Before 2007-08, most global financial reform initiatives were based on a near consensus about the benefits from the free circulation of capital between jurisdictions, and from free cross-border competition between financial services firms. As a consequence of the financial crisis in the US and Europe, however, this near consensus can no longer be taken for granted. One implication is the increasingly tangible possibility of at least a partial fragmentation of the global financial system.
There are many indications that this fragmentation is becoming more likely. Rating agencies were unregulated in most of the world outside the US before the crisis (South Korea being one exception), but the G20 recommended they should be regulated and supervised by all major jurisdictions, with the risk of incompatible regulatory frameworks or inconsistent supervisory practices leading to geographical divergences in rating methodologies within the same rating agency. Another example is over-the-counter derivatives, the trading of which was hitherto cleared bilaterally by market participants, but for which the G20 mandated central clearing in regulated clearing houses, starting in 2013. Many investors fear a division of corresponding markets along the borders of country or currency areas. A third indication is the growing acceptance by international financial institutions, particularly the International Monetary Fund (IMF), of the adequateness of capital control measures under certain conditions, against the previously received wisdom of the so-called Washington consensus.
Around the globe, supervisors have nudged banks to ring-fence assets and maximise lending in their respective jurisdictions, in some cases pushing for splitting off of activities previously conducted through branches. In several countries that have run into fiscal difficulties, domestically-headquartered banks have been encouraged to increase their purchases of national sovereign debt. “Financial repression,” an expression long reserved to economic historians, has re-entered the mainstream financial vocabulary. These developments have been particularly striking in the euro area, where countries are in principle committed to total openness to capital flows, but where an abrupt U-turn from financial integration to financial fragmentation has been identified by policy authorities including the European Central Bank. The developments are by no means unique to Europe, though, and variations of the same themes have been observed in most if not all main economic regions.
Simultaneously, the pre-crisis momentum for harmonisation of global financial standards has run into some setbacks in crisis-affected countries. The US has delayed any decision about the adoption of International Financial Reporting Standards, which it had endorsed for US-listed foreign firms in 2007 and had seemed on the verge of extending to US-listed issuers in 2008. In another example, the European Union, after having championed the global use of the Basel II Accord on capital standards during the 2000s, now seems set to adopt legislation that the Basel Committee has deemed materially non-compliant with the new Basel 3 Accord that was adopted in 2010. For all the G20 talk about global solutions to global problems, financial reform has often seemed to be more driven by politics in the post-crisis context than in the previous period – and as the saying goes, all politics is local.
This new reality creates an unprecedented challenge for Asian policymakers. Asia has gained from dynamic financial development in the past two decades, and is entering a new phase in which cross-border financial openness could have a particularly beneficial impact, leading to better capital allocation and favouring the diffusion of efficient financing mechanisms. Generally speaking, Asian policymakers arguably have a vested interest in the continuation or even the acceleration of global financial integration. Until recently, they could take for granted that such integration would continue as a natural consequence of commitments to financial openness in both the US and Europe, which together dominate those global institutions that most influence the global financial order: the IMF, the International Accounting Standards Board, or the Basel cluster around the Bank for International Settlements.
But this assumption that the West will champion further cross-border openness of the global financial system can no longer be taken for granted. As a consequence, Asian policymakers may have to take a more prominent leadership position in global financial reform discussions to make sure that the impetus towards global financial integration is not reversed. This would be a new situation. Some Asian policymakers may feel ill-prepared for it, but even so could find its implications difficult to escape.