8 Challenges Posed by the Globalization of Finance and Risk

Garry Schinasi
Published Date:
December 2005
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While it is reasonable to presume that the structural financial changes that occurred in international markets since the mid- to late 1970s have been beneficial overall, it would be complacent to ignore, and not try to reduce, the costs and adverse consequences of these changes. The structural features that now characterize the modern international financial system seem to have simultaneously increased the efficiency, volume, and volatility of international financial activity. They have also been associated with an increase in the complexity of financial transactions, the integration of national financial markets, the creation of large internationally active financial institutions, and the redistribution of financial risk ownership. Based on experiences in the 1990s and early 2000s—with asset-price volatility and bubbles, dramatic shifts in asset allocations and international capital flows, financial market turbulence, and financial crises—a lack of understanding about these structural changes might have increased the potential for mispricing and misallocating capital within the international financial system, and for financial turbulence and instability. This chapter examines several challenges to financial stability associated with these structural changes, with a view to identifying areas in which improvements can be made in the ability to maintain both financial efficiency and international financial stability. In the remainder of the chapter, these structural financial changes taken together will be referred to as the globalization of finance.

The first section of the chapter briefly discusses the globalization of finance (encompassing financial modernization and internationalization, greater securitization, and market integration) and identifies the key structural financial changes that have occurred since the mid- to late 1970s. These structural financial changes are posing a number of challenges to both private market participants and national authorities responsible for prudential oversight. The second section of the chapter examines challenges in four broad areas that might have financial-stability implications: transparency and disclosure, market dynamics, moral hazard, and systemic risk. In each of these areas, the main challenges are either directly or indirectly related to the actual structural financial changes that have come to characterize the modern international financial system. One common theme is that the existing frameworks for ensuring international financial stability—a composite of private market discipline and nationally oriented prudential oversight—do not appear to have kept sufficient pace with structural changes. A final section suggests ways forward in dealing with some of these challenges. Two presumptions are maintained throughout the analysis: first, international financial stability is a global public good, one that needs to be nurtured collectively and continuously if it is to be preserved; and second, as the international financial system evolves, so, too, will the collective challenges of ensuring its stability.

The Process of Globalization and Its Impact on the International Financial System

The structural changes that occurred in national and international finance since the mid- to late 1970s—when financial liberalization began in earnest—are part of a complex process best described as the globalization (and modernization) of finance. Financial globalization has been a necessary counterpart to the expansion of international trade and payments, the growing financing needs of countries and market participants, the globalization of national economies, and the expanding opportunities for international investments. While each of these processes has driven economic and financial developments during much of recent history, the processes themselves as well as their consequences have accelerated along with recent advances in information and computer technologies. In many ways, the 1990s was the first full decade in which a critical mass of these structural changes manifested themselves in international financial markets.

Key elements of this ongoing transformation are

  • the integration of national financial markets, investor bases, and borrowers into a global financial marketplace, with greater diversity in the quality, sophistication, and geographic origin of borrowers and lenders (Tables 8.1, 8.2, and 8.3);
  • an increase in the technical capability (and the use of information and computer technologies) to unbundle, price, trade, distribute, and manage financial (credit, counterparty, market, liquidity, operational) risks;
  • greater reliance on securitized, market-oriented forms of finance, and less on traditional bank-intermediated finance;
  • rapid growth in, and predominance of, derivatives markets, and the increasing reliance of financial and nonfinancial entities on them, most recently in the form of new vehicles for transferring credit risks—through markets, special purpose vehicles, and instruments—from original owners to different owners;
  • the continued blurring of distinctions between financial institutions, and more recently, nonfinancial entities, and the activities and markets they engage in;
  • diversification of banking from lending into fee- and service-based businesses, and transformation of balance-sheet activities into more tradable and off-balance-sheet positions, along with the associated bank disintermediation (Tables 8.4, 8.5, and 8.6);
  • rapid growth and increasing importance of nonbank financial institutions—institutional investors such as pension funds, insurance companies, mutual funds, and hedge funds—with different governance structures and motives (Table 8.7) (resulting in significant consolidation in the banking industry as a competitive reaction);
  • consolidation of financial activities into large, complex internationally active financial institutions—some as conglomerates combining traditional commercial and investment banking, insurance, and asset management—that provide a menu of financial products and services in a range of wholesale and retail markets and countries;
  • emergence of hybrid entities engaged in both nonfinancial and financial activities, operating in the same financial instruments and markets as commercial and investment banks, mostly as their counterparties.
Table 8.1.Cross-Border Transactions in Bonds and Equities(Percent of GDP)
United States
Sources: Bank for International Settlements; and national balance of payments data.Note: Gross purchases and sales of securities between residents and nonresidents.

No breakdown in bonds and equities is available.

Sources: Bank for International Settlements; and national balance of payments data.Note: Gross purchases and sales of securities between residents and nonresidents.

No breakdown in bonds and equities is available.

Table 8.2.International Equity Issues by Selected Industrial and Developing Countries and Regions(Millions of U.S. dollars)
Industrial countries
United Kingdom2,904.24,024.93,691.23,260.23,776.54,735.27,202.48,021.16,386.312,431.418,041.117,616.14,913.54,698.316,137.6
United States1,698.85,740.47,852.810,323.25,278.88,110.18,968.910,239.811,273.016,392.819,554.56,536.11,603.2481.8409.9
Developing countries and regions
South Africa0.0143.4144.357.1206.8379.0641.0984.9409.0601.11,971.9277.3329.81,083.31,571.1
Hong Kong SAR0.0287.8313.8844.3410.71,546.96,716.64,968.21,460.45,245.211,546.01,605.53,867.16,086.37,551.8
Korea, Rep. of40.0200.0150.0328.21,167.91,310.01,150.9630.0495.56,870.7964.73,676.41,553.71,222.64,855.3
Czech Republic0.
Latin America
Middle East
Source: Dialogic Bondware.
Source: Dialogic Bondware.
Table 8.3.Outstanding International Debt Securities by Nationality of Issuer for Selected Industrial and Developing Countries and Regions(Billions of U.S. dollars)
All countries2,022.32,389.22,700.13,111.23,479.74,284.35,353.26,362.57,502.29,189.611,661.813,928.0
Industrial countries1,644.41,937.42,202.12,519.82,797.63,476.64,492.85,454.16,532.98,097.310,382.912,474.8
United Kingdom185.8212.8229.3274.0312.8373.2488.3588.4656.0825.01,134.01,446.3
United States174.1203.3261.3383.6545.1834.51,301.11,748.62,324.72,716.83,073.43,358.8
Developing countries and regions
South Africa1.
Hong Kong SAR6.212.313.015.322.621.625.630.938.241.751.454.3
Korea, Rep. of14.919.527.543.751.253.049.749.448.554.663.974.5
Czech Republic0.
Latin America
Middle East
Source: Bank for International Settlements.
Source: Bank for International Settlements.
Table 8.4.Major Industrial Countries: Bank Deposits of Commercial Banks(Percent of total bank liabilities)
United States75.578.
United Kingdom86.587.968.561.860.6
Source: OECD, Bank Profitability: Financial Statements of Banks, various years.Note: Interbank deposits and nonbank deposits.

All banks.

Source: OECD, Bank Profitability: Financial Statements of Banks, various years.Note: Interbank deposits and nonbank deposits.

All banks.

Table 8.5.Major Industrial Countries: Bank Loans of Commercial Banks(Percent of total bank assets)
United States63.365.063.464.763.1
United Kingdom43.662.152.153.952.6
Source: OECD, Bank Profitability: Financial Statements of Banks, various years.

All banks.

Source: OECD, Bank Profitability: Financial Statements of Banks, various years.

All banks.

Table 8.6.Major Industrial Countries: Tradable Securities Holdings(Percent of total bank assets)
United States18.019.221.419.820.2
United Kingdom9.27.518.519.721.1
Source: OECD, Bank Profitability: Financial Statements of Banks, various years.

All banks.

Source: OECD, Bank Profitability: Financial Statements of Banks, various years.

All banks.

Table 8.7.Major Industrial Countries: Financial Assets of Institutional Investors(Billions of U.S. dollars, unless otherwise noted)
Insurance companies1
United States2,397.42,541.02,803.93,016.33,358.33,645.93,943.04,001.84,087.6
United Kingdom669.2660.1817.11,021.61,204.11,387.31,588.41,459.71,394.8
Pension funds
United States3,354.93,547.94,226.74,745.75,563.66,231.96,857.36,805.06,351.3
United Kingdom683.2660.5759.7893.21,058.41,136.21,281.51,116.3954.0
Investment companies
United States2,051.12,195.32,725.83,372.84,182.15,103.76,298.26,447.86,596.6
United Kingdom191.1201.5238.1310.7341.7369.3451.4442.0394.5
Other forms of institutional saving
United States1,248.31,300.71,480.61,594.01,739.41,874.72,175.52,267.92,222.2
United Kingdom
All investors
United States9,051.79,584.911,237.012,728.814,843.416,856.219,274.019,522.519,257.7
United Kingdom1,543.61,522.11,814.92,225.52,604.22,893.13,321.33,017.92,743.3
Total assets of all investors
(percent of GDP)
United States136.3135.9151.8162.9178.4192.0207.8198.7191.0
United Kingdom162.2143.0162.8172.0194.2202.0227.7212.8190.9
Source: OECD, Institutional Investors Statistical Yearbook, 2003.

Life and nonlife insurance companies.

Source: OECD, Institutional Investors Statistical Yearbook, 2003.

Life and nonlife insurance companies.

These key structural changes have transformed the international financial system by opening it up to

  • an accelerated expansion of cross-border financial activity;
  • new interdependencies among market participants, markets, and financial systems;
  • greater international mobility of capital and market liquidity;
  • enhancements in efficiency in international markets;
  • greater complexity of financial instruments and trading strategies and tactics;
  • faster adjustments of financial flows and asset prices.

This transformation in the international financial system has increased investor and borrower awareness of financial risks and rewards around the world. It has also made the maintenance of financial stability more challenging.

Global financial markets directly and indirectly serve a large number of globally diverse end users, including countries, multinational corporations, financial and nonfinancial businesses, and ultimately individual savers and investors. However, the bulk of this international financial market activity occurs within a complex and sophisticated network of international financial relationships among the world’s largest and most active financial institutions, although smaller internationally active financial institutions, as well as nonfinancial entities (such as General Electric, General Motors, and others), continue to compete in providing financial services.82 The worldwide reach and domestic penetration of some of the global banks and financial services conglomerates, and the speed with which they have attained this reach and penetration, are staggering; some financial brand names now rival the name recognition enjoyed by Coca-Cola, Mercedes-Benz, and Sony.

Many of these global institutions derive a large share of their net earnings and returns on capital from their cross-border activities. Moreover, many of them operate in all of the major international markets on a 24-hour basis, by passing their trading activity and risk management systems between their subsidiaries operating in one international financial center as it closes to subsidiaries in another center as it opens. This relatively small group of international institutions (numbering perhaps no more than 50 institutions and probably fewer) intermediate the bulk of transactions in global currency, bond, equity, derivative, and interbank money markets. They also intermediate the bulk of cross-border capital flows between the major financial centers and play a major role in placing most of the funds invested in the emerging capital markets. These institutions and their financial relationships transcend national borders and markets, legal jurisdictions, and supervisory and regulatory frameworks.

There is little reason to doubt that over the years, and as a result of the globalization of finance, the international allocation of capital and asset pricing efficiency within the mature markets and across international financial markets improved significantly. In addition, by gaining access to international capital and lower cost financing alternatives, and, ultimately, through higher growth and improved living standards, developing countries as a group also benefited from these structural changes.

While the benefits are clear, the extent to which individual countries, both advanced and emerging, have been able to balance those benefits against the costs of this dramatic transformation has not been uniform, as demonstrated by the increased volatility, turbulence, and financial crises of the 1990s. In addition, even where the net benefits have been obviously positive, negative side effects—such as increased financial-asset price volatility, an apparent increased tendency toward liquidity pressures, and sharp asset price adjustments—have persisted. Thus, even in countries and markets where the net benefits are positive, consideration of some adjustments is desirable.83

Challenges Posed by Financial Globalization

In the 1990s, adequately comprehending the complexity of the international financial system became increasingly challenging. It is now significantly more challenging, and in many cases more costly to

  • assess financial risks (counterparty, market, liquidity, and operational);
  • anticipate market dynamics and the way in which financial disturbances will be transmitted from one counterparty, market, or country to another;
  • understand how financial risks are distributed across institutions within national and across international markets;
  • assess financial risks and vulnerabilities, and national and international systemic risk.

In the private sector, these challenges were the driving force behind financial consolidation and conglomeration, undertaken in part to capture perceived (if not actual) economies of scale and scope in providing financial services to a more internationally focused group of clients. Unexploited economies of scale and scope in supervising financial institutions and in international financial market surveillance may also exist.

This section examines four broad areas posing significant challenges related to aspects of the globalization of finance:

  • reduced transparency and, by implication, less effective market discipline;
  • more rapid and volatile market dynamics;
  • increased moral hazard;
  • the changed nature of systemic financial risk.

Reduced Transparency and the Effectiveness of Market Discipline and Official Oversight

The ability of globally active, highly integrated financial services firms to engage in modern techniques of finance in a diverse set of markets and countries has been associated with a corresponding separation between the initial allocation of capital and the distribution of financial risks and rewards. For example, a European global bank operating in Hong Kong SAR can take a stake in a Chinese company, unbundle the cash flows, the capital appreciation of the investment, and the counterparty risk, and sell these pieces separately to investors residing in a variety of locations and legal jurisdictions. Globalization has accordingly reduced the informational content of balance sheets and reduced the transparency of international financial activities. At the same time, financial risks have been redistributed internationally and among different classes of institutions, and financial markets have become more complex and complete, in the sense that opportunities for raising funds, investing, and engaging in financial risk-taking more generally have expanded significantly.

Because of this reduced transparency about who owns financial risks, financial stakeholders (both private and public) find it more difficult to evaluate risks and risk concentrations. Existing financial disclosure rules might not have kept pace with the globalization of finance, particularly the complexity and completeness of markets, and may be inadequate for ensuring effective private market discipline. Additional disclosure requirements may be necessary for classes of financial entities (hedge funds and other nonbanks) and hybrid entities (such as GE and GM) engaged in intermediation and market making now subject to few, if any, disclosure requirements and little supervision.

In market-based economies and financial systems, the primary market mechanisms for constraining private risk-taking and leverage from reaching too far beyond prudent levels are firms’ internal private discipline (set by internal incentives and enforced by top management in financial firms) and market discipline (provided by external incentives from creditors, equity holders, and counterparties). Internal and market disciplining mechanisms are intended to detect growing financial imbalances within firms and penalize them—the former through internal management controls (such as credit and concentration limits, value-at-risk limits, and so forth) and the latter through market mechanisms (appropriate incentive structures, arbitrage opportunities, profit and loss statements, and market-related governance such as the threats of takeovers and bankruptcies)—before they become large and threatening to a particular financial institution, market, or set of markets.

Presumably, the development of an unsustainable risk profile by a single financial institution will become known and will be reflected either in the institution’s share price or in its ability to raise capital or attract deposits. Reliance on private market discipline as a line of defense against systemic problems rests on the fundamental assumption that sufficient and appropriate information is available, on a timely basis, to investors and counterparts so they can assess reasonably accurately the risk profiles of their counterparts and their relationships with them. Without sufficient and timely information, the market disciplining mechanisms relied upon to address financial imbalances before they become vulnerabilities might not produce the appropriate self-corrective adjustments.

In addition to reducing the effectiveness of market discipline, lower transparency may also diminish the effectiveness of financial supervision and surveillance. Most supervisory and regulatory frameworks evolved around the traditional functions of commercial banking (lending and deposit taking) and nationally oriented financial markets. However, banks now engage in less of this traditional activity while providing a much broader menu of financial services to a more internationally diverse clientele in global markets. Moreover, many institutional investors now engage in commercial banking–type activities even though they are neither regulated nor supervised as banks.

As a result, credit and market risk exposures now reside either in other institutions not necessarily regulated as banks, or across the wide diversity of participants in securities markets for which surveillance is not always effective or even possible. Thus, large classes of market participants now own credit risk but are not closely regulated or supervised for this kind of financial risk-taking. In recent years, banks have sold much of the credit risk embodied in their loan books to insurance companies and pension funds through credit derivatives and other vehicles for securitizing risks, motivated in part by regulatory arbitrage: bank loans are subject to capital requirements, whereas charges for credit risk are lower for insurance companies and do not exist for pension funds. Although banking supervision has evolved to some extent along with the transformation of finance, it has not done so completely. Moreover, the regulation of other financial institutions—insurance companies, for example—has not kept pace with globalization, bank disintermediation, diversification of financial businesses, and increased use of direct finance in securities markets. The bottom line is that without the right kind of timely information, those in charge of official market surveillance and systemic risk management will find it difficult to know where all of the risks and vulnerabilities reside within the international financial system and where and how they might be concentrated.

Regulators and supervisors around the globe have been aware of these challenges for some time now, and have been pursuing efforts to deal with them. For example, with the adoption in 2005 of the Basel II framework for capital adequacy (Basel Committee on Banking Supervision, 2004), financial institutions worldwide and supervisors of internationally active financial institutions began making a transition likely to last several years, from a rules-based to a risk-based capital adequacy framework. Moreover, before the ink was dry on this international agreement, supervisors and more generally policymakers in many Group of Ten countries were continuing to consider how to put in place mechanisms for evaluating the governance and internal management control structures of globally active banks and securities firms. Given the breakdowns in corporate governance and accounting in the early 2000s and even continuing into mid-2005, and the prospect for continued rapid financial innovation and structural change, supervisors and the financial institutions themselves should consider redoubling these efforts, and possibly accelerate them.

At a more general level, the Group of Ten and Group of Seven have, as collective official bodies, also made progress in improving the amount of information they share and their surveillance of the global economy and financial system, working closely with the IMF and Bank for International Settlements. Despite these efforts, however, there is little doubt that globally consolidated surveillance of the global economy and financial system, and also of the global financial institutions that make up its financial core, can be improved significantly, in part through closer coordination between the responsible authorities. Moreover, financial institutions and financial market participants more generally, including global corporations, can be provided more direct and transparent incentives to manage the risks they face through the involvement of the highest levels of policymaking in these important issues.

Overall, the objective of enhancing the degree of transparency and disclosure is to improve financial market efficiency through greater market discipline. To be effective, policy changes to enhance market transparency and improve disclosure requirements must be designed to strike the appropriate balance between (1) requiring the provision of the appropriate kind and amount of information (publicly to the markets and confidentially to the authorities), and (2) encouraging rather than inhibiting efficiency-enhancing financial activity. Finding the correct balance entails providing the appropriate kind of information that, on the one hand, private counterparts require to assess counterparty risk accurately and that, on the other hand, allows systemic risk managers to assess market imbalances and vulnerabilities soon enough to take preemptive actions against potential turbulence. Ideally, information to both private and official stakeholders would be provided without impeding the efficient production and allocation of financial products and services.

Impact of Globalization on Market Dynamics

The greater securitization and globalization of finance has dramatically altered the structure of market dynamics, measured by the magnitude of changes in financial asset prices and transactions flows, and the time scales over which they occur. Transactions costs have been reduced to a minimum, and markets are now electronically linked, have a greater diversity of borrowers and lenders, and can accommodate large volumes of transactions over a short span of time. The high degree of capital mobility, the growing volume of cross-border transactions, and the links between trading exchanges and clearinghouses have tended to reduce the time it takes to rebalance portfolios and to reallocate large volumes of capital internationally. This increased speed has been facilitated by the large financial intermediaries with global reach that manage large, geographically dispersed portfolios of diverse asset classes for a wide variety of classes of investors. The broad experience in international markets since the early 1990s seems to suggest that markets have become more subject to periods of “feast and famine,” in which the amplitudes (and perhaps the frequency) of financial cycles have increased as a result of structural changes. Indeed, the increased frequency of sharp price movements84 and the apparent increase in the ability to shift capital and market liquidity reflects the roles played by global financial institutions and the ways they manage their portfolios and risks.

Four closely related aspects of the modernization and globalization of finance are influencing the structure of market dynamics at the same time that they are enhancing efficiency. First, nonfinancial firms, investors, and financial institutions rely to a much greater extent on securities markets rather than bank loans for obtaining funding. Securities are actively traded and repriced, and financial institutions are relying increasingly on global markets to fund and risk-manage their exposures.

Second, the large, internationally active financial institutions, which intermediate the bulk of capital internationally, rely heavily on modern portfolio risk management and control systems to manage portfolios (including those of their clients) and inventories of risks they own to provide financial services to clients. Financial positions and risks are actively managed and hedged by relying on sophisticated trading strategies involving both underlying assets and derivatives across a range of markets. Mark-to-market risk management and accounting, stop loss orders, collateral calls, and dynamic hedging are all used to limit losses when prices move counter to expectations. While extremely beneficial for managing risk, enhancing efficiency, and safeguarding the soundness of individual institutions, the widespread use of these techniques can lead to massive and persistent selling (or buying) pressures in already declining (or rising) markets, which exacerbates price movements (which results in under- or overshooting). Markets also show an increased tendency to become more highly correlated during times of heightened financial activity, in part because investors hedge positions in geographically distinct markets. For instance, prior to the Russian default in 1998, investors in Russian investments hedged their credit exposures by taking short positions in Brazilian paper on a highly liquid futures exchange, because Russian and Brazilian credit risk seemed to be correlated. Because of this proxy hedging, turbulence in Russia created turbulence on Brazil’s exchanges.

Third, large, internationally active financial institutions (many of them conglomerates) engage simultaneously in market making and position taking. Their market-making activities have them holding inventories of risks (financial positions) for which they try to minimize their risk exposures by hedging in repurchase and derivatives markets. Hedging and rehedging is a continuous process, and involves sophisticated trading and risk control systems.

Fourth, as a result of the previous three conditions, the financial activities of the major international financial institutions are liquidity hungry and are predicated on readily available liquidity and the ability to put on or liquidate positions quickly. Thus, liquidity and speed have become hallmarks of modern finance and key underlying attributes of the international financial system.

Market psychology also plays a role. Financial markets have long been subject to cycles of market sentiment, in which excessive optimism suddenly gives way to excessive pessimism. This phenomenon is sometimes attributed to market irrationality, but it can have fundamental underlying causes. Early in the cycle, a critical mass of market participants begins to view some investment opportunity in a more attractive light than in the past. This belief might be triggered by a new paradigm, a strong track record of returns, or the observation that those market participants that are viewed as having “inside information” or special expertise are pursuing that opportunity and profiting from it. Any of these reasons can cause trend-following behavior by market participants who extrapolate past returns, and “copycat” behavior by those that attempt to “free ride” on the superior information of “insiders” and “experts.” Eventually, some event puts the initial optimism in question; in response, risk is reassessed and portfolios are rebalanced. Sentiment deteriorates rapidly, capital is withdrawn, and prices fall further, potentially creating a cycle of price declines and eroding sentiment that feeds upon itself.

These psychological dynamics are common to financial markets, and may have been at work during some of the episodes of volatility and turbulence in the 1990s and in the first half of the first decade of the 2000s. For example, in retrospect, many of the elements of market psychology and the associated market dynamics were evident in U.S. and other equity markets during the inflating and then dramatic bursting of the “dot-com” bubble in the late 1990s and early 2000s. Suggestions that the economic structure changed in the 1990s may have led market participants to overweight the unusually favorable experience and invest in new and unknown companies and industries. In emerging-market countries, the short price history of markets most likely provided a potentially distorted favorable picture of the risks of investing in those markets during the early 1990s. After a pause following the Asian crises in 1997–98, the Russian default in 1998, and problems surrounding Argentina, Brazil, and Turkey in the early years of the 2000s, this trend may have reappeared more recently and continuing into 2005, where many emerging markets are borrowing on very favorable terms. Finally, as this book goes to press in mid-2005, financial journalists around the globe are openly speculating in print about whether the generous liquidity in international financial markets—and a presumption that it will continue to be provided on generous terms—may still be boosting asset prices in a wide variety of markets. If so, this would be a continuation of what likely occurred throughout the later years of the 1990s in many markets and countries, which culminated in the spectacular bursting of the equity bubble in 2000.

As a result of all the factors outlined above, market dynamics have changed in two important ways. First, modern finance allows risks to be priced and traded more actively, more continuously, in larger quantities, and ideally more safely. Changes in fundamental economic value once hidden on bank balance sheets are now recognized more quickly and more frequently in a mark-to-market environment through market prices. In addition, as market prices provide continuous (albeit noisy) signals about value, market participants reappraise risk, rebalance portfolios, and deploy or withdraw capital. This reassessment and rebalancing can, in turn, feed back to market prices. Thus, along with potential improvements in efficiency have come more frequent changes in asset prices and financial flows, and possibly more rapid and complicated market dynamics.

Second, because the market makers that provide critical market liquidity (the globally active financial institutioins) are often also traders and investors, large price shocks can result in the withdrawal of capital from market making, a decline in market liquidity, and sharp and disruptive price declines (not only in the market that originally experienced the shock, but in any market where market makers might have been active).

Many of these features of modern finance are efficiency enhancing most of the time, and even in times of stress when used in moderation. However, when a critical mass of these features are pushed simultaneously to their limits, turbulent market dynamics can result, particularly where there is high leverage, similar position-taking (herding), and excessive reliance on—and presumption of—continuous market making and ample liquidity. The number of episodes of turbulence in the 1990s and early 2000s with these characteristics suggests that market dynamics have been altered significantly during the process of financial modernization and globalization. This is most evidenced by (1) the frequency of sharp and rapid price movements in both mature and emerging markets; (2) the at-times sharp changes in correlations across markets, sometimes from negative to positive; and (3) the increased ability to shift capital and local market liquidity. These changes are posing challenges to private market participants in their attempts to maintain steady profit margins and to manage financial risks. They are also challenging the ability of national and international authorities to prevent, manage, and resolve financial-system problems.

If effective market discipline is practiced, the fast pace of market dynamics alone should be sufficient encouragement for private market participants to insulate their business activities, net incomes, and balance sheets from the sharp price movements and changes in market liquidity. One factor inhibiting market discipline is moral hazard: some of the most important market participants are, in fact, a vital part of the public financial infrastructure (payments systems), and are therefore, at times, subject to several forms of moral hazard.

Role of Moral Hazard

The existence of financial safety nets (for depositors, financial institutions, and markets) creates the presumption that when market discipline is not sufficient to prevent systemic problems, the public sector will manage and resolve the crisis through supervision and market surveillance, and occasionally through more direct means of financial support. As discussed in Part I, financial stability is a public good that can be adversely affected by a collection of private actions. Without financial safety nets—for example, deposit insurance to protect depositors against bank failures—private market participants might collectively lack the willingness or ability to undertake optimal levels of financial risk, and they might therefore engage in suboptimal levels of financial intermediation. Massive withdrawals from intermediation, market making, and risk-taking occurred frequently in the 1990s, during episodes when the widespread fear of private losses disrupted the normal operation of financial markets, to an extent that raised systemic problems—as, for example, at the height of market turbulence in the autumn of 1998 and more recently in 2001 when the “dot-com” equity bubble deflated. The threat of massive withdrawals from private financial risk-taking was seen as possibly affecting economic growth and financial stability, which is one reason central banks intervened to reduce the cost of liquidity and financial risk-taking.

Prudential oversight and other elements of official involvement constitute preventive and corrective mechanisms that—like market discipline—provide a degree of insurance and stability to national financial systems and more broadly to the international financial system. However, official involvement must remain within reasonable boundaries and not lead market participants into thinking they can engage in imprudent risk-taking without suffering the consequences of bad outcomes. The presumption should be that official involvement occurs only up to the point that it encourages normal and prudent risk-taking.

This poses a difficult balancing act for policymakers who are responsible for encouraging normal risk-taking and at the same time insuring the financial system against systemic problems. The challenge is for banking supervision, market surveillance, and financial policymaking more generally to balance efforts to maintain financial stability and manage systemic risks against efforts to ensure that market participants, especially systemically important institutions, bear the costs of imprudent risk-taking and accordingly have the right incentives to avoid imprudence. Accountability may also need to be bolstered in some cases, to foster and promote discipline in the exercise of official supervision and surveillance. Overall, the ideal set of reforms would create a composite of private and regulatory incentives that encourages financial institutions and market participants to internalize the potential for systemic risk in their private risk-taking.

The Changed Nature of Threats to Financial Stability and Systemic Risk

As previous sections have suggested, the evolving character of the global financial system raises challenges for maintaining financial stability and systemic risk management, too. Over the past several decades, in efforts to safeguard financial stability, countries have put in place private and official lines of defense against systemic problems as well as mechanisms for managing and resolving financial problems when these lines of defense are breached. Efforts to maintain financial stability and manage systemic risk necessarily rely on a combination of private market discipline and taxpayer-financed financial safety nets, supplemented by official prudential oversight and monitoring in the form of financial supervision, regulation, and surveillance. These defenses are built on the presumption that a systemic financial event is one in which the problems at one institution might cascade through a payments system, interbank relationships, or depositor runs and infect other institutions to the point of posing risks for the financial system itself. This concept may have become too narrow, given the expanded opportunities for risk-taking and reliance on markets for financing.

As financial systems have been transformed from nationally oriented bank-based systems to internationally integrated market-based systems, financial infrastructures, including official national payments systems, have also been reformed to reduce systemic risk. Market-based financial systems—in which securities are traded in markets—have lower potential for traditional systemic risk than bank-intermediated systems. Securities firms hold tradable, liquid assets and have a higher proportion of longer-term funding; economic shocks are often absorbed by price changes, and the effects of the shocks are spread and dispersed more widely (in fact, almost globally).

However, the greater reliance on securitized finance in national financial systems and the international financial system appears to have created a more market-oriented form of systemic risk, involving an array of markets and their underlying infrastructures, which are primarily privately owned and operated. As a result, systemic risk may now be more highly concentrated in capital and derivatives markets (as discussed in Chapters 9 through 11), and involve private settlement systems and quasi-private clearinghouses.

As noted, in addition to relying on private market discipline, current financial regulatory frameworks generally provide a financial safety net supported by prudential regulations requiring banks to maintain sufficient capital and to adhere to reporting and accounting standards and best business practices. Regulations are designed to ensure that financial institutions—particularly systemically important ones—have sufficient capital to absorb internally any losses sustained so that taxpayer costs are minimized. Adherence to standards and best practices helps to ensure that losses are quickly and adequately reflected in profit and loss statements so that private stakeholders can exercise market discipline on financial institutions to implement changes that prevent future losses. This general approach has worked reasonably well in the mature financial systems in limiting collateral systemic damage from private financial excesses (imprudent risk-taking) and problems throughout the 1990s and so far in the 2000s.

Nevertheless, this approach is not without tensions. It creates potential conflicts between the objectives of regulators and those of regulated institutions. Regulators—by providing insurance—underwrite private risk-taking beyond some prudent limit that might not otherwise be taken; and regulated institutions have incentives to find ways to take greater risks within (and sometimes beyond) the boundaries of market discipline and official rules of the game, including regulatory capital constraints. A danger in imposing further constraining regulations is that the regulatory environment might then tend to inhibit efficiency-enhancing risk-taking. Alternatively, the danger in not adequately enforcing existing regulations and perhaps reforming them is that financial institutions will take risks not usually considered worth taking.

A complicating factor is the element of dynamic competition—a dynamic game—between the regulated and the regulator. Because of the combination of technological advances, private incentive structures, and increased competition in providing financial services, private financial practices tend to adapt quickly and dynamically to structural changes, more so than it is possible for supervisory and regulatory frameworks to adapt to monitor them. In part because of differences in resources and incentives, the ability of the private sector to capture the gains from technological advances may have exceeded the ability of officials to learn how these technologies can be applied to the measurement, calibration, and management of systemic risk. As noted by one former senior regulator, this dynamic game can be likened to that of a “bloodhound chasing a greyhound”: regulators have trouble keeping pace with the ability of internationally active financial institutions, and the gap between them may be widening.

These challenges may have no perfect or final solution. It is neither possible nor desirable for supervisory authorities to know as much about a financial institution and its risk-taking activities as the financial institution’s own management. Nevertheless, financial authorities necessarily must continuously reassess policy instruments intended to encourage prudent financial activity, behavior, and risk management, recognizing that some instruments are likely to be imperfect and blunt. The policy challenge is to develop instruments that are effective in encouraging prudent behavior and management but that do not inhibit efficiency-enhancing activities. As markets evolve and become more complex, regulatory frameworks need to be continuously adapted to the changing nature of private financial risk and systemic risk.

Summarizing these observations, the transformation of the modern financial system is changing the nature of systemic risk.85 A fundamental concern and challenge is that existing private incentives may no longer be strong enough to prevent excesses and that the existing lines of defense presently inadequately address some aspects of the transformed, more market-oriented systemic risk. Reforming existing private and public mechanisms (including crisis prevention and management mechanisms) to deal adequately with all these evolving elements of the international financial system may be desirable. In addition to encouraging and monitoring reforms of private risk management and control systems of the major financial institutions, Group of Ten financial policymakers may also need to consider reforming systemic risk management systems to more effectively deal with the evolving nature of systemic risk and events. This most likely will entail development of a more global orientation and approach, as has taken place so far in the policy discussion on, and reform of, financial standards and codes, under the rubric of reforms of the international financial architecture in the aftermath of the Asian, Russian, and Long-Term Capital Management crises and more recently in changes in legislation (in the United States and Europe) introduced in the early 2000s to address some of the breaches of corporate governance and accountability.

Ways Forward

Looking back on the past several decades, the cumulative processes of globalization appear to have transformed the international financial system into a fast-paced, global mechanism for distributing both risk ownership and financial distress, a system in which a relatively large number of episodes involving financial turbulence and crises occurred. A key question is, do the volatility, turbulence, and crises experienced since the early 1990s accurately represent what can be expected in international financial markets in the future or was some of the turbulence part of a still ongoing transitional phase of globalization?

In the private sector in mature markets toward the end of the 1990s, the large internationally active financial institutions had already learned lessons, and incorporated them into their institutional memories in the form of new risk management and control systems, and greater attention to diversifying their portfolios of businesses and not just their portfolios. Likewise, some national authorities—many of them surprised by much of the turbulence—reexamined and reformed their banking regulations and supervisory frameworks during the 1990s, particularly toward the end of the decade. Similarly, the international (mostly official) community undertook initiatives, some under the umbrella of reforming the international financial architecture (mostly for dealing with crises in emerging markets), but also many initiatives involving international supervisory, regulatory, and other bodies—including international financial institutions—addressing the issue of how to improve supervision, regulation, market surveillance, and crisis management and resolution.

The apparent resilience of the advanced countries’ financial systems during the second half of the 1990s—and more recently during, and in the aftermath of, the bursting of the global equity “dot-com” bubble in March 2000, the record levels of corporate bond defaults in 2000–2001, the related series of breaches of corporate governance and accountability, and the financial fallout of the events of September 11, 2001—suggests that these efforts have enhanced the financial systems’ ability to diversify private and national risks sufficiently to reduce potential, and realized, private and systemic financial losses to a manageable level. All concerned also seem to have a greater appreciation of the interdependencies between macroeconomic stability and financial stability, especially the importance of central bank policies (including monetary and financial-stability policies) in balancing these two important aspects of stability. Because of all these factors, advanced-country financial systems have become more insulated from, and better able to cope with, shock waves in international markets, even with financial system problems in Japan, the second largest banking system in the world, and other systemically important events that at times seemed fundamentally to threaten international financial stability. However, financial activity has become significantly more complex and less transparent, and containing financial excesses before they become large enough to produce the potential for volatility and turbulence is even more difficult.

By contrast, financial systems in many emerging-market countries do not seem to have acquired the same degree of insulation and resilience. Many developing countries have access to global finance but have not yet been able to effectively manage the risks associated with it. For a number of reasons they have not fully kept up with structural changes and fully prepared themselves for a world of modern finance and modern financial markets. In many cases, fundamental and enduring macroeconomic and microeconomic structural reforms have not been achieved, or if achieved, not maintained. In addition, financial structural reforms have not been achieved—such as transparent and effective legal systems; guaranteed contract performance and collateral collection; financial infrastructure building, including financial supervision and regulation, and well-designed, monitored, and enforced safety nets; and corporate governance structures—even in the high, sustained-growth countries. For many emerging markets, the globalization of finance has been a double-edged sword: during good times, the flows aid their economic and financial development but during bad times, the setbacks can be highly disruptive. The propensity for country crises seems to have increased for these countries as a result of their accessing global financial markets without also having achieved the necessary reforms.

Looking forward, and in considering further reform efforts, it is prudent to presume that while the international financial system has become more efficient and resilient than it was before the 1990s, it may also have become more likely to experience sharp asset-price and capital movements, market turbulence, crisis situations, and perhaps even the potential for systemic risk. Accordingly, national and international authorities alike must focus more attention on building better financial infrastructures; improving national and international financial surveillance, supervision, and regulation; and establishing clear mechanisms and rules of coordinating reforms and interventions when such interventions are necessary. Key to any reform efforts would be a reconsideration of the balance of reliance placed on private market discipline and on official oversight in ensuring financial stability. Greater reliance on the former and less on the latter should be strongly considered, but would require significant enhancements to market transparency, financial disclosure, and governance and accountability.

In improving supervisory and regulatory frameworks, appropriate attention should be paid to three lessons learned from the turbulence and crises of the 1990s (and since then), each lesson applying equally to mature, international, and emerging markets. The first is that greater supervisory attention to internal risk management and control systems, to the capability and involvement of senior management in these processes, and to corporate governance mechanisms is crucial for the future. One way to preserve the financial efficiency gains, to safeguard financial stability, and to protect the public interest in providing a financial safety net, may be to penalize errant institutions by requiring them to hold more capital than the minimum required by existing international agreements (the policy of super-equivalency that has been followed for some time by some countries, such as the United Kingdom). The strategy of this approach is to better insulate the less responsible institutions from negative outcomes. This would be one step in the direction of creating an incentive structure that encourages financial institutions and market participants to internalize, privately and individually, the financial-stability implications of their collective private risk-taking.

The second lesson is to make better use of market discipline. An important feature of having strong and, if possible, failsafe infrastructures—in particular, real time gross settlement payments systems—is that financial institutions, even large ones, can be allowed to fail and be liquidated without necessarily threatening the stability, or even the effectiveness, of national payments systems. Accordingly, the benefit of improving transparency and both regulatory and public disclosure is that the probability will be higher that both market participants and supervisors will see hints of errant investment strategies or financial problems as they begin. Greater transparency and disclosure also make it easier for supervisors and policymakers to come to more informed judgments about the potential collateral damage that other institutions or markets might suffer if one institution is allowed to fail. Moral hazard also inhibits the effectiveness of market discipline as a deterrent to systemic financial problems. In these cases, national and international risk management can be improved, and financial supervision and regulation can play a more proactive role to ensure that access to the financial safety net is not being exploited. Some combination of transparency and disclosure, effective supervision, and market discipline will aid tremendously in safeguarding national financial systems and in so doing safeguard the efficiency and smooth functioning of the international financial system.

A third lesson for all countries—but particularly the Group of Ten countries—is to more fully recognize and operationalize the principle that, because of the globalization of finance, international financial stability is a global public good transcending national objectives and interests. As the experience in the 1990s demonstrated, mature financial markets—in Europe, Japan, and the United States—can be both affected by, and sources of, international financial instability and international systemic risk. While all countries can contribute to international financial stability by achieving and maintaining national financial stability, financial system policies designed exclusively to achieve national objectives can create problems in other countries or in international financial markets.

The private financial sector provides a relevant example. Just as a global orientation to risk management and control is required to be profitable in providing private financial services in global financial markets, a global approach may also be required to effectively supervise, regulate, and provide surveillance of international financial activity in global markets and thereby preserve international financial stability. In this regard, a key implication of the globalization of finance is that without some fully recognized and operationally binding international coordination mechanisms, nationally focused financial system policy frameworks may not be able to provide the type of global orientation necessary for promoting and ensuring enduring international financial stability.


For example, General Motors and other U.S. automobile manufacturers routinely provide credit to purchase an automobile, and thereby incur credit risk. Likewise, many large retailers provide credit cards to purchase goods in their stores. This is a significant change because, more so than nonbank financial institutions, the financial activities of nonfinancial entities generally are not subject to financial regulation and supervision.


See Volker (1998 and 1999).


Examples of sharp price movements include U.S. equity markets in 1987 and 1997; bond market turbulence in 1994 and 1996; major currency swings throughout the 1990s; Mexican (1994–95), Asian (1997), Russian (1998), and Long-Term Capital Management (1998) crises; and global equity markets in 2000 and 2001 (see Table 1.6).


This was noted most clearly by Hans Tietmeyer in 1999 when he was President of the Deutsche Bundesbank: “… systemic risk is not a given quantity. To a large extent, it is an endogenous variable which depends on the structures of the financial markets, on the supervisory framework at the national and international levels and on the decisions taken by the political and monetary authorities” (Tietmeyer, 1999, p.1).

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