Why global financial standards are vital in a fragmented world

The benefits of globalization, including in the area of finance, have been re-evaluated since the global financial crisis of 2007-12. The previous consensus among economists on the desirability of free capital flows was replaced by a more nuanced view that includes the need to correct some of the excesses of financial globalization.

The experience of many countries that suffered the consequences of spillovers from banking crises originating abroad led their authorities to re-assess the benefits of financial openness in terms of access to a broader pool of saving, market discipline and diversification of risks.

In particular, countries that hosted branches of foreign banks tried to protect themselves from the contagion of crises in the parent bank. Home authorities also saw their banks suffer losses in their overseas operations and tried to limit the desired degree of openness of the home country regulation, as seen in the ring-fencing of retail banking in the UK adopted in 2009, for example.

All these reactions may be characterized as “intended” fragmentation, in the sense that its origin is regulatory and its results mostly desirable.

More recently, other shocks fuelled the fragmentation trend. The pandemic highlighted the vulnerability of the domestic economy as a result of an excessive reliance on foreign providers and increased the value of strategic autonomy in the provision of certain key supplies or infrastructures, such as medical, energy and food supplies or financial markets infrastructures.

The war in Ukraine accelerated this trend. Sanctions to Russia were seen in many countries – especially emerging ones – as a wake-up call that exposed their dependence and vulnerability in the provision of essential financial infrastructures in areas like wholesale payments or central bank reserves’ management.

This “weaponization of finance” led many emerging market economies to look at alternative capital markets, currencies or infrastructures, which compounded the fragmentation trend.

There is ample anecdotal evidence of the withdrawal of foreign banks from their establishments abroad in the form of branches and subsidiaries, as outlined in McKinsey’s 2017 report The New Dynamics of Financial Globalization.

In some cases, it was a retreat to their winter quarters to protect themselves from the global financial crisis, while in others it was a government or regulatory requirement in the context of the public aid these banks received.

In yet other cases it was a reaction to a regulatory tightening in host countries. Many branches of foreign banks were transformed into subsidiaries as a way for host authorities to reaffirm their control of their local operations.

What are the implications of these trends? The first and most evident is a less efficient allocation of capital and suboptimal risk diversification.

This is accompanied by lower competition – and less efficiency – in local financial and banking sectors, which tends to create solvency problems sooner or later, since inefficient banks develop weaknesses that, little by little, erode their soundness.

To the extent that domestic financial markets become more isolated this would also weaken market discipline, which is especially harmful in a context of increasing volumes of public and private debt. On the positive side, all these trends point to a world in which there will probably be less contagion from one country or region to the rest.

In this fragmenting world, global standard setters like the Basel Committee on Banking Supervision or the Financial Stability Board (FSB) continue to develop a common regulatory framework in key areas.

Without the efforts of national authorities gathering in international standard setting bodies to ensure a certain degree of convergence in regulation, the fragmentation of the global financial system would have been considerably worse.

But, at the same time, the trend towards subsidiarization of the operation of foreign banks abroad tends to diminish the interest of national authorities in developing and applying international standards, a recent example being the delay in the finalization of Basel III in the US.

The increasing number and complexity of financial standards is in sharp contrast with the weakening of their enforcement. It would be desirable to move towards broader, more principle-based standards and a strengthened compliance.

At the same time, it is necessary to make compatible the technical work of experts of independent national regulatory agencies in these standard-setting bodies with the democratic process and sovereignty of national legislators to decide on the transposition of these standards to each jurisdiction. Focusing the mandate of independent central banks on their core functions would help to strengthen their accountability.

It would also be desirable to expand the scope of these standard-setting exercises to new areas like digital finance and sustainability. Common principles on the regulation of artificial intelligence (AI) – like the ones developed by the Council of Europe or the United Nations – or financing the transition to a net zero economy would provide a much needed consistency in the efforts of national authorities.

These exercises, however, face considerable difficulties, partly because of the lack of a proper global governance in these new areas.

The umbrella of the G20 as a political debate forum and the FSB as its technical arm is adequate for some of these exercises, but the G20 lacks global membership, and the FSB does not have a mandate in areas like data protection or AI.

Ideally, the international regulatory community would need appropriate bodies to discuss a common approach to these new challenges, but there is little appetite for new bodies in the global financial architecture.

A more realistic approach would be to expand the scope and mandate of existing bodies like the FSB and the Bank for International Settlements as they have the capacity and resources. It is precisely in a world with strong centripetal forces where international regulatory coordination is more necessary than ever.

To sum-up: the global financial crisis led to a correction of the excesses of financial globalization, which was positive in limiting international spillovers of financial crises.

More recently, the emphasis on strategic autonomy and the weaponization of finance are introducing additional fragmentation in the global financial system that may entail more costs than benefits, especially for emerging economies.

In this context, maintaining the standard setting process in the relevant fora and extending it to new areas like digitalization and sustainability is key to upholding the benefits of free capital flows while preserving global financial stability.