Cambridge Journal of Regions, Economy and Society Advance Access originally published online on March 27, 2009
Cambridge Journal of Regions, Economy and Society 2009 2(2):303-331; doi:10.1093/cjres/rsp004
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This article appears in the following Cambridge Journal of Regions, Economy and Society issue: Spatial Circuits of Global Finance [View the issue table of contents]
Financial stability, the Basel Process and the new geography of regulation
School of Public and International Affairs, Virginia Tech, Blacksburg, VA 24061, USA. dsb{at}vt.edu
JEL Classifications: G18, G28, E42
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Abstract |
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Abstract
IntroductionThe post-Bretton Woods era has witnessed the integration of the global financial system at an unprecedented pace. However, much of its institutional governance structure remains hinged on the old paradigm of national economies. Despite highly globalized financial markets, I find evidence of substantial clustering in the context of regional financial activity. Addressing the regulatory challenges of globalization, the so-called ‘Basel Process’ provides policy makers with a unique institutional arrangement that straddles the gap between the old and the new geographies of financial markets. The evolving architecture of the global financial system calls for a careful balancing of globally co-ordinated, locally decentralized regulation on the one hand and effective, centralized intervention mechanisms on the other hand.
Keywords: financial stability, Basel Process, geography of regulation, international financial architecture, Basel II
Received on October 15, 2008. Accepted on January 27, 2009.
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Introduction |
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The spatial organization of international finance is one of the chief similarities between the two waves of capitalist globalization (1820–1914 and 1960 to present). While the integration of the global financial system is preceding at an unprecedented pace in the current wave, I argue that increased globalization does not mean the ‘end of geography’ for finance (O'Brien, 1992). Rather, it implies a different kind of geography; it is no longer the ‘old’ geography with competing nation states as the key spatial units of interest, but a ‘new’ geography is emerging, where globally dispersed creditors and debtors are the main actors.1
At the same time, much of the institutional governance structure of the global financial system is still hinged on the old paradigm. Individual governments (or national institutions such as central banks, regulators and supervisory institutions) continue to influence international financial markets through monetary and fiscal policy and—perhaps equally importantly—by influencing the regulatory architecture of the global financial system, albeit co-ordinating their efforts at the level of international financial institutions. Yet, largely disconnected from the realities of globalized markets, a significant part of these endeavours is typified by ‘old geography’ thinking which views globalization as a ‘flattener’ in the sense of Friedman (2005). But instead of bringing about a more uniform distribution of risk in financial space, globalized capital markets have encouraged the build-up of significant, regionally concentrated imbalances. And so, rather than reducing it, financial globalization has actually increased overall systemic risk.
The recent financial market turmoil is revealing the increasing fault lines between the old and new geographies. Under the new geographical paradigm, contagion between certain financial market segments—rather than contagion between countries—has become the primary concern. The rapid transfer of risk from one area to another poses new challenges for regulators. The ‘glocalization’ of financial market implies that the dissavings behaviour of suburban households in the USA has the potential to jeopardize teachers’ pension plans in a small Norwegian municipality. More generally, global turmoil in financial markets is causing local fallout; as the eye of the current financial storm crossed the Atlantic, dozens of local councils in the UK were at risk of losing hundreds of millions of pounds of taxpayers’ money held in Iceland's stricken banks.
Among the plethora of regulatory efforts that address the new realities of financial globalization, the so-called ‘Basel Process’ seems uniquely positioned to provide policy makers with an institutional arrangement that straddles the gap between the old and the new geographies of financial markets. The Bank for International Settlements (BIS), the world's oldest and perhaps least well-known international financial institution, provides the locational anchor for the Basel Process which has come to form the natural home for the global policy co-ordination among central bankers and regulators. Perhaps one of the most prominent recent initiatives arising out of this process is the new capital adequacy framework, commonly referred to as Basel II. While the beginning of the World War I marked the beginning of the end of the first period of globalization of the world economy, the Great Depression acted as a catalyst for a fundamental redesign of the global financial system. In early 1930, its new institutional centre became the BIS. In addition to facilitating German war reparation payments, the BIS’ mission should be ‘[...] to promote the co-operation of central banks and to provide additional facilities for international financial operations’.2
With the foundation of the BIS, the Basel Process was born which in turn has become an indispensable pillar of the global financial system, critically shaping the international financial architecture over the last 80 years. As such, it continues to play an important role in co-ordinating the multilateral efforts of central banks, regulators, supervisors and market participants alike and is thus distinctively geared towards fostering and maintaining financial stability, both globally and locally.3 Indeed, the Basel Process is arguably one of the first truly ‘glocal’ institutional responses, anticipating many of the challenges arising in the context of a more complex, highly integrated world economic system today.
However, giving rise to the current global financial turbulence, the recent sub-prime crisis has subjected the Basel Process to intense internal and external scrutiny. This episode of financial instability might yet prove to be one of the most challenging tests for the Basel Process as authorities strive to improve their local regulatory frameworks in search of incentives for prudent behaviour and in response to the global challenges of financial integration. In this context, it is not those aspects of the current crisis with ample historical parallels that represent the most immediate trial to the Basel framework. Globalization, old and new, has seen several episodes where—as part of the credit cycle—excessive lending eventually lead to a state of over-indebtedness.
Rather, it is the ‘key twists’ that set the current financial crisis apart from other instances of financial upheaval (Bordo, 2008, 6–8). It is the shift of focus in markets from stress on banks’ liabilities to stress on their assets; it is the institutional shift from banks to non-banks that has led to significant increases in systemic risk as financial risk is spread throughout the globalized marketplace. The Basel Process is further challenged by the notion that—along with a prolonged period of historically low interest rates—the roots of the current crisis include major changes in regulation, lax oversight and a relaxation of the normal standards of prudent lending. These are the very elements of ‘glocal’ policy making for which the Basel Process seeks to facilitate global co-operation and local implementation.
However, while financial innovation has facilitated the sidestepping of national regulation and arguably increased informational asymmetries among market participants, this paper argues that the Basel Process has mitigated the downside of the current crisis. Although not being able to avoid the crisis altogether, it has helped to identify the most pressing regulatory policy issues within a globalized financial system.
The remainder of this article is organized as follows: The next section discusses the process of globalization and its implications for financial markets and financial stability. This is followed by a section on the inner workings and institutional components of the Basel Process. The paper moves on to look at various aspects of financial regulation and investigates the determinants of its spatial distribution within a globalized system. The next section addresses global and regional regulatory policy issues in the context of the current financial crisis and the final section offers an outlook and some conclusions.
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Globalization of markets and financial stability |
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The process of globalization is fundamentally altering global financial markets through their closer integration, unlocking a huge potential for international risk sharing.4 As part of this process, financial institutions are evolving both nationally and internationally. For example, the most recent BIS triennial survey highlights that—in addition to the 70% surge in foreign exchange turnover in the 3 years to April 2007—the growth in transactions between banks and other financial institutions, such as hedge funds, was particularly strong (Galati and Heath, 2007). At the same time, this transformative impact of financial globalization is also changing the role of national institutions, not only in the economies of the industrialized countries.
The critical policy challenges associated with a more integrated financial system were most dramatically illustrated over the course of the turbulent weeks in October 2008 when policy makers around the globe were struggling to find national remedies for an unfolding global crisis. Indeed, the current financial market turmoil serves as a powerful reminder of an old institutionalist adage, namely that of the perennial challenge of adapting institutions, which are themselves the products of past processes, to the requirements of present conditions (Knight, 2006).
Globalization has not only lead to a closer integration of financial markets and transformed financial institutions but also the nature of financial transactions themselves is another critical way in which the financial systems in national economies have come to differ. In this context, financial systems can be classified by focusing on the degree to which financial transactions are conducted on the basis of a direct banking relationship between a bank and its customer or a system where the majority of transactions are conducted at ‘arm's-length’.5 The IMF (2006) highlights that—over last decade or so—increasing financial innovation has been a key contributing factor in the general trend towards more arm's-length financial systems in industrialized countries. While national differences persist, the changing nature of financial system has altered the mechanics of the transmission mechanism, for the factors could undermine financial stability.
Indeed, Lipsky (2008d) and other recent research from the IMF (2008c) suggest that the nature of the financial system plays a critical role in the propagation of financial shocks to economic activity. In particular, this work provides substantial evidence of procyclical leverage by commercial banks in arm's-length financial systems compared to relationship-based systems. This may explain a large part in the local differences in spillovers from financial crisis to the real economy.
The uneven world of global finance
With financial globalization now a well-established fact, questions about the spatial impacts of this process have become the focus of a significant amount of research activity. At the centre of this research is the question of whether the impacts of financial globalization are evenly spread out across space. Perhaps unsurprisingly, there is an increasing body of evidence on the substantial regional differences in the ways and to the extent in which the process of globalization has had local effects. Most notably, there is growing support for the notion of regional clustering in the context of regional financial activity.
The rise of international banking centres is a topic that has received a lot of recent attention from the perspective of the spatial concentration of regional financial activity. In addition to the traditional focus on agglomeration externalities within the financial services industry in a given location, more recent work concentrates on the spatial position of such centres relative to other locations from a network perspective. Focusing on cities as loci for economic, political, social and cultural globalizations, Taylor (2005) provides a taxonomy of leading world cities on the basis of an empirical analysis of interlocking networks. In the specific context of financial globalization, von Peter (2007) shows that—in addition to the more traditional indicator to financial activity—the prominence of an international banking centre also reflects cross-border linkages with other locations. His work illustrates that the largest global financial hubs are also the most important intermediaries.6
The central tendency of increasing concentration is also evident in other areas at the core of the global financial system: No more than 50 global financial institutions dominate global transactions in the main financial centres7; the largest five stock exchanges (New York, NASDAQ, Tokyo, London and Shanghai) account for almost two-thirds of the US$60 trillion in global stock market capitalization; there are only three major international central securities depositories (Euroclear, Clearstream and SegaInterSettle) carrying out the book entry transfer, clearing and settlement of global securities transactions and the vast majority of international inter-bank messages uses the same worldwide financial messaging network Society for Worldwide Interbank Financial Telecommunication. Large-value payment systems now play a key role in the global financial infrastructure by discharging payment obligations between banks and, dominated by VISA and MasterCard, there is less than a handful of global retail payment systems (CPSS, 2005). Overall, the world of financial activity is certainly becoming more spiky or curved, rather than flat—a view long held by Florida (2005) and recently refined by McCann (2008).
Regional disparities and clustering
While the financial integration of European economies is well documented, Karreman (2008) provides evidence of a distinct spatial order of financial geographies around several city clusters in Central and Eastern Europe. In stark contrast, Asia shows much less inward financial integration. Addressing the puzzle of little regional financial integration in Asia, Garcia-Herrero et al. (2008) highlight that the lack of financial market liquidity is one of the key reasons why Asian capital is predominantly invested in major financial centres, despite the geographic proximity and significant regional trade flows.
The persistence of such varying regional financial geographies may appear surprising when contrasted with the dramatic reduction in explicit barriers to international investment activity over the last 60 years. Stulz (2005) attributes these limits of globalization largely to regional differences in institutional characteristics and agents’ behavioural responses. However, as financial globalization intensifies, we can expect a further reduction in the importance of these phenomena over time. In particular, by opening borders, financial globalization provides means and incentives for corporate insiders to protect the rights of their minority investors more through better corporate governance.
The World Economic Forum's 2008 Financial Development Indicators provide a convenient and insightful way to summarize regional characteristics of financial globalization (WEF, 2008). The Financial Development Indicators comprehensively measure different aspects of the financial sector for a broad sample of 52 industrial and developing countries. The main index is formed on the foundation of seven conceptual pillars that cover different features of complex financial systems, namely the institutional environment; the business environment; financial stability; banks; non-banks and financial markets and their size, depth and access. In order to quantify spatial differences in financial development, I perform a hierarchical cluster analysis on the main principal components of the World Economic Forum's (WEF) seven financial development sub-indices. This enables me to identify the 10 types of clusters, which are displayed in Table 1.8
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The main intuition behind this approach of constructing a regional typology of global financial development is 2-fold. First, countries are clustered into groups that share similar features of financial development and, second, by examining the way in which these clusters vary, we obtain additional insights into the different economic dynamics that influence each region. Perhaps one of the most interesting results from this analysis is the evidence of regional financial integration among groups of clusters with several cores and peripheries. For example, the dendrogram in Table 1 suggests linkages between a G-7-based core with a periphery of emerging market economies (EME). Likewise, the financial integration of Asian economies with oil exporting countries is consistent with the corresponding evidence on trade flows. Financial interdependencies of the small open economies in the industrialized periphery, entrepôt economies and large emerging market economies also appear compatible with the prevailing patterns of economic exchange. Lastly, the financial development characteristics of small private banking centres like Switzerland and Singapore only display a limited amount of financial similarity (as measured by the WEF's Financial Development Indicators) with the rest of the world. Indeed, this multipolar view of the global financial system offers interesting parallels to a world-systems perspective.9
The regional variation in the financial development suggested by the Financial Development Indicators might also be reflected in diverging economic growth between these regions, suggesting a certain amount of decoupling of global business cycles. Recent evidence by Kose et al. (2008) actually confirms that, during the current period of globalization, there has been some convergence of the regional business cycles among both industrial and emerging market economies. This contrasts with the widely held belief of greater global cyclical interdependencies as countries appear to converge within groups, but diverge between those groups.10
Figure 1 reveals that the regional clusters that were formed on the basis of their similarities in financial development also display distinctly different growth characteristics of per capita GDP over the course of the last 25 years. Indeed, performing an empirical investigation of growth rates that accounts for the cluster differences, I find significant evidence for β-convergence in countries’ per capita incomes. Most notably, perhaps, my results suggest that there are important differences in the rate of convergence between clusters. Measured relative to the growth of the industrial core, the speed of convergence tends to be higher for those clusters that display lower levels of financial development. In addition, the cross-sectional dispersion of economic growth rates significantly falls from 1980 to 2004, which is consistent with 
-convergence.11 Not only are these growth dynamics largely consistent with the decoupling hypothesis of converging regional economic activity but they also strengthen the link between differences in regional financial systems and the corresponding cyclical behaviour of national economies.
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In the context of developing countries, Knight (1998) highlights that differences between the responses of competitive and imperfectly competitive banking sectors can cause them to affect economic activity differently. There are ‘gaps’ in the institutions and market structures of developing and transition economies and eliminating these gaps may reinforce the financial market discipline in these countries. These gaps are clearly visible in the bimodal distributions of the institutional and the business-related components of the WEF's Financial Development Indicators, which are illustrated in Figure 4.
The global regulatory challenge
The new realities of financial globalization pose unprecedented regulatory challenges that frequently call for ‘stronger and more effective international institutions as a way of monitoring the activities of multinational financial institutions’ (Moshirian, 2008, 2288). In an environment of globalized markets on the one hand and significant regional differences on the other hand, regulatory efforts need to emphasize the complementary roles of market discipline and official oversight. At the same time, a successful global framework for financial regulation needs to be able to accommodate the varying degrees of financial ‘glocalisation’, i.e. the specific mix of global, homogenizing trends and local, heterogeneous characteristics. Such efforts ought to recognize that countries with their diverse national institutional histories and legal systems provide the central building blocks for the globalized financial system.
Although drafted more than three quarters of a century ago, the BIS Statutes have lost none of their relevance for the process of fostering a stable global financial system. Strengthening both monetary and financial stability is the traditional remit of central banks and other monetary agencies, but achieving these twin objectives may not be possible without the close co-operation of other regulatory and supervisory bodies.
In addition, the various components and players of the global financial system—namely the financial markets themselves, institutions and the associated infrastructure—may not all be subject to the same sources of concern and threats. This requires different policy approaches and measures in order to achieve the stability of the financial system as a whole. Because the stability of the financial system depends so critically on the institutions, structures and governance arrangements that comprise it, continued policy co-ordination and co-operation is paramount. The Basel Process plays the central role in providing the necessary policy framework. Operating at various levels, it is explicitly designed to strengthen the stability and resilience of the global financial system. The precise inner workings and the individual institutional elements of the Basel Process are examined more closely in the next section. Before looking at what is essentially a policy response to the threat of financial instability, however, I need to examine the actual policy challenge itself, i.e. the advancement of financial stability.
Promoting monetary and financial stability
Promoting both monetary and financial stability are key policy goals for national authorities, and—despite the increasing interlinkages of globalized financial markets—the implementation of these goals still rests almost exclusively with national institutions. The current financial crisis is a powerful reminder of the increasing difficulties to obtain these objectives without co-ordinated efforts at the supranational level. Such co-ordination, however, presupposes some degree of consensus about the relative definitions and potential trade-offs between monetary and financial stability. While there is broad agreement on the definition of the former, this is much less the case for the latter.
Consensus with regard to the definition of monetary stability has emerged over the last 10 years and permits various notions ranging from stability of the (anticipated) value of money to price-level stability or even low levels of inflation. Indeed, there is also broad agreement that monetary stability is a vital ingredient for sustainable economic growth, that there is unique institutional responsibility for it (i.e. the central bank) and that the authorities need to be engaged in continuous efforts to achieve it. The story for financial stability, however, is somewhat different; there is a much broader spectrum of definitions and consensus only seems to exist in so far as financial stability is deemed a ‘good thing’ and that it is mostly noticed by its absence.12
Broadly speaking, one can distinguish between a systems approach—primarily linking financial stability to a well-functioning financial system—and a more narrow definition relating to the (excess) volatility of an observable financial variable, such as asset price volatility or interest rate smoothness.13 The debate around finding a suitable definition is more than a semantic one, particularly since any given definition predetermines the role assigned to monetary policy in contributing to financial stability.
From a historic perspective, one can broadly distinguish between three types of financial instability. First, there is volatility-based instability, such as the crises of the European Exchange Rate Mechanism in the 1980s and 1990s, the 1987 stock market crash, the 1994 emerging market bond market instability, the 1998 Russian default, the Argentinean default in 2001 and most recently, the US sub-prime crisis that started in 2007. A second type of instability is stress-based instability, which is often triggered by the default of an individual institution. This type of instability commonly sees severe market disturbances where operational problems can trigger cross-border contagion. Instances of stress-based instability include the insolvency of Credit-Anstalt in 1931, the collapse of Bankhaus Herstatt in 1974, the folding of the Bank of Credit and Commerce International in 1991, the Barings scandal in 1995, the failure of Long-Term Capital Management in 1998 and the most recent string of institutional failures, from Northern Rock to Bear Stearns, Lehman Brothers and the American International Group (AIG). Lastly, there are instances of crisis-based financial instability that are largely characterized by a triggering development that originates in the real economy or the financial system. Costly bank insolvencies and major adjustments in the level of asset prices tend to follow. During this type of financial instability, there is often a very strong (reinforcing) interaction between the financial sector and the real economy, with strong contagion effects both domestically and internationally. Aside from the Great Depression, the Scandinavian banking crisis in the late 1980s, the bursting of the Japanese asset bubble in the 1990s, the Mexican crisis (1994–95) and the Asian financial crisis all fall into this crisis.
While no episode of financial upheaval neatly fits into any one of the three categories, a classification can be informative for policy purposes. The current global financial crisis is an important case in point; what started as distant volatility rumblings of market-based financial instability in the sub-prime market in mid-2007 has snowballed into a fully blown global crisis with major financial instability across several market and institutional segments.
In addition to classifying the nature of potential financial instability, policy makers are concentrating a significant portion of their efforts on the early identification of the latent threats to financial stability. For what follows, it is useful to identify the following sources of financial instability:
- Changes to the scope of the existing regulatory and supervisory framework, i.e. a shift in the ‘the perimeter of regulation’ due to deregulation or financial innovation.14
- Globalization and financial integration have created a larger financial sphere, which is simultaneously characterized by more competition, consolidation and increasing concentration.
- Idiosyncratic and systemic risks, such as liquidity squeezes and excessive leverage that form over the course of credit cycles.
From the perspective of the policy makers, however, it is clear that some of the elements that might potentially harbour a threat to financial stability are actually very desirable for achieving the goal of monetary stability. Financial innovation, e.g. has been key to making the transmission mechanism for monetary policy more effective. This apparent contradiction raises the question of a latent trade-off between monetary and financial stability and is explored in more detail in Bieri (2008).
The institutional responsibilities for financial stability are traditionally shared across different institutions, namely finance ministries, the central bank and regulators. While clearly defined accountabilities for each of the institutions involved is a sine qua non, the actual goal of financial stability can only be brought about by an effective co-ordination of these efforts. This is the role of the Basel Process.
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Regulatory co-operation via the Basel Process |
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In light of the increasing globalization of financial markets in the post-Bretton Woods era, central banks and regulatory authorities have recognized the growing need for a central vehicle for co-ordinating their efforts. With their various regulatory and supervisory initiatives and by providing the institutional building blocks, the Basel-based committees form the natural home for such a global co-ordination exercise. Collectively, this interaction of the committees and their working groups is referred to as the Basel Process. As such, it encompasses a global framework aimed at harmonizing regulatory and supervisory processes and standards. As a complement to this section, I recommend to the interested reader a very comprehensive guide by Davies and Green (2008) that covers the inner workings of the international regulatory system in a level of detail that is well beyond the scope of what is possible here.
Figure 2 gives a schematic overview of the specialized division of labour between the various committees and regulatory bodies that are involved in the Basel Process. This chart highlights that although the global financial system is increasingly interlinked, much of the international regulatory system still operates on a sectoral level. While this dichotomy is ever more problematic, the Basel Process provides a unique institutional framework for future regulatory and supervisory co-coordination. Before looking at the distinctive characteristics of this arrangement in more detail, the key building blocks of the Basel Process are described first.
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Permanent committees hosted at the BIS, originally established by the G10 central banks. The BCBS, CGFS and CPSS are relatively autonomous from the BIS with regard to setting their agendas and activities. 
Including the Markets Committee (formerly the Gold and Foreign Exchange Committee). 
Handles the secretariat functions for the Central Bank Counterfeit Deterrence Group. *Independent organizations whose secretariats are hosted by the BIS, but do not directly report to the BIS or its member central banks. Source: Author's illustration.Components of the Basel Process
The Basel-based committees represent the main components that are at the very centre of the Basel Process. The Basel Committee on Banking Supervision (BCBS), established by the G10 central banks in 1974, deals with the activities of commercial banks. It is this committee (including its roughly 30 technical working groups) that is responsible for what is undoubtedly the most prominent recent initiatives arising out of the Basel Process, namely the new capital adequacy framework, commonly referred to as Basel II (BCBS, 2004).
The Markets Committee together with the Committee on the Global Financial System (CGFS), established in 1963 and 1971, respectively, broadly cover issues related to the functioning of foreign exchange and related financial markets.15 While both committees focus on recent financial market developments, possible future trends and considerations of the short-run implications of particular current events, discussions in the Markets Committee are informal and are not released to the public. Discussions and deliberations in the CGFS, on the other hand, are conducted with a view to formulate appropriate policy recommendations for central banks. The topics monitored by the CGFS are also often referred to as ‘macroprudential issues’.16
The Committee on Payment and Settlement Systems (CPSS), established in 1990, focuses on market infrastructure issues and therefore monitors and analyses developments in domestic and cross-border payment, settlement and clearing systems. The International Association of Insurance Supervisors (IAIS) was established in 1994 and deals with various aspects of insurance companies. Since 2002, the BIS is also hosting the International Association of Deposit Insurers (IADI), which promotes the international co-operation among deposit insurers and other institutions.
In combination, the activities of the BCBS, the IADI and the IADI thus encompass the institutional aspects of the core of the global financial system. Yet, despite their different reporting structures and individual constituencies, their embeddedness in the Basel Process facilitates the collaboration and co-ordination between these entities.17
The increasing deregulation, liberalization and globalization of financial markets of the past two decades led to an increasing erosion of the dividing lines between banks, securities companies and insurance companies. As a result, closer co-operation between the regulatory and supervisory bodies dealing with the specific segments of the market became a pressing priority. In response to this challenge, the International Organisation of Securities Commissions became involved more actively in the Basel Process with the explicit aim of staying in closer contact with the BCBS and IAIS. In 1996, a Joint Forum of these three committees was established.
Progressing globalization also called for closer co-operation between those elements of the Basel Process that are responsible for the overall functioning and stability of the financial system. This has lead to a strengthening of ties of the CGFS and the CPSS with the other committees, respectively, monitoring macro and micro aspects of the infrastructure of the international financial system. In addition, the BIS and the BCBS jointly established the Financial Stability Institute (FSI) in order to promote co-operation among supervisors, primarily through sharing experiences in workshops and seminars. The main priority in the FSI's mission is to promote sound supervisory standards and practices globally and to support full implementation of these standards in all countries. The FSI thus fulfils a less high-profile, but crucial role in the Basel Process in so far as it provides a global platform for the dissemination of supervisory standards and practices. Furthermore, it is an important forum for agencies from ‘peripheral’ countries to interact with the G10-based core of the BCBS.
As the convergence of global regulatory and supervisory best practices continued throughout the 1990s, the need for more co-ordination and co-operation also became more apparent at the level of various other international standard-setting bodies and the institutions entrusted with monitoring these standards, primarily the IMF and the World Bank. In 1999, the establishment of a more comprehensive framework for co-ordinating these efforts was placed under the umbrella of the Financial Stability Forum (FSF), which hosts its secretariat at the BIS, but is operationally independent from the BIS and only reports to its members.
The FSF is the main international body orchestrating financial stability efforts, bringing together national financial authorities, international financial institutions, international regulatory and supervisory groupings as well as committees of central bank experts. As illustrated in Figure 2, the FSF thus represents the highest level in the hierarchy of the Basel Process, co-ordinating the efforts of these various bodies in order to promote international financial stability, to improve the functioning of markets and to reduce overall systemic risk. In contrast to the lower level core of the Basel Process, however, the FSF solely acts in a co-ordinating function and is not actively involved in policy co-operation and implementation. The FSF's architectural blueprint for the global international financial system designates three broad areas as key for sound financial systems which deserve of priority implementation, depending on individual countries’ circumstances; these areas are shown in Figure 3 as the pillars that constitute the basis of sound financial systems.
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The increasing speed of financial innovations and stronger global linkages between markets has called for the closer co-operation of the various components of the Basel Process at different levels and intensities. The distinctive character of this arrangement as an institutional response to financial globalization is now discussed in more detail.
Unique characteristics of the Basel Process
Comprehensiveness
Since its foundation, the BIS—and with it the Basel Process—has continuously adapted to the changing circumstances of the global financial system. As financial globalization intensified in the 1990s, the BIS shifted some attention from the industrial core to leading emerging market economies and enlarged its membership significantly, institution, the BIS has managed to achieve global relevance, without being encumbered by the administrative burdens of universal membership. Yet, while member countries play a key role in the activities of the Basel Process, non-member countries and other international organizations are actively participating in many of the elements of the Basel Process.
The Basel Process also actively supports the dialogue private sector on a range of regulatory issues at a global and regional level. Senior representatives from industry organizations, such as the Institute of International Finance, are regularly invited to participate in the various stages of the consultation process. In the specific context of regulation and supervision, the Basel Process reflects the diversity of approaches of its participating members, drawing upon the four main approaches to financial supervision currently employed around the world (institutional, functional, integrated and twin peaks).18
Regional inclusiveness
Despite its global focus, the Basel Process is able to incorporate regional elements without necessitating separate regional channels for co-operation. This does not, however, imply that the ‘glocal scope’ of the Basel Process diminishes all needs for regional efforts of regulatory harmonization. Analogous with the principle of decentralizing the provision of local public goods in a system of fiscal federalism, such regional efforts remain important complements to the overall objective of furthering global financial stability for which the Basel Process is the locus. For instance, the Committee of European Banking Supervisors promotes co-operation and convergence of supervisory practice across the European Union, yet at the same time, its national members are participating in global initiatives via the Basel Process. Similarly, a wide-ranging treatment of the various aspects of regional harmonization, particularly in Asia, and the Basel Process is provided by Yoshikuni (2002).
Flexibility and scalability
Given the complexity and linkages between the various relevant topics that form the area of competence of the Basel-based committees, successful international co-operation is only possible as long as there exists a clear division of labour between the individual committees and their secretariats. At the same time, the Basel Process has remained sufficiently flexible to respond in a timely manner to new global financial challenges. Regular meetings at either the committee level or working group level form the main mechanism that drives this process. The meeting structure of the Basel Process is unique in its own right, spanning the full range of organizational hierarchies of its participating institutions; from the consultations among senior policy makers to the meetings of technical experts and the exchange of best practices among practitioners.
However, a common criticism levelled at meeting-based efforts driven by other international bodies is that such processes are overly bureaucratic and cumbersome. Furthermore, it is often argued that such committees lack a free and open exchange of views and discussions, not at least because of an alleged heavy influence through the opinions and beliefs of the organizing body. The informal nature of the Basel Process avoids many of these pitfalls, despite a considerable amount of ‘behind-the-scenes activities’.19
With many of the key issues pertaining to the stability of the global financial system becoming increasingly integrated across markets, participants and borders, the diligent co-ordination of activities among the committees is of paramount importance. In this vein Yoshikuni (2002, 5) summarizes the function of the Basel Process as one of
[... providing] the international financial community with the opportunity to explore good governance in various regulatory and supervisory issues in forums that allow a frank exchange of views with the support of highly sophisticated analysis.
The approach of the Basel Process has also found its successful applications at a regional scale. Most notably, perhaps, in the European Union where the development of financial service industry regulations was guided by the so-called Lamfalussy Process—a ‘regionalized version’ of the Basel Process—named after Baron Alexandre Lamfalussy who was General Manager of the BIS from 1985 to 1993.
Network elements of the Basel Process
Recent studies on the formation of social capital highlight the importance of network effects in the transmission of knowledge spillovers (Agrawal et al., 2008). In this context, the Basel Process plays a little-discussed, but vital role in the formation of ‘regulatory human capital’ by representing a vast network of contacts across institutions and markets within the global financial system. Many of secretariat members of the Basel-based committees and the FSF are officials on fixed-term assignments from their national institutions. Over the course of their careers, they usually rotate their positions across several institutional components of the Basel Process. Indeed, Volker and Ferguson (2008) emphasize that strong leadership and high-quality people can offset some degree of impediments and deficiencies that stem from non-optimal regulatory structures.20
In combination, its comprehensiveness, inclusiveness, flexibility and the network externalities render the Basel Process a unique framework for effective global policy co-operation.
Basel II as a model for global co-operation
The new capital adequacy framework, commonly referred to as Basel II (BCBS, 2004), represents the most prominent of the recent initiatives arising out of the Basel Process. After almost 4 years of intense consultation, Basel II was endorsed by central bank governors and the heads of bank supervisory authorities of the G10 in June 2004. Himino (2004) offers a comprehensive overview of the Basel II framework, arguing that it provides a common language that improves communication about risk exposures among banks, supervisors and investors.
Without a doubt, the development of such common language is one of the most important tributes to the functioning of the Basel Process. In this context, the Quantitative Impact Studies (QIS) are perhaps the best case in point and stand out as a practical example of the actual mechanics of this consultation process. In line with the Basel Process's overall philosophy as an ongoing progression of policy co-operation, the QIS did not end after the release of the Basel II Framework. Recently, member countries conducted QIS 4 on a national level and then QIS 5, which represents the latest, high-quality data impact calibration exercise including data from 382 banks in 32 countries (BCBS, 2006b).21
The road to Basel II thus serves as important evidence of how well the Basel Process works and provides a suitable process template for other global policy co-ordination efforts, well beyond the realm of regulation and supervision. Indeed, Tarullo (2008, 197) stresses that
[...] the very novelty of Basel II also makes is an experiment of considerable interest in addressing challenges in regulating other forms of international activity or considering alternatives to trade arrangements as mechanisms to reducing barriers to international trade and investment.
Perhaps because of its exemplary role as an international arrangement, recent discussions about possible regulatory failures in the context of the current financial crisis have consistently singled-out specific shortcomings in Basel II.22 While such a debate is far too narrow in focus given the extent of the crisis and the need for reform, I will address some of these criticisms when addressing global and regional regulatory policy issues in the penultimate section.
Aside from the capital accord, the Basel Process has served as the core infrastructure to facilitate the creation of international standards and best practices such as the 25 Core Principles for Effective Banking Supervision (BCBS, 1997, 2006a).23 The IADI's 2008 release of its Core Principles for Effective Deposit Insurance System provides another example of regulatory output that followed the Basel Process model for global co-operation. Beyond simply developing guidance on deposit insurance issues, the IADI Core Principles are an important complement to the BCSB counterpart, drawing ‘heavily on the practical experience of its members, associates and observers’ (IADI, 2008, 3), namely the FSF and the BCBS itself.
Evolution, co-operation and accountability
The influence of market participants has rendered the Basel Process more transparent and market oriented. The inclusion of this new element into the process is probably best illustrated in the context of Basel II with the decision to allow banks to use their internal models to assess risks. This represents a very significant shift to a market-based, market-defined, approach to financial regulation. While the proponents of this change emphasize the benefits through the aspect of market discipline, there are some concerns about the (democratic) accountability deficit of such developments.24
As the political geography of the world is still more or less organized around the building block of the nation state, central banks and other institutions involved in the Basel Process are inevitably going to be held accountable by the citizens of their nation states, even if their nature is not directly susceptible to democratic pressure. While BIS and its central bank members have engaged in several initiatives to improve the transparency of decision-making processes, the Basel Process might not always be considered ‘accountable’ in the ways citizens might want.25 For example, Kane (2007a,b) argues that participants in the BCBS process lacked sufficient democratic accountability to reconcile the fundamental conflicts between bank, regulator and societal interests that arise in efforts to connect national safety nets. Referring to ‘gaps in the cross-country regulatory contract’, he explains how national differences in regulatory accountability made gaps in the cross-country deal more easily tolerated in other BCBS countries than in the USA.
More prominently, the Lamfalussy Process has incurred considerable public criticism as it allows some elements of bypassing accountable oversight by the Council of the European Union and the elected European Parliament. This echoes similar concerns by Robinson (2002) who argues that the international framework for governing globalization lacks accountability and is undemocratic, thus largely embodying a move away from representative, participatory democracy towards a state of technocratic governance.
Despite the fact that financial globalization has created rising interdependencies between institutions, markets and infrastructure and the co-operative efforts of the Basel Process in response, there remains a good deal of local and sectoral fragmentation in the international regulatory system. The next section explores some of the spatial aspects of regulatory arrangements in the global financial system and investigate to what extent these regional disparities are linked to geography and institutions.
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The geography of regulation |
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Starting with Acemoglu et al. (2001), there is a significant strand of literature that pays renewed attention to the link between institutional arrangements and economic performance. For example, Bosker and Garretsen (2006) show the importance of relative geography and provide empirical evidence for how the spatial linkages between countries matter for a country's per capita GDP. In one of the few studies that look at these effects at the sub-national level, Clifton and Romero-Barrutieta (2006) find that both geography and institutions are very important for economic development, having significant effects that can last hundreds of years. Unsurprisingly, Roubini (2008) confirms that the level of financial development increases with GDP. This raises the question regarding the qualitative nature of the interaction between regional financial stability and local institutions in the ‘production process of financial development’.
Regional regulation and the ‘production of financial development’
The two panels in Figure 4 plot estimates of the distributions of the sub-indices of the WEF's Financial Development Indicators, which highlight important differences in the input–output characteristics of such a ‘production of financial development’. The indices in the left panel represent the regulatory and institutional inputs, which support financial intermediation and the optimal provision of financial services. The indices in the right panel, by contrast, measure the ‘variety, size, depth, and efficiency of the financial intermediaries and markets that provide financial services’26 and the size and depth of the financial system which is the resulting output of financial intermediation.
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One of the most striking aspects of these plots is the well-defined distributional differences for individual indicators. In particular, the distributions for the indices that capture the quality of institutions, the business environment and the measure for capital availability and access are distinctly bimodal.27 In terms of the clusters identified in ‘Regional disparities and clustering’ above, closer inspection reveals that these modes primarily encompass the emerging market economies at the lower end of the distribution and industrialized countries at the higher end.
Despite such modal clustering due to regional differences, the left panel reveals that there are important similarities in the distribution of financial development inputs. These quantities incorporate measures for the regulatory and supervisory environment, the degree of financial sector liberalization, availability of human capital and the quality of the technological infrastructure. In contrast, however, neither the components of the ‘intermediation production function’ nor the intermediation output itself show similar distributional resemblances.28
One compelling interpretation of these input–output differences of financial development is to view them as diverging, yet related outcomes of (financial) globalization. Specifically, the increased global co-ordination efforts among policy makers through initiatives such as the Basel Process have tightened the relationships between financial development inputs. At the same time, however, the regional variation in the production process of financial intermediation is another upshot of the same globalization phenomenon. Indeed, Cox (2008) argues that geographically uneven development is a necessary outcome of the global accumulation process. The significant distributional differences of banks, other financial institutions and markets thus characterize a new international division of labour in financial intermediation. In this sense, policy makers’ actions might be viewed as ‘leaning against the wind’ of vertical displacement in an attempt to prevent a further weakening of the state due to globalization.
Because the ongoing financial globalization increases the interdependence of national financial systems, substantial quality differences can lead to contagion and cross-border spillovers in times of crisis. However, input-based measures of regulation—such as the sub-indices of the WEF's Financial Development Indicators—might only provide an incomplete picture of the actual differences in the quality of regulation across regions. While Basel Process-based harmonization and co-ordination efforts undoubtedly lead to an increased adoption of regulatory and supervisory best practice around the globe, this does not necessarily imply that local compliance with such standards is up to par.29 In an insightful recent study, Cihák and Tieman (2008) derive an output-based measure of regulatory quality when assessing countries’ practical implementation of regulation and supervision. Their paper uses data from the IMF–World Bank assessments of local compliance with the series international standards and codes that form the three pillars of financial stability as illustrated in Figure 3.
Using this dataset, I calculate the regional variations in the quality differences with regard to pillars two (regulation and supervision) and three (institutions and infrastructure) across the three main financial sectors (banking, insurance and securities). Figure 5 bears witness to some of the striking regional differences in the actual quality of the regulatory and institutional fabric. Regional variation aside, it is remarkable that, on average, countries’ indicators for sound financial systems score significantly below full compliance with the standards. There is also significant variation of compliance across sectors, with some notable disparities between pillars two and three; e.g. the average quality of regulation is highest in the banking sector, yet the institutional quality of the banking sector scores lower than that for insurance and securities.
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Furthermore, there are sizable differences in the regulatory quality across regions, only some of which can be explained by differences in economic development. It might therefore be erroneous to conclude that higher levels of economic activity lead to financial systems that are superior with regard to their financial stability. Cihák and Tieman (2008) caution against such inference by stressing that higher income countries have more complex financial systems where non-compliance with standards may be much more problematic from a systemic perspective. The current financial crisis lends further clout to this argument, since—in contrast to previous crises—its epicentre is not at the periphery of the global financial system, but at its very core.
Geography and financial integration
The previous sections have highlighted the close link between institutional quality and local financial stability. However, it is also clear that significant regional differences persist despite the homogenizing forces of globalization and that—perhaps more importantly—the transmission mechanism from regulation to financial stability depends on the level of economic development. This empirical relationship is illustrated clearly in the left panel of Figure 6.30 The relationship between regulation as proxied by the institutional environment and financial stability tightens for the more developed economies, which—in terms of the clusters identified earlier—includes the industrial core, the developed periphery and the private banking hubs. Since the more developed countries are more integrated in the global economy, the quality of financial stability can thus be interpreted as an indicator of a country's level of integration into the global economy. In other words, we may interpret financial stability as a measure of a country's distance or ‘remoteness’ within the global financial system. Thus, the higher the financial stability in a given country, the more globalized or integrated is its financial sector.
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The impact of a country's relative geography, or remoteness, within the global financial system on its macroeconomic growth was studied by Rose and Spiegel (2008). They showed that countries that are further from major locations of international financial activity systematically experience more volatile growth rates in both output and consumption, even after accounting for political institutions, trade and other controls. However, there are two additional elements that need to be taken into consideration in this context. First, while there is ample evidence that a country's macroeconomic vulnerability depends on its trade openness, swings in economic growth also critically depend on ‘how differences in financial systems affect macroeconomic behaviour’ (IMF, 2006, 103). Second, their analysis does not account for the fact that there is significant variation in the regional levels of financial integration, as measured by the prevailing quality of financial stability.31
Using the Rose and Spiegel (2008) data set, I address the first issue, i.e. accounting for how the transmission mechanism of financial systems affects economic cycles, by adding the WEF's Financial Development Indicator measure of financial stability to their empirical framework. Equation (1) presents the modified regression set up for the Rose–Spiegel estimation.
 | (1) |
The results from the ordinary least squares (OLS) estimation of Equation (1) are displayed in Column 1 of Table 2. With the exception of the coefficient on the government expenditure to GDP ratio, all parameter estimates are significant. While this confirms the Rose–Spiegel findings for a smaller sample (i.e. those countries covered by the WEF's Financial Development Indicators), the key parameter of interest on financial stability not only is highly significant but also displays the expected sign. This suggests that the original Rose–Spiegel parameter estimates might suffer from omitted variable bias, since the quality of financial stability has a statistically relevant impact in reducing a county's macroeconomic vulnerability.
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However, given the large amount of clustering and regional disparities in the level of financial development identified earlier, it might be misleading to use regression techniques that focus on the ‘average effect for the average county’. Using a quantile regression approach instead, I observe that financial stability and the other drivers identified by the Rose–Spiegel analysis are of crucial importance for a handful of highly globalized countries.32 At the same time, the same measures of integration and remoteness do not seem to matter for the volatility of output for countries at the fringes of the financial systems. The results of the parameter estimates for the 10%, 25%, 50%, 75%, and 90% quantiles are reported in Columns 2–6 in Table 2.
The quantile regression results for the impact on financial stability on macroeconomic vulnerability are displayed in the right panel of Figure 6. The OLS estimates are presented as horizontal lines, together with their confidence intervals. It is clear that the Rose–Spiegel style OLS estimates do not tell the whole story. The quantile regression curves show that the value of the estimated coefficient on financial stability varies over the conditional GDP volatility distribution. In contrast to when the quantile regression solution is evaluated at the median country (i.e. at the 50% quantile), financial stability does not appear to have a significant influence on the variability of output at low quantiles. However, for those countries with high output volatility at the upper quantiles, the coefficient on financial stability rises sharply, which suggests a stronger transmission mechanism between the financial system and the real economy. In other words, the coefficient on financial stability can be interpreted as a measure for how strongly a country is integrated in the global economy via its financial markets. Thus, as the global financial system becomes more integrated as a whole, there is more risk of contagion and a greater propagation of financial shock across markets. As a consequence, the macroeconomic ripple effects of a crisis are felt most in those countries with more powerful links between their financial sector and the goods sector of the economy.
Although the above analysis is not able to address questions about the precise cyclical interaction between regulation, financial stability and the level of integration in the global financial system, there is ample evidence that regional differences in geography and institutions still play an important role despite global trends. Recognizing the continued importance of both local and global processes that characterize the landscape of the global financial system, the next section looks at some of the potential ‘glocalization’ tensions that this might entail from a regulatory perspective.
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Financial stability in the age of turbulence |
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Similar to its monetary equivalent, achieving financial stability is not a one-off effort, but rather a continuous quest by the various bodies involved in the process. In this context, the identification of potential threats is a key ingredient for a consistent strengthening of the stability of both national and global financial systems, the boundaries of which have become increasingly blurred due to increasing inter-market linkages. Put differently, the separation between national and global aspects of financial stability look increasingly artificial, not at least because of the incessant threat of contagion.
Furthermore, financial innovation has facilitated the sidestepping of national regulation and increased information asymmetries between market participants and regulators. There is increasing consensus that important gaps in the regulatory boundaries present the most imminent impediment to restoring global financial stability (Lipsky, 2008b).
Current threats to financial stability
In his timely and very aptly entitled memoirs-cum-economic treatise, Alan Greenspan, the former Chairman of the Federal Reserve, offers three rules of thumb as guidance for the (re)design of regulation in a globalized financial system (Greenspan, 2007, 374–375). First, ‘regulation approved in a crisis must be subsequently fine-tuned’. Second, ‘sometimes several regulators are better than one’, and lastly, ‘regulations outlive their usefulness and should be renewed periodically’. Given his own active involvement in the Basel Process during his time at the Federal Reserve, it should not come as a surprise that Greenspan's recommendations are mirrored by a number of issues that are on the radar screens of the different bodies involved in the Basel Process. These include, but are certainly not limited to, the following themes.
Resilience of financial markets and institutions.
As historically low global growth rates lead to sharp corrections in market valuations, the balance sheets of many financial institutions are exposed to immense strain (skyrocketing default rates, collapsing equity markets and widening credit spreads). While financial imbalances have been building up for some time, there is ample evidence that markets perceived the system as stable and improving only until shortly before the recent meltdown. This raises several questions; why was the significant upsurge of systemic risk not reflected in market prices prior to the current crisis? Could there be a threat to future financial resilience, if the macro environment does not improve further?
Excess global liquidity.
Accommodative monetary policy in many industrial economies has supported a revival of the global economy after several major adverse shocks. However, the associated strong growth in liquidity has raised some concern, including accelerated inflation, financial imbalances and spillovers from the G-3 to other smaller economies.
Concentration risk.
Advances in financial innovation have lead to a redistribution of risks within the global economy. Recent events in the collateralised debt obligations have highlighted that new financial instruments can lead to a concentration, rather than a diversification of risks among market participants. Perhaps one of the most troublesome regulatory aspects of current crisis is that policy makers in many countries have addressed the problem of concentration risk in financial markets by actively promoting still more concentration among financial institutions. Encouraging healthy banks to takeover unhealthy ones is part of the market-based solution. Yet, while Salin (1963) reminds us that monopolies are a priori neither good or bad, policy makers are curiously silent about future possible consequences of this crisis-induced, government-approved consolidation of the banking industry.
Lender of the last resort.
As excessive lending eventually leads to a state of over-indebtedness during most credit cycles, even a relatively modest economic downturn can trigger the unravelling of the financial system as insolvent institutions mark the start of an incipient banking crisis. The monetary authorities would now traditionally act as lender of the last resort (LOLR) in propping up the banking system and prevent the credit markets from seizing up by injecting substantial liquidity into the system. While this aspect of the LOLR function is no different in the current crisis, the rapid changes in the financial markets due to innovation have changed the institutional requirements for the global financial system. This is particularly true with regard to the role of the central bank as LOLR in the context of risks that are emanating from non-bank institutions (e.g. insurance companies or hedge funds).
As the current financial market crisis continues to unravel, some of these themes will gain increased urgency and others might have to be re-prioritized by policy makers. The co-ordination of such actions and dialogue is precisely one of the institutional strengths of the Basel Process.
As highlighted above, Basel II—one of the most visible regulatory outputs of the Basel Process in recent years—has come under (renewed) intense scrutiny over the last few months. The next section briefly looks at what the financial upheavals in the US sub-prime market could imply for the Basel Process and for the supervisory and regulatory aspects of the international financial architecture as a whole. What lessons can be learnt? Did international standards, like Basel II, actually aggravate the situation, or even provoke it? For instance, the recent dislocations in the credit markets are lending new support to the argument that value-at-risk (VaR) measures based on fair value accounting tend to increased correlations across markets during a financial crisis.33
Basel II and the current financial markets crisis
In the context of the current financial market upheavals, the sub-prime-related multi-billion asset write-downs and credit losses of investments banks34 seem to confirm many of the long-standing concerns and criticism by some of the most vociferous critics of Basel II.
Daníelsson et al. (2001) argue that Basel II fails to address many of the current deficiencies and inconsistencies of the global regulatory system. They also maintain that Basel II is creating the potential for new sources of instability. In addition, Basel II fails to recognize that risk is endogenous and thus VaR-related risk measures can reinforce crises. In a similar vein, statistical models might be inconsistent and biased, thus frequently underestimating downside of risk. The current capital accord might also be problematic in its heavy reliance on credit rating agencies due to lack of regulation and unobservable risk estimates. This line of reasoning has gained renewed clout in the wake of the implosion of Lehman Brothers and the partial nationalization of AIG, which were arguably triggered by the announcement of impending changes to their ratings. Critics also argue that Basel II does not incorporate a meaningful definition of operational risk, let alone deal with the definition of adequate models and the identification of suitable data sources.
Finally, there is the argument that financial regulation is inherently procyclical. According to this view, the simultaneous adoption of a set of regulatory principles around the globe harmonizes investment decisions during a crisis and, as a consequence, regulation becomes destabilizing instead of stabilizing. Basel II, so the argument, increases this tendency significantly, which in turn increases the risk of a systemic financial crisis and thus financial instability. In a related contention, Daníelsson (2002) emphasizes that since market data are endogenous to market behaviour, statistical analysis made in times of stability does not provide much guidance in times of crisis. For regulatory use such as Basel II, the model and market-price risk measures may give misleading information about risk, and in some cases may actually increase both idiosyncratic and systemic risk.
Policy makers, however, are far from putting the blame for current regulatory failures on Basel II, but rather point to the ‘Balkanisation of regulation’ (Knight, 2008). It is thus the institutional fragmentation across market segments and the fragmentation across national jurisdictions within a globalized financial system that regulators and supervisors identify as the main culprit for the current crisis. There has been a different treatment of on- and off-balance sheet assets in much of historic regulation. Thus, the goal for future regulation should be a more consistent approach in this regard, ‘so [that] the same risks get treated in the same way irrespective of who is holding them’.35 If the implementation of Basel II had proceeded faster in the G10 countries, the banks that are at the core of the crisis would have had much less over-leveraging.
It is, of course, too early to gauge the precise impact of the current crisis on Basel II. Sound regulation is not static and—in keeping with Greenspan's third rule of thumb—the BCBS’ proposed revisions to the Basel II market risk framework will only be the first in a series of forthcoming adjustments. Basel II's significant reliance on the scores from credit ratings’ agencies is very likely to have to be reassessed. Another area that is likely to see revisions is Basel II's main thrust on solvency. This might be a fallacy of misplaced emphasis, since it ignores one of the golden rules of banking, namely that most banks fail because of a lack of liquidity, not (immediately) due a lack of capital (Goodhart, 2008b).
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Outlook |
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The rapid process of globalization in the post-Bretton Woods era has fundamentally changed the landscape of financial markets. Although financial globalization implies, by its very nature, increased interlinkages and co-dependencies between markets, institutions and infrastructure, the respective regional differences and specific characteristics will remain important elements in shaping local financial systems. The current financial crisis bears witness to this fact. The multilayered transformations of the geography of finance, including the innate ‘glocal’ tensions that arise from it, are posing significant challenges to policy makers both nationally and internationally. This bi-polar process is set to continue, even if—in times of crisis—some of the effects of globalization appear reversible. The global financial market place will become more curved and spiky, not flat.
For almost 80 years, the Basel Process has been playing a unique role in fostering global financial stability. The various committees engaged in this process provide a unique platform or forum for discussing and analysing current sources of concern or threats to stability. All of which—in isolation or combination with each other, both short term and longer term—need diligent monitoring and a close consideration of the appropriate steps in order to ensure further progress in the respective fields.
Anchored both globally and locally, the Basel Process seems a natural locus for a new paradigm of regulation and supervision that synthesizes the old geography of institutions with the new geography of global financial markets. The cornerstones of such a new approach are outlined in Borio (2003) and summarized in Table 3. Reflecting the importance of both global change and local impact, the objective of a macroprudential approach is to limit the risk of financial stability which might result in significant losses in terms of the real output. In contrast, the objective of the microprudential approach is to limit the risk of financial instability at individual institutions, regardless of their impact on the overall economy.
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However, given the historic proportions of the current financial crisis, what would be the lessons that can be drawn from such an approach? In view of the inherently procyclical nature of the global financial system, the BIS’ former economic adviser Bill White (2008) argues that financial turmoil such as the current episode is best contained through a ‘new macrofinancial stability framework’. Specifically, the primary characteristic of such a framework would be the focus on systemic developments, combined with even closer co-operation between central banker and regulators in monitoring the build-up of systemic risks.
The microprudential lesson of the current crisis is perhaps best illustrated using an analogy from Kashyap et al. (2008). Instead of attempting to write the most comprehensive fire code possible, some thought should be given to installing more sprinklers to put out local fires at the source. In the midst of the current financial crisis, however, it is clear that the global financial system needs both. The Basel Process as an institutional arrangement for global financial regulation and the IMF as a crisis intervention mechanism are both capable of dealing with the challenges of globalized financial markets.36 Yet, in order to function properly, both mechanisms need to rest on local institutional foundations. This also raises the issue of the treatment and resolution of cross-border failure in a world of national fiscal and legal competencies. While this problem is well understood, political appreciation and the will to act in a co-ordinated manner rather than a further rearrangement of the international regulatory framework seem most pressing.37
Some additional fundamental questions, however, remain. How do we reconcile the severity of the current market meltdown with the fact that—as Goodhart (2008a) puts it—‘almost every central bank which published a Financial Stability Review, and international financial institutions, such as the BIS and IMF, which did the same, had been pointing for some time prior to the middle of 2007 to a serious under-pricing of risk’?
Possible answers could be found in the work of Stigler (1971). One of the key contributions of his economics of regulation is the insight that regulation often induces changes in behaviour that go against the intended effects of the regulation. Worse still, progress can often hide the bad effects of regulation for a long time and ‘thereby immunize the regulation politically’ (Peltzman, 2007, 188). In the current context, one might argue that it was precisely the current regulatory framework that was responsible for creating behaviour that offsets some or all of the intended regulatory effects by providing incentives for regulatory capital arbitrage in the form of securitization. This off-setting behaviour then acted as the catalytic effect for the current financial crisis. Similarly, the criminalization of human error in the post-Enron environment has further encouraged the displacement of necessary risk taking to the fringes of the regulatory perimeter.
From a public finance perspective, financial stability is an important public good that traditionally has been produced and provided by national governments. Globalization, however, has brought about a partial shift in the optimal locus of production, since financial stability is no longer a fully spatially delineated public good. Nonetheless, location still matters in finance, despite new technology and deregulation and, as Hyman Minsky believed, ‘[...] economies evolve, and so, too, must economic policy’ (Summers et al., 1991).
In conclusion, the changing architecture of the global financial system might perhaps call for a reappraisal of financial Ordnungspolitik as pioneered by Eucken (1950). This implies a careful evaluation of balancing the need for a framework of globally co-ordinated, decentralized local regulation on the one hand and effective, centralized intervention mechanisms on the other hand. The first period of globalization gave birth to the Basel Process. The current period of globalization needs a prudent new arrangement of a redesigned architecture of the global financial system with the elements of the Basel Process equally active at its centre and its periphery. The end of geography in financial regulation is anything but imminent.
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Appendix A. Regional economic convergence |
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The great majority of empirical studies that analyse economic growth across countries make use of some version of the so-called convergence equation (e.g. Mankiw et al., 1992 or Sala-í-Martin, 2006). In its most general form, this empirical relationship can be written as
 | (2) |
i is a country- or cluster-specific effect. The estimates for β-convergence are summarized in Table A1.
Table A1. Estimating β-convergence across regional clusters, 1980–2004
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a A random-effects specification is chosen for the panel estimation on the basis of a Hausman test for the full model with cluster dummies where Probability > 
2 = 0.582. White’s (1980) heteroskedasticity corrected standard errors are reported in parentheses.
b The dummy coefficients indicate cluster-specific convergence differences relative to the industrial core cluster.
* Coefficients significant at the 10% level.
** Coefficients significant at the 5% level.
Source: Author's calculations.
The coefficient of the initial per capita income is negative and significant which is consistent with the standard convergence literature, such as Mankiw et al. (1992) or Bernanke and Gürkaynak (2001). Column 1 shows the simple benchmark specification of the cross-sectional convergence equation imposing full parameter homogeneity, whereas Column 2 introduces dummy variables for the clusters identified in Figure 1. Columns 3 and 4 report the results of a random-effects panel estimation of the growth convergence dynamics for the 25 years from 1980 to 2004.
The majority of the cluster dummy coefficients are significant which indicates that a given country's speed of convergence depends on its cluster membership. Most importantly, there is evidence that—with the exception of the private banking hubs—all other clusters exhibit per capita growth convergence rates that exceed those of the countries in the industrial core. A cluster's average level of financial development is indicated in Column 5 as a percentage of the industrial core cluster. There is a significant negative correlation of –0.811 between the speed of convergence and the relative level of financial development. The evidence for -convergence is based on the observation that the standard deviation of per capita growth decreased from 5.195% in 1980–85 to 3.861% in 2000–05.
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Appendix B. Financial development index data summary |
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Table B1. Correlations of Financial Development Indicators sub-index components
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Source: Author’s calculations from WEF (2008).
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Appendix C. Overview of the global regulatory structure |
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Table C1. List of entities related to the Basel Process
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IASC, International Accounting Standards Committee; IFAC, International Federation of Accountants.
a The location either indicates the seat of an organization’s headquarters, i.e. where its most important functions are concentrated, or the location of a committee’s permanent secretariat. The BIS Quarterly Review regularly provides an overview of the most recent activities of the Basel-based committees and the FSF. These activities are also reviewed in the BIS Annual Report, e.g. BIS (2008, 153–186).
b This term is used by the Joint Forum to denote ‘any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance).’ Source: Author's compilation.
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Acknowledgements |
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I would like to thank the editor, Harry Garretsen, and two anonymous referees for their helpful comments and valuable suggestions that led to a much improved version of this paper. The usual disclaimers apply.
The section on the Basel Process draws upon and extends my unpublished manuscript entitled ‘The Basel Process, financial stability and the age of turbulence’.
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Notes |
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1 Baldwin and Martin (1999) discuss the similarities and differences of the two waves of globalization. However, with regard to finance, Battilossi (2006) notes that the first wave was almost exclusively a European phenomenon.
2 Article 3, Statutes of the BIS (20 January 1930).
3 The BIS’ first half-century, from its founding in Basel in 1930 to the end of the Bretton Woods system, are the subject of a detailed, economic and historic account by Toniolo (2005).
4 See Bracke and Schmitz (2008) for recent evidence on how international equity holdings act as a risk-sharing device in industrial and emerging countries.
5 Generally, arm's-length financial systems rely heavily on prices as a transmission mechanism for information, competition and the enforcement of standardized legal contracts. Relationship-based financial systems, on the other hand, rely more on the direct exchange of information and enforcement mechanism between borrowers and lenders.
6 The likelihood that 1 US$ transferred between any country pair goes through the UK is highest (20%), followed by France, Switzerland, Germany and the USA (von Peter, 2007, 41).
7 In 2004, 75% of foreign exchange market transactions were conducted by only 11 banks in the USA and 16 banks captured 75% of the market in the UK (BIS, 2005, 8).
8 By construction, the WEF indicators are more suited to producing relative rankings rather than for a comparison of levels. However, the hierarchical clustering is only performed after reducing the dimensionality of the data by transforming it into its principal components, which should lessen this concern. The cross-sectional nature of the data further mitigates this issue in contrast to such an analysis in a time-series setting. See Roubini and Bilodeau (2008) for a detailed description of the index methodology and the seven sub-components of the WEF Financial Development Index.
9 Cf. Wallerstein (1983).
10 A seminal paper by Baumol (1986) gives rise to the vast strand of empirical growth literature that investigates regional ‘club convergence’. See Canova (2004) for a recent survey.
11 See Appendix A for a description of the methodology of the growth convergence analysis and for a detailed summary of the results.
12 One of the earliest definitions of financial stability is given by Bagehot (1873): ‘[It is ...] not a situation when the Bank of England is the only institution in which people have confidence.’ More recently, at the 1997 Jackson Hole Conference dedicated to ‘Maintaining Financial Stability in a Global Economy’, Crockett (1997) introduced the distinction between two types of financial instability: that of institutions and that of markets.
13 Mishkin (1992) offers a systems-based definition, describing a stable financial system as one which ensures ‘[...] without major disruptions an efficient allocation of savings to investment decisions’.
14 Senior IMF officials argue that the excessive risk taking by global financial actors outside this very perimeter lies at the origin of current crisis (Lipsky, 2008c).
15 Unlike the CGFS, the Markets Committee does not have a formal policy mandate from the G10 governors. It mainly serves as a forum for open and informal exchanges of views among senior officials responsible for market operations in the G10 central banks.
16 See Borio (2003) for a detailed description of this concept and how it relates to other aspects of regulatory and supervisory arrangements. A schematic overview of such arrangements is provided in Table 3 and is discussed in more detail in the final section.
17 See Appendix C for an overview of the reporting structures of individual components of the Basel Process.
18 See Volker and Ferguson (2008) for a recent assessment and detailed discussion of these regulatory approaches.
19 For example, the multi-year effort in the context of the review of the 1988 Accord on capital adequacy involved more than 40 working groups, including many ad hoc and temporary ones that were co-ordinated under the umbrella of the BCBS.
20 Both the newly appointed BIS General Manager Jaime Caruana and FSF Chairman Mario Draghi are good examples of Basel Process insiders: In addition to his most recent position at the IMF, Mr Caruana was Governor of the Bank of Spain, served on the European Central Bank's Governing Council and was Chairman of the BCBS. He is also a member of the FSF. Mr Draghi was in various capacities at the World Bank, the Italian Treasury and Goldman Sachs before being appointed Governor of the Banca D'Italia.
21 I would like to thank an anonymous reviewer for suggesting this point.
22 The most recent Global Financial Stability Report from the IMF (2008a), e.g. recognizes that the current crisis has increased the uncertainty about appropriate capital adequacy measurements despite Basel II.
23 Indeed, Demirgüç-Kunt et al. (2006) find a positive relationship between bank soundness and compliance with the core principles which suggests that regular and accurate disclosure of financial data to regulators and market participants yields sounder banks.
24 I am grateful to an anonymous reviewer for highlighting this issue.
25 The 2006 Global Accountability Report assigns a relatively low ‘accountability score’ to the BIS in comparison to other international institutions (Blagescu and Lloyd, 2006).
26 WEF (2008, 4).
27 Beyond just a visual characterization, the bimodality of these distributions is a statistical feature of the sub-indices of the Financial Development Indicators that is confirmed by the dip test.
28 The cross-correlations between the sub-indices of the Financial Development Indicators, listed in Table B1 in Appendix B, represent an alternative way of looking at this. The countries in the sample exhibit a comparatively high correlation between the prevailing level of regional financial stability and the quality of institutions and the business environment. At the same time, however, the components of the intermediation and output-based sub-indices of the Financial Development Indicators are considerably less correlated.
29 As standards are different between groups, a comparison within groups is most meaningful.
30 The line in the left panel shows an exponential fit of the data for illustrative purposes.
31 In a related context, the importance of financial stability as a key driver of differences in the composition of national balance sheets is emphasized by Obstfeld et al. (2008). Their work suggests that both financial stability and financial openness are key elements in explaining the vast regional imbalances of national foreign exchange reserve holdings.
32 See Buchinsky (1998) and Koenker and Hallock (2001) for recent surveys on quantile regression techniques.
33 Compare IMF (2008b).
34 According to the IMF, global bank write-downs associated with the current financial crisis exceeded $580 billion by October 2008, almost 6% of US GDP (Lipsky, 2008a). By early 2009, that figure had almost doubled, reaching $1,038 billion (Financial Times, 18 January 2009).
35 Speech by then BIS General Manager Malcolm Knight at the World Economic Forum (Financial Times, 26 January 2008).
36 In this context, Lerrick and Meltzer (2003) propose an equivalent lower cost alternative to the IMF for the role of the international lender of last resort.
37 Cf. Goodhart (2008c).
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