This post was published by Bruegel and the Peterson Institute. It is based on a forthcoming paper presented at the joint conference “Asian Capital Market Development and Integration: Challenges and Opportunities” co-organized by the Asian Development Bank, Korea Capital Markets Institute, and the Peterson Institute, in Seoul on October 24, 2012.
Before 2007–08, most global financial reform initiatives were based on a near-consensus about the benefits from the free circulation of capital across jurisdictions and from free cross-border competition among financial services firms. As a consequence of the financial crisis in the United States and Europe, however, this near-consensus can no longer be taken for granted. One implication is the increasing possibility of a fragmentation of the global financial system.
Such a trend could take many forms. Rating agencies were unregulated in most of the world outside the US before the crisis (South Korea being one exception). But the G-20 recommended that they be regulated and supervised by all major jurisdictions. Implementing that recommendation raises the risk of incompatible or inconsistent regulatory frameworks and supervisory practices among different countries. Rating methodologies could vary even within the same rating agency. Another example of fragmentation could arise for over-the-counter (OTC) derivatives. Trading has until now been cleared bilaterally among market participants. The G-20 has mandated central clearing in regulated clearing houses starting in 2013, however. Many investors fear a division of corresponding markets along the borders of country or currency areas. A third new development would flow from the new standards at international financial institutions, particularly the International Monetary Fund (IMF), governing the adequacy of capital control measures under certain conditions. But these new standards could potentially run counter to the previously received wisdom of the so-called Washington consensus.
Across the globe, supervisors have nudged banks to separate and protect assets and maximize lending in their respective jurisdictions, in some cases pushing for subsidiarization of activities previously conducted through branches. In countries that have run into fiscal difficulties, domestically headquartered banks have been pressed to increase their purchases of national sovereign debt. “Financial repression,” an expression long reserved to economic historians, has reentered the mainstream financial vocabulary to describe the possibility of such pressure. These developments have been striking in the euro area, where countries are in principle committed to total openness to capital flows but where an abrupt U-turn from financial integration to financial fragmentation has been identified by policy authorities, including the European Central Bank (ECB). They are by no means unique to Europe, though, and variations of the same themes have been observed in most if not all main economic regions.
Simultaneously, the pre-crisis momentum for harmonization of global financial standards has run into setbacks in crisis-affected countries. The United States has delayed any decision about the adoption of International Financial Reporting Standards (IFRS), which it had endorsed for US-listed foreign firms in 2007 and had seemed on the verge of extending to US-listed issuers in 2008. In another example, the European Union, after championing the global use of the Basel II Accord on capital standards during the 2000s, now seems set to adopt legislation that the Basel Committee has deemed materially non-compliant with the new Basel III Accord adopted in 2010. For all the G-20 talk about global solutions to global problems, financial reform often seems more driven by politics in the post-crisis context than in the previous period. And as the saying goes, all politics are local.
This new reality poses an unprecedented challenge for Asian policymakers. Asia has gained from dynamic financial development in the past two decades, and is entering a new phase in which cross-border financial openness could improve the allocation of capital and make financing mechanisms more efficient. Asians generally are likely to benefit from the continuation or even the acceleration of global financial integration. Until recently, Asians could take such integration for granted, counting on the commitments to financial openness of both the United States and Europe, which dominate the global financial order as embodied by such institutions as the IMF, the International Accounting Standards Board, or the Basel cluster around the Bank for International Settlements.
But the assumption that the West will continue to champion further cross-border openness of the global financial system can no longer be taken for granted. As a consequence, Asians may have to take more leadership in global financial reform discussions to make sure that global financial integration is not reversed. This would be a new situation. Some Asian policymakers may feel ill-prepared for such a trend, but they could find its implications difficult to escape.