Abstract
This chapter considers the efficacy of key reforms across the finance sector since the major crisis in 2008, including capital management standards, responsible lending standards, and the establishment of an incremental framework governing systemically important financial institutions. It suggests that in a best-case scenario, these reforms will enhance the survival prospects of finance entities and the continued functioning of financial systems during extreme events without support from public sources. But without more, these reforms, are unlikely to prevent or mitigate many of the most devastating economic and social costs of financial crises and deep recessions on society. Interest rates are still relatively low and continued access to cheap credit in many countries is undermining lending standards and resulting in levels of indebtedness that are unsustainable and that will exacerbate the resilience of governments and populations in coming decades. Moreover, policies introduced to promote financial stability are not preventing an accumulation of systemic risks and the world is ill-prepared for further financial crises and adverse economic shocks. Mounting systemic risks are exacerbated by fragile financial and economic environments in key areas, high levels of private and or public indebtedness in many countries, greater interconnections between finance and economic activities worldwide, a continuing concentration of assets, liabilities and risks across the finance sector, and increasing levels of financial activity relative to the real economy.
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Notes
- 1.
King (2016), pp. 2–3 citing a senior Chinese central banker.
- 2.
King (2016), p. 40.
- 3.
Financial Stability Board (2017a).
- 4.
Financial Stability Board (2017b).
- 5.
European Central Bank (2016), p. 3. See also Schinasi (2004). Schinasi notes that financial stability is a broad concept that encompasses private and public participants and the financial infrastructure, including the legal system and regulatory frameworks for financial regulation, supervision and surveillance. He suggests that financial stability entails preventative and remedial dimensions and arises along a continuum. He limits the concept to potential consequences for the real economy and notes that policies aimed at financial stability often involve a trade-off between resilience and efficiency. For example, higher capital requirements reduce the risk of a bank failure but also result in higher capitals costs and foregone investment opportunities.
- 6.
European Central Bank (2016), p. 3. See also International Monetary Fund, Financial Stability Board and Bank for International Settlements (2016), p. 4. This multibody document defines systemic risk as ‘the risk of widespread disruption to the provision of financial services that is caused by an impairment of all or parts of the financial systems, and which can cause serious negative consequences for the real economy.’
- 7.
European Central Bank (2016), p. 3.
- 8.
- 9.
These committees include the Basel Committee on Banking Supervision, the Committee on the Global Financial System, the Committee on Payments and Market Infrastructures, the Markets Committee, the Central Bank Governance Forum, and the Irving Fisher Committee on Central Bank Statistics.
- 10.
These independent organisations include the Financial Stability Board, the International Association of Insurance Supervisors, and the International Association of Deposit Insurers.
- 11.
Membership of the Basel Committee is comprised of the central bank governors and national bank regulators of G20 countries. For an outline of transnational coordination of private law governing international finance, see Brummer (2011), p. 257.
- 12.
The G20 (or Group of Twenty) is an international forum for the governments and central bank governors from 20 major economies. The members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, South Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, United Kingdom and United States, as well as the European Union (EU). The primary aim of the G20 is to promote international financial stability.
- 13.
Of course, the full efficacy of these established standards and rules will only be tested when extreme events or conditions arise and the financial survival of specific corporations are at stake.
- 14.
- 15.
See e.g., The Joint Forum (2015), p. 11.
- 16.
For an outline of the Basel III standards, see Keefe and Pfleiderer (2013).
- 17.
King (2016), p. 4.
- 18.
European Central Bank (2016), p. 15.
- 19.
Moral hazard exists in banking when bankers are not adequately incentivised to guard against risk because they are protected from the consequences of their actions. Some commentators suggest that moral hazard concerns remain because deposit insurance coverage has generally increased since the crisis. See e.g., Cihak and Demirguc-Kunt (2013), p. 8.
- 20.
The Joint Forum (2015), pp. 1–2.
- 21.
The Joint Forum (2015), pp. 1–2.
- 22.
The Joint Forum (2015), p. 7.
- 23.
- 24.
The Joint Forum (2015), pp. 1–2.
- 25.
See Clark and Drage (2000), pp. 164–165.
- 26.
See, e.g., European Banking Authority (2016).
- 27.
Federal Reserve (2016), p. 1.
- 28.
See Allen et al. (2014), pp. 14–15.
- 29.
See, e.g., Commonwealth of Australia, Financial System Inquiry (2014), p. 47.
- 30.
- 31.
See e.g., Dell’Ariccia et al. (2016), p. 1093.
- 32.
Cerutti et al. (2012), pp. 12, 15. See also Lim and Minne (2014), pp. 2, 8 citing Reinhart and Rogoff (2009), which documents 2678 domestic financial crises (measured on a yearly basis) in the 47 countries for which data was available between 1800 and 2005. Of these events, 919 were currency crises, 155 were domestic debt crises, 532 were banking crises, and 1072 were stock market crashes.
- 33.
Reserve Bank of New Zealand (2016).
- 34.
See Crowe et al. (2011).
- 35.
- 36.
Igan and Loungaini (2012).
- 37.
Aizenman and Pinto (2011), p. 24. Aizenman and Pinto note that the economic output and social costs associated with financial crisis are estimated to average more than 10% of GDP.
- 38.
See, e.g., International Monetary Fund (2012), pp. 14–15.
- 39.
International Monetary Fund (2008), p. 6. See also The Financial Crisis Inquiry Commission (2011), pp. xvii–xx; International Monetary Fund Staff Discussion Note (2012), p. 9. The issuance and sale of securitised products across the globe, particularly those linked to subprime mortgages, grew at exponential levels during the 1990s and 2000s.
- 40.
International Monetary Fund (2011), pp. 4–7.
- 41.
The Financial Crisis Inquiry Commission (2011).
- 42.
Financial contagion can be defined as ‘a price movement in one market resulting from a shock in another market’: Kodres and Pritsker (2002), p. 772.
- 43.
International Monetary Fund (2016), pp. 61–62. This report notes that legacy economic and financial issues remain today.
- 44.
Reserve Bank of New Zealand (2016), p. 9 citing Floden (2014) and Cecchetti et al. (2011). Floden found that countries with higher levels of aggregate household debt to income in 2007 suffered larger consumption reductions controlling for other factors. Ceccchetti examined the relationship between debt and economic growth in 18 advanced countries since 1980 and found that high levels of public and corporate debt adversely affected economic growth and there was a negative relationship between high levels of household debt (above 85% of GDP) and future economic growth.
- 45.
- 46.
- 47.
Bunn and Rostom (2014), pp. 304–315; Anderson et al. (2014). The Bunn study estimates that the high levels of household debt in the UK resulted in a fall in private consumption of around 2% between 2007 and 2012. The Anderson et al. study found that households with LVRs of 100% reduced their consumption between 2007 and 2011 significantly more than households with LVRs of 60%.
- 48.
Ogawa and Wan (2007).
- 49.
- 50.
- 51.
See Benes et al. (2016).
- 52.
The Joint Forum (2010).
- 53.
- 54.
- 55.
- 56.
- 57.
- 58.
Aizenman and Pinto (2011), p. 25.
- 59.
See Benes et al. (2016), Dell’Ariccia et al. (2016) and Lim et al. (2015). Dell’Ariccia et al. found that macroprudential tools can reduce the incidences of credit booms and decrease the probability that booms end badly. Lim et al. found that macroprudential tools such as loan-to-valuation and debt-to-income caps, ceilings on credit growth, reserve requirements and dynamic provisioning rules can mitigate the procyclicality of credit.
- 60.
Kragh-Sorenson and Solheim (2014).
- 61.
Reserve Bank of New Zealand (2016).
- 62.
See, e.g., The Financial Crisis Inquiry Commission (2011).
- 63.
Many countries now have responsible lending rules. For example, in the United States, Title XIV of the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) (the Mortgage Reform and Anti-Predatory Lending Act) imposes new mortgage underwriting standards, prohibits or restricts specified mortgage lending practices and regulates payments to mortgage loan officers and brokers. Lenders are banned from steering consumers into high cost, unaffordable loans: § 1403, 124 Stat 1376, 2140. Lenders must also verify a borrower’s ability to repay the mortgage in its entirety, including consideration and documentation of specified factors such as the borrower’s credit history, employment status, income and debt-to-income ratio: § 1411(a)(2), 124 Stat 1376, 2142–3.
- 64.
Caprio (2013), p. 14.
- 65.
- 66.
Resolution plans are intended to allow systemically important financial institutions to continue or to wind down in an orderly manner, while still protecting depositors, and without the use of taxpayer funds.
- 67.
- 68.
Financial Stability Board (2015). The additional capital requirements range from 1 to 3.5% of risk-weighted assets. The higher loss absorbency requirements (along with capital conservation and countercyclical buffers) will become fully effective on 1 January 2019.
- 69.
See, e.g., Lagarde (2014) Lagarde, the managing director of IMF, concludes that the too-big-to-fail problem has not been solved because the largest financial institutions still pose a major source of systemic risk and their implicit subsidies continue. She suggests the behaviour of the financial sector has not changed sufficiently since the financial crisis because the industry ‘still prizes short-term profit over long-term prudence [and] today’s bonus over tomorrow’s relationship.’ See also Dallas (2013).
- 70.
Sarin and Summers (2016), p. 13. The authors note [at 33] that ‘we have no doubt that but for Dodd Frank and regulatory actions, the financial system today would be much more fragile.’ However, they suggest [at 34] that their results do not go as far as to support heavier regulation of large banks. They conclude that consideration needs to be given to market prices as indicators of asset values. The paper highlights a substantial decline in the price-book ratio for the largest financial institutions and suggests this is consistent with a dramatic decline in franchise value, caused at least in part by new regulations. The present author is an experienced analyst of the finance sector and has reservations concerning the paper’s focus on price to book ratios and the hypothesised linkages between the fall in these ratios and the conclusion that further regulation is not required. She suggests it is not surprising that the price to book ratios are well below pre-crisis levels, given the much higher levels of capital included in the book values of financial institutions. She notes that the valuation of a financial entity reflects a wide range of financial indicators of the institution and the broader environment in which it operates, and as this paper highlights, the prospective earnings potential and health of these environments is fragile.
- 71.
See Allen et al. (2014), pp. 4–5.
- 72.
- 73.
See King (2016). King describes this as a savings glut. See also Dell’Ariccia et al. (2016). Dell’Ariccia et al. note that both stock and real estate prices surge during credit booms and lose traction at the end of a boom creating balance sheet vulnerabilities for the financial and nonfinancial sectors and repercussions for the broader economy.
- 74.
King (2016), p. 43.
- 75.
- 76.
- 77.
- 78.
- 79.
Das (2016).
- 80.
- 81.
International Monetary Fund (2016), p. 1.
- 82.
European Central Bank (2016), pp. 11–12, 24–25, 28–30; Financial Stability Oversight Council (2016), p. 34; International Monetary Fund (2016), p. x; Gourinchas and Obstfeld (2012). Gourinchas et al. found that domestic credit expansion and real currency appreciation were the most robust and significant predictors of financial crises during the period from 1973 to 2010.
- 83.
King (2016), p. 46.
- 84.
See North and Buckley (2012).
- 85.
- 86.
- 87.
Yergin and Stanislaw (2002), pp. 394–395, 415.
- 88.
See, e.g., Milan and Sufi (2016), p. 35. The authors note that since 1960 there has been an unprecedented surge in the scale and scope of financial activities in advanced economies. At present, New York and the City of London are the two largest financial centres.
- 89.
Commission of Experts of the President of the UN General Assembly on Reform of the International Monetary and Financial System (2009), p. 47.
- 90.
Monaghan (2009).
- 91.
Turner (2009).
- 92.
Demirguc-Kunt and Huizinga (2011). This study found that systemically large banks achieved lower profitability and operated with higher risk than other banks and concludes that it is not in the shareholders’ interest for a bank to become large relative to its national economy. They hypothesise that inadequate corporate governance structures at these banks enabled managers to pursue risky high growth strategies at the expense of shareholders.
- 93.
Cecchetti and Kharroubi (2012). This study found that a fast-growing financial sector is detrimental to aggregate real growth.
- 94.
- 95.
See s 121(a) of the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) (Dodd-Frank) allows the Financial Stability Oversight Council (FSOC) to:
-
(1)
limit the ability of the company to merge with, acquire, consolidate with, or otherwise become affiliated with another company
-
(2)
restrict the ability of the company to offer a financial product or products
-
(3)
require the company to terminate one or more activities
-
(4)
impose conditions on the manner in which the company conducts one or more activities; or
-
(5)
If the Board of Governors determines that the actions described in paragraphs (1) through (4) are inadequate to mitigate a threat to the financial stability of the United States in its recommendation, require the company to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated entities.
The Trump administration has indicated that it wishes to roll back some of the Dodd-Frank reforms, but it is not clear whether this will include the removal of s 121(a).
-
(1)
- 96.
Financial Stability Oversight Council (2011).
- 97.
Creighton (2016), quoting Friedman.
- 98.
Anginer and Demirguc-Kunt (2014). A study of 12,000 publicly traded banks in more than 45 countries over the period 1998–2012 found that macroprudential regulation that emphasised capital measures reduced systemic risk.
- 99.
Eyers and Grey (2016).
- 100.
Corderoy (2016).
- 101.
Corderoy (2016). See also World Economic Forum (2017), preface; Goldcare (2016). Klaus Schwab, the Founder and Executive Chairman of the World Economic Forum, indicates that ‘continued slow growth combined with high debt and demographic change creates an environment that favours financial crises and growing inequality.’ The Goldcare article reports that Japan pressed G7 leaders to note that ‘the risk of the global economy exceeding the normal economic cycle and falling into a crisis if we do not take appropriate policy responses in a timely manner’. It highlights an increase in global debt of $57 trillion since 2007 and suggests there is a risk of debt crises in China, the United States, the Eurozone and the United Kingdom.
- 102.
See Yergin and Stanislaw (2002), p. 402.
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North, G. (2018). Well Governed, Sustainable and Socially Responsible Financial Corporations: Remote or Real Expectations?. In: du Plessis, J., Varottil, U., Veldman, J. (eds) Globalisation of Corporate Social Responsibility and its Impact on Corporate Governance. Springer, Cham. https://doi.org/10.1007/978-3-319-69128-2_2
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