several experts, including some US regulators, think that the prescribed increases in capital are insufficient.

Other measures of the reform agenda

The reform agenda is not of course limited to banks' capital and their liquidity management. For example, the FSB vets progress on the convergence of accounting standards in accordance with the G20 objective of the eventual achievement of a single set of high-quality accounting standards.

The FSB is responsible for oversight of reform of Over-The-Counter (OTC) derivatives markets (in other words, those not exchange-traded), which includes estimates of the extent to which such derivatives are being centrally cleared and reported to trade repositories.

It provides support for the introduction of the global Legal Entity Identifier (LEI) system, a standardized system to identify institutions across the globe.

It has developed oversight and reporting on shadow banks, financial institutions which hold assets of a total amount similar to those of the rest of the financial sector and which have many features of, as well as interactions with, banks but are not inside the normal regulatory perimeter.

It has organised a review to enable less regulatory reliance on the ratings of credit rating agencies. And it has undertaken the development of a resolution regime for insolvent global systemically important financial institutions.

But many would argue that a major weakness of the FSB's coverage so far is the absence from it of macroeconomic policies concerning subjects such as controls over capital movements and foreign-exchange markets despite the inclusion in its mandate of the monitoring of macroeconomic risks.

Criticisms and shortcomings of international regulatory agenda

Generally, the view has been expressed that the international regulatory agenda has given excessive emphasis to reforming the traditional prudential framework for banks and to strengthening the infrastructure within which financial transactions are carried out to the exclusion of other issues with an important bearing on financial stability.

Financial crises are usually linked to both domestic macroeconomic developments and to shocks due to cross-border capital movements.

The severity of such crises is also likely to reflect breakdowns of internal risk management in the banking sector.

Thus, policies dealing with external financing are an integral part of governments' armouries of financial policies. And the size, structure and complexity of financial institutions, which can reduce the effectiveness of internal controls - perhaps especially in the case of large banks -, also belong to any comprehensive agenda of regulatory reform. This is true of banks in AEs and EDEs.

The vulnerability of banks and other financial institutions to cross-border financial shocks means that the regulatory agenda cannot be considered in abstraction from policies concerning the exchange rate and the management of foreign reserves and from controls over capital transactions.

The first two subjects are in fact part of the agenda for the prevention and controlling of financial crises, though not necessarily with proper acknowledgement of their limitations and of the links of cross-border finance to the stability of a country's banks and other financial institutions.

Capital controls have now been accepted by orthodox policymakers as a legitimate policy for maintaining financial stability but only on a market-friendly and temporary basis.

The alternative view concerning such controls is that in a world characterised by high degrees of integration of domestic and global capital markets, where large capital movements are increasingly normal, there are strong arguments in favour of active long-term management of a country's capital account and abandonment of liberalisation as the eventual objective of policy.

This view has many supporters - including the writer - but lacks official endorsement.

There have been steps in European countries towards structural reforms of the banking sector, in particular in the form of separation of banks' retail from their other activities. But these have met resistance from the banking lobby and have so far been limited.

Concentration and firm size in the banking sector would not be likely to command consensus among member countries as legitimate subjects for policy guidance in the FSB. This seems unlikely to change. Indeed, mergers of weak with stronger institutions, and thus bigger institutions and greater concentration in the banking sector, have actually been part of the policy response in some AEs to the GFC.

Another important observation is that the focus of the reform agenda is not truly global. As explained above, the agenda was drawn up by the FSB in response to a mandate from the G20. Thus, it is not surprising that the perspective of its standards is frequently that of AEs and EDEs with relatively advanced financial sectors.

This has meant little attention, for example, to countries' supervisory capacity, limitations of which can pose serious problems with regard to implementation of international banking standards.

Moreover, since about 2013, reports of the work of the BCBS indicate that much of it has concerned highly technical issues affecting the rules for measuring credit and market risks for banks in the principal AEs.

Under market risks, for example, supervisory approval for use of a bank's models for measurement now applies at the micro-institutional level of each of a bank's trading desks rather than at a bank-wide level.

As is acknowledged by the BCBS (Coen, 2018**), there appear to have been voices even within the regulatory community which have questioned whether the rules adequately balance simplicity, comparability and risk sensitivity.

[** Coen W (2018), "The market risk framework: 25 years in the making", Keynote speech at the ISDA Annual General Meeting by the Secretary-General of the BCBS, April.]

Compatibility of the reform agenda with GATS rules

Major parts of the General Agreement on Trade in Services (GATS) which bear on financial regulation are Article VII (recognition of standards), Article XII (restrictions to safeguard the balance of payments), Articles XVI and XVII (specific commitments as to market access and national treatment), and the Annex on Financial Services, paragraph 2(a) (accommodation of prudential measures including those in possible conflict with other provisions of the GATS).

The most important of these articles from the point of the reform agenda and related actions taken by countries in the aftermath of the GFC are probably paragraph 2(a) of the Annex on Financial Services (often referred to as the "prudential carve-out") and Article XII.

In financial crises, these two provisions may need to be read in conjunction with each other.

The practical scope of the prudential carve-out's permission for "measures for prudential reasons... or to ensure the integrity and stability of the financial system" is qualified since such measures also "shall not be used as a means of avoiding the Member's commitments or obligations under the Agreement".

The apparent ambiguity has led many critics to argue that there should be redrafting to achieve greater clarity. But this has not been granted.

The acceptance of restrictions to safeguard the balance of payments is designed for periods of severe balance- of-payments stress and is subject to various conditions such as not exceeding those necessary to deal with the balance-of-payments stress and being temporary.

Some flexibility is introduced by the phrase "Members may give priority to the supply of services which are more essential to their economic or development programmes". But the scope of this flexibility is not clear.

The combination of Article XII and the prudential carve-out would probably serve to justify the imposition of capital controls in a crisis combining balance-of-payments stress and the risk of widespread insolvencies among banks.

But the problem with the approach of Article XII is that, probably partly because it was negotiated before experience of recent major incidents of financial instability beginning with the Asian crisis in 1997, it accommodates only temporary capital controls and not longer-term ones which the governments involved might believe to be required, let alone the use of management of the capital account as a more permanent measure for the prevention and control of financial crises which, as mentioned above, has been advocated by some critics of current approaches.

New challenges

Since work began on the post-GFC repair of the regulatory regime for financial institutions and markets, new challenges for international financial regulation have arisen. Some are the result of technological innovations capable of radically altering financial transactions.

Others concern the response of the financial sector to environmental problems.
These are of interest not only in themselves but also for what they indicate concerning the adaptability to changing conditions of international rules and standards for trade in financial services.

Banking and other financial operations have in recent years been radically affected by opportunities provided by advances in computer technology.

Distributed ledger technology (DLT) (often treated as a synonym of blockchain technology, though the latter is in fact simply one type of DLT) is an example that has recently been much discussed in the news  [Mills D et al. (2016), "Distributed ledger technology in payments, clearing, and settlement", Washington DC, Federal Reserve Board].

DLT has many actual and potential applications, including for the transmission of messages and for payments, clearing and settlement (PCS). Under the latter heading, there is already widespread recognition of DLT's utility in trade finance owing to the reduction in the number of intermediaries required and thus in costs associated with traditional trade finance transactions [BIS (2018), Annual Economic Report, Basel, Bank for International Settlements, June: 106].

DLT for these purposes does not seem to require alterations in the framework of financial regulation or in the coverage of GATS rules. In countries' schedules of GATS commitments, for example, the role of DLT would presumably be included explicitly under PCS or under some other denomination for the same activities.
There is no reason to expect that regulation of these activities would pose a special issue under the heading of National Treatment.

The environment may prove to be a source of more open-ended problems for both management and regulation in the financial sector. Awareness of these problems is increasing among financial institutions and investors.

For example, a survey of banks conducted by the International Chamber of Commerce (ICC) in 2016 found the following: 75 per cent tracked developments and market demands/expectations related to sustainable trade and sustainable trade finance; 65 per cent were implementing (or considering implementing) more stringent environmental and social criteria in respect of trade finance transactions; and 55 per cent had rejected trade finance transactions due to internal or external environmental policies [ICC (2016), Rethinking Trade and Finance, ICC Banking Commission].

The ICC has identified three areas where banks can - and presumably should - take action: bank-client engagement which involves integrating considerations of sustainability risk into due-diligence processes and other aspects of the relationship; into risk screening of trade finance from a sustainability point of view; and into pricing practices by banks which reward better sustainability.

Much of the FSB's work in this area has involved promotion among non-financial as well as financial companies of fuller disclosures concerning their practices with relation to climate-related issues.

Government environmental policy involving financial firms has not yet had major implications for the regulatory regimes under which the firms operate, including GATS rules.

However, this may change in the not-too-distant future if forecasts concerning the drastic effects of climate change prove to be reasonably accurate. These effects may trigger political and social innovation which include a retreat from liberalisation of international trade in banking services. Article XIV of the GATS accommodates measures "necessary to protect human, animal, or plant life or health".

The Decision on Trade in Services and the Environment adopted by the Trade Negotiations Committee in December 1993 endorses Article XIV and mandates the Committee on Trade and Environment "to examine and report, with recommendations, if any, on the relationship between services trade and the environment including the issue of sustainable development".

This is impeccable as far as it goes but may need to be extended and strengthened when some of the environmental threats forecast actually materialise.

By Andrew Cornford, Geneva. Andrew Cornford, with the Observatoire de la Finance in Geneva, contributed this comment based on his remarks at a panel session at the WTO Public Forum last week.]

Source: SUNS - South North Development Monitor, SUNS #8772 Friday 12 October 2018.