[Financial,Reform,after,the,Crisis:,An,Early,Assessment]after the rain

　　 　　Financial reform has been a core dimension of the initial global policy response to the financial turmoil of 2007–08. At the first G-20 summit of heads of state and government in November 2008, more than four-fifths of the action points in the final declaration were about financial regulation. Obviously, the crisis is not over at the time of writing, and the cycle of financial reform it triggered is very far from complete. But it can be said confidently that the crisis has been transformational for financial regulatory policy, at least in the United States and Europe.
　　One of the key lessons of the crisis is the close interdependence between the detailed features of financial systems and macroeconomic outcomes. Thus, the tight separation of financial and macroeconomic issues, which is entrenched both in academia and in the policymaking community, needs to be overcome. Initiatives to better analyze “macro-financial” linkages and to conduct “macro-prudential” policy have mushroomed since the start of the crisis, although they generally fall short of a fully joined-up framework. From this perspective, the focus of this paper is financial regulation in an old-fashioned sense, understood as a cluster of interrelated policies designed to ensure the proper functioning and integrity of financial systems. This scope includes public regulation and supervision of bank capital, leverage, liquidity, and risk management; control of moral hazard and financial industry incentives; protection of the customers of financial services; and the regulation of capital markets. Other reform areas such as capital-flow controls, prevention of money laundering, and the taxation of financial activities can overlap with this agenda, but are not considered here part of it in a strict sense.
　　The general impetus of financial reform as a reaction to the crisis, in the United States and Europe, has been toward more regulation, or re-regulation. This is admittedly too simplistic a generalization: This policy area is multidimensional and cannot be reduced to a simple choice between less or more regulation. Nevertheless, there was a clear turning point in 2008 with the renewed realization that financial systems, including banking systems, could not be left to their own devices, both because of the large potential economic cost of financial crises and because public expenditure is often a key component of their resolution. For a variety of reasons this age-old wisdom was neglected in the preceding decade in both the United States and Europe more than in the rest of the world, including Australia, Canada, Japan, and emerging economies.
　　Financial regulation is a complex thicket of highly technical policy challenges, often subject to the use of mutually incomprehensible jargons even as they are mutually interrelated. The devil is generally in the details, and elegant quantitative models of policy tradeoffs are rarely available. Analytical frameworks tend to be similarly fragmented across different academic silos, including economics, financial research, accounting, political science, and sociology. From an economic research perspective, this is a less mature field than other policy areas such as fiscal, trade, or labor. Hopefully, the crisis itself will result in new avenues for research, the results of which might start to become available in a few years’ time.
　　The dynamics of financial reform
　　In the European Union, a distinct driver of financial reform in the two decades preceding the crisis was the effort to create a single market for financial services, particularly after the introduction of the euro in 1999. Landmark corresponding pieces of legislation include the 1989 Second Banking Directive, which encouraged the creation of crossborder branches; the 1993 Investment Services Directive, which established a single “passport” regime for investment banking operations throughout the European Union; the 2002 Regulation on International Accounting Standards, which paved the way for the European Union’s adoption of International Financial Reporting Standards (IFRS) in 2005; the 2004 Markets in Financial Instruments Directive (MiFID), which broke the monopoly of national stock exchanges and established the basis for EU-wide competition among trading platforms; the 2006 Capital Requirements Directives, which transposed the Basel II Accord and paved the way for a harmonized regulatory framework for bank capital requirements; and the 2009 Solvency II Directive (the preparation of which started long before the crisis), which established a parallel capital regulation framework for insurance companies.
　　EU harmonization efforts have themselves been a powerful stimulant or enabler for global regulatory projects. The two most prominent pre-crisis examples in this respect are IFRS and the Basel II Capital Accord. In the case of accounting, the European Union’s decision to adopt IFRS, made at the political level in 2000, finalized through the above-mentioned 2002 regulation, and implemented in 2005–06, was the trigger for their subsequent adoption by a significant number of jurisdictions that now represent about half of the aggregate market capitalization of large companies worldwide. In the case of Basel II, the European Union was instrumental in the negotiation of the accord in the first place, and was among the first to implement it with the adoption of the Capital Requirements Directives and subsequent rulemaking in individual member states. According to the Basel Committee on Banking Supervision, by September 2011, implementation of the Basel II Accord was complete in 21 of the committees 27 member countries, with at least two more countries planning to join in 2012.
　　The IMF and the FSB
　　While the G-20 is by its very nature a political body, the coordination of the global financial regulatory agenda during the crisis has been mostly the joint preserve of the IMF and FSB, these being “the principal institutions of governance of the global financial architecture”. The IMF has played a significant role through its Financial Sector Assessment Program (FSAP). The FSAP, which is conducted by the IMF alone in developed economies and jointly with the World Bank in developing and emerging economies, is a comprehensive assessment of a country’s financial-sector stability. In September 2010, the FSAP was made a more regular feature for 25 jurisdictions, for which the assessment will be renewed at least every five years. This meant an end to the de facto exception under which some large countries escaped the scrutiny of the FSAP until the crisis: The first FSAP of the United States started in June 2008 and was completed in July 2010; and the first FSAP of China started in August 2009 and was completed in June 2011.
　　The FSB’s role is multifaceted and still to a large extent, a work in progress. It has set up numerous working groups and coordinates work on multiple fronts, often at the explicit request of G-20 leaders. However, the actual work of standard setting and rule making generally remains at the level of specialized global authorities. One case in point is the FSB’s report on the “shadow banking system,” published a week before the 2011 G-20 summit in Cannes. Many of this report’s recommendations are addressed not to individual jurisdictions but to global bodies that are FSB members, particularly the Basel Committee and the International Organization of Securities Commissions. Such patterns mean that assessing the FSB’s contribution to the policy process is far from straightforward. In some cases, the FSB’s work can be little more than reporting initiatives of its members; in other cases, FSB leadership is essential for pressing other bodies into taking action. In practice, there appears to be a continuum of situations between these two extremes.
　　Challenges and outlook
　　It is far too early to present a settled picture of post-crisis financial reforms and their impact on the global financial system. Huge challenges remain and it is still unclear how they will be met. First and foremost, the crisis has not yet been resolved, and the interaction between crisis management and long-term reform creates uncertainties of its own. Second, in spite of widespread calls for “macro-prudential”approaches, the interaction of financialsector policy with other dimensions of economic policymaking remains largely unsettled. Third, how to effectively regulate cross-border financial firms remains a fundamentally unanswered question. Fourth, other reforms will be difficult to implement in an internationally consistent manner, raising concerns about the possible fragmentation of the global financial space. Fifth, the reforms will affect the financial system’s contribution to economic growth in multiple ways, which on the whole remain poorly understood.
　　Ongoing crisis management
　　The most obvious uncertainty is that the financial crisis is far from over. Although it was partly overcome in the United States in 2009, it is still worsening in Europe and could again spillover to other parts of the world. This creates a triple risk of forbearance, populism, and irrelevance.
　　Concerns about financial instability in jurisdictions where the financial crisis remains unresolved, including much of continental Europe at the time of writing, can easily lead to excessive forbearance as has been the case in several past episodes of systemic banking fragility, such as in Japan in the 1990s. For example, large continental European countries such as Germany and France were widely reported as being reluctant to tighten the definition of capital and impose higher minimum capital requirements in the negotiation of the Basel III Accord and in the subsequent discussion of SIFI (systemically important financial institution) surcharges. Similarly, the first draft of the EU legislation transposing Basel III softens some of the Basel Committee’s tightening of the definition of capital, and prohibits the voluntary application of higher capital requirements by individual member states. The same factor was at play when European policymakers forced the IASB in October 2008 to amend the IAS 39 standard on financial instruments and allow more flexibility in the classification of financial instruments by struggling European banks. This is especially important as the European Union prepares to introduce legislation on banking crisis management and resolution. A proposal is expected from the European Commission in early 2012. It is arguably impossible to eliminate moral hazard from banking sector policy frameworks, but it is arguably even more difficult to prevent it when such frameworks are prepared in a climate of systemic instability.
　　The risk of populism complements that of forbearance, and the two can be simultaneous. As the ongoing crisis creates a political demand for action, and action at a fundamental level is prevented by the bias towards forbearance, policymakers can be tempted to adopt a punitive attitude toward the financial sector, in response to popular perceptions rather than in-depth policy analysis. This has arguably been the case with initiatives, particularly in the European Union, to put hard limits on the scope of remuneration practices in the financial industry and to impose specific taxation on aspects of financial activity. In certain cases, such impulses can be aligned with strategies of “financial repression,”namely the forced investment of domestic savings in government securities, or in other forms of repression of market mechanisms for price setting and capital allocation, such as the attempts to discourage some forms of hedging against sovereign risk or to suspend the publication of credit rating decisions affecting troubled countries. Given the complexity of financial regulation, it can be difficult to disentangle such populist motivations from other drivers of financial reform. Nevertheless, they are likely to gain in prominence if the European crisis worsens and leads to more financial and economic dislocation.
　　Furthermore, embarking in longterm financial reform while a major financial crisis is still ongoing and unresolved creates a risk of irrelevance of the corresponding legislative and regulatory initiatives, to the extent that the eventual crisis resolution can be expected to usher in a new round of reform to ensure that “it never happens again.” Examples in the European Union are the successive rounds of amendments to the Capital Requirements Directive of 2006, or the three consecutive regulations to create a tighter legal framework for the activity of credit rating agencies.
　　Each of these three factors, in certain circumstances, can contribute positively to the quality of policymaking. Forbearance can be a rational calculation to minimize financial dislocation, even though it increases moral hazard. Populism can help assert the autonomy of financial reform against pressure from the financial industry. Successive rounds of regulatory reform can result in gradual improvements of the regulatory framework and correction of past missteps. But each of them can also easily have negative consequences in terms of the sustainability and efficiency of the financial policy framework.
　　Financial systems and growth
　　Finally, one of the most open questions of all is how the post-crisis financial reform agenda might affect the ability of the financial sector to contribute to overall economic growth. This issue too has multiple dimensions.
　　As mentioned above, the conse- quences of tighter capital requirements on economic growth have been a matter of heated controversy in the context of the preparation of Basel III, with a stark contrast between simulations conducted by the financial industry that predicted a devastating effect of the proposed rules on future output (IIF 2010), and those of the supervisory community that forecasted a much milder impact (MAG 2010 and BCBS 2010a). Ultimately, the G-20 leaders implicitly endorsed the Basel committee’s more sanguine assessment when they adopted Basel III at the November 2010 Seoul Summit.
　　However, this quantitative argument fails to capture the complexity of the impact of financial reform on growth. In most countries in the developed world at least, large companies have fairly easy access to international capital markets, and their funding conditions are not overly affected by domestic regulatory frameworks. Smaller companies and other borrowers, by contrast, including younger firms which have the greatest growth potential, have no such access, and their ability to mobilize external finance is likely to be most affected by financial reforms. What is at stake is not just the aggregate volume of credit, but how this credit is allocated by heterogeneous intermediaries towards heterogeneous firms and other borrowers. Regulated banks are only one part of this picture, which includes the loosely defined “shadow banking system” and interacts with the broader economy in ways that existing economic models generally fail to describe comprehensively.
　　In particular, the impact of the ongoing movement towards re-regulation on global financial integration could materially impact economic trends, to the extent that financial openness is associated with higher levels of economic growth. Also, how regulation might encourage or limit competition among financial intermediaries, innovation in financial services, and the allocation of capital to risky new ventures, remains poorly understood, especially given the large number of interrelated recent or ongoing financial reform initiatives.