Why International Financial Cooperation Remains Essential

IMF Blog, March 23, 2017

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Economic growth appears to be strengthening across the large economies, but financial-sector regulation remains necessary to ensure the safety and resilience of global capital markets.
The Group of Twenty (G20) finance ministers and central bank governors reiterated support for continuing financial-sector reform at their meeting in Baden-Baden.
The 2008 global financial crisis was exceptionally severe in magnitude, breadth, and persistence, and is one in a long series of financial crises stretching back centuries.
Financial crises impose high human costs on those who lose jobs, homes, and savings.

Governments adopt an array of financial regulations to reduce the risk of failures that could reverberate across the economy, including:
- balance-sheet standards
- insider trading rules
- broader conflict-of-interest laws
- consumer protections
Market failures motivating regulation:
- Firms may behave recklessly despite shareholder incentives (historical examples cited from Tulip Mania to the subprime boom).
- Managers may act prudently for personal risk but not for society because some costs of failure fall on others, such as shareholders and taxpayers.

Financial activity crossing national boundaries has increased complexity for national regulators, creating at least four major complications:
- It is hard to assess operations of financial institutions that extend beyond their home countries.
- Firms may take advantage of regulatory differences to place riskiest activities in lightly-regulated locations.
- Complex institutions with operations spanning several national jurisdictions are harder to wind down if they fail.
- Countries might compete for international financial business while supporting national “champions” through lax regulatory standards.
These factors undermine global financial stability, especially as financial instruments and networks become more complex.

National regulators launched a process of consultation and coordination under the aegis of the Basel Committee on Banking Supervision in 1974.
The Basel Committee focuses on banking regulation.
The Financial Stability Board, set up by the G20 after the financial crisis of 2008, coordinates development of regulatory policies across broader international financial markets, bringing together national authorities, international financial institutions, and sectoral standards setters.
International agreements on regulatory and supervisory standards discourage a race to the bottom by establishing a level global playing field.

After the 2008 crisis, the Basel Committee undertook the Basel III accord, which includes higher minimum standards for both the quality and quantity of bank capital.
- Bank capital is described as the equity cushion that allows banks to absorb losses without going bankrupt and needing government support.
Basel III also includes additional measures to reduce banking risk because even higher capital levels could be threatened in a severe panic.
Even while Basel III is still being phased in globally, banks are already much better capitalized and less vulnerable to market jitters than they were a decade ago.
The United States recapitalized and restructured banks more aggressively after the crisis and recovered more quickly than countries that did not.
The Financial Stability Board created a common approach to handling the failure of the largest and most systemic financial institutions to enable safe wind-downs of insolvent institutions, especially large, international, and complex ones.
If insolvent institutions cannot be wound down safely:
- government bailouts are more likely
- risk-taking is excessive
- market discipline is subverted

Tradeoffs of regulation:
- Requiring more capital and liquidity can, in principle, raise the cost of credit for households and businesses or reduce market liquidity.
Empirical evidence:
- Research studies indicate that any unintended consequences are relatively small.
- The benefits of a safer financial system are described as unquestionably large.
Complexity concerns and possible simplifications:
- Financial regulations have become much more complex; in the United States, for example, the Dodd-Frank Act is more than a thousand pages long and has generated tens of thousands of pages of follow-up implementation rules.
- Potential simplifications cited:
- Making the threshold for designating banks as systemic, currently set at a balance-sheet size of $50 billion, more flexible.
- Simplifying regulation of community banks without increasing system risk.
- Simplifying implementation of stress tests that assess banks’ resilience to economic and financial shocks.
Core tenets of the global regulatory regime should be preserved despite opportunities for simplification.

The relative resilience of financial markets in recent years, partly resulting from more stringent internationally agreed standards, should not be taken as evidence that regulation is an excessive drag on growth.
Quoting Hyman Minsky: “success breeds a disregard of the possibility of failure…”
Continuing international financial cooperation remains essential as the solid foundation of a strong and stable world economy.

Authors: Tobias Adrian, Maurice Obstfeld; March 23, 2017

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