11.4 Reforms and Preventive Measures in the Global Financial System

The global financial system underwent significant reforms after the 2008 crisis. These changes aimed to strengthen regulation, improve crisis management, and address systemic risks. Key areas included tougher capital requirements for banks, better oversight of derivatives, and enhanced international cooperation.

International institutions play crucial roles in this reformed system. The IMF monitors global stability and provides crisis lending. The World Bank supports financial sector development in emerging economies. The BIS sets banking standards, while the FSB coordinates global reforms and assesses risks.

Key Reforms and Institutions in the Global Financial System

Key areas of financial reform

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• Strengthening financial regulation and supervision involves increasing capital requirements for banks to ensure they have sufficient buffers to absorb losses, implementing stress tests (scenario analysis) and risk assessments to identify potential vulnerabilities, and enhancing transparency and disclosure standards to improve market discipline
• Improving crisis management and resolution frameworks entails establishing clear procedures for handling bank failures and resolutions, such as bail-in mechanisms that require creditors to bear losses and reduce the burden on taxpayers
• Addressing systemic risk and interconnectedness focuses on monitoring and regulating systemically important financial institutions (SIFIs) that pose risks to the broader financial system, and developing macroprudential policies (countercyclical capital buffers) to mitigate systemic risk
• Reforming over-the-counter (OTC) derivatives markets aims to increase transparency and standardization of derivatives contracts (credit default swaps), and requiring central clearing and reporting of derivatives trades to reduce counterparty risk
• Enhancing international cooperation and coordination involves strengthening the role of the Financial Stability Board (FSB) in setting global standards, and promoting information sharing and joint supervisory efforts among national regulators

Role of international financial institutions

• International Monetary Fund (IMF) plays a key role in conducting surveillance and monitoring of global financial stability, providing financial assistance and crisis lending to member countries (balance of payments support), and offering technical assistance and capacity building for financial sector reforms
• World Bank Group supports financial sector development and strengthening in emerging economies, promotes good governance and institutional reforms, and provides financing and risk management tools for infrastructure projects (project finance)
• Bank for International Settlements (BIS) serves as a forum for central bank cooperation and research, sets international standards for banking regulation such as the Basel Accords (capital adequacy ratios), and monitors global financial markets to identify potential risks
• Financial Stability Board (FSB) coordinates and oversees the implementation of global financial reforms, identifies and assesses systemic risks in the global financial system, and promotes information sharing and best practices among member jurisdictions (peer reviews)

Effectiveness and Challenges of Financial Reforms

Effectiveness of regulatory measures

• Increased resilience of the banking sector due to higher capital buffers (common equity tier 1) and improved risk management practices, enhancing the ability to absorb losses and withstand stress
• Greater transparency and market discipline resulting from improved disclosure requirements and reporting standards (IFRS 9), leading to better informed investors and more efficient market pricing of risk
• Limitations and unintended consequences include the potential for regulatory arbitrage and migration of risk to less regulated sectors (shadow banking), increased compliance costs and reduced profitability for financial institutions, and potential for reduced lending and economic growth due to tighter regulations
• Ongoing challenges and emerging risks such as the adaptation of financial innovation and technology (fintech, crypto-assets), climate-related financial risks and sustainability concerns, and geopolitical uncertainties and shifts in the global economic landscape

Challenges in cross-country reform coordination

• Differences in national regulatory frameworks and priorities arising from varying levels of financial development and market structures (bank-based vs. market-based systems), and political and economic considerations influencing reform agendas
• Regulatory fragmentation and potential for arbitrage due to inconsistencies in the implementation and enforcement of global standards, creating opportunities for financial institutions to exploit regulatory gaps and loopholes (offshore financial centers)
• Coordination and cooperation challenges in aligning interests and reaching consensus among diverse jurisdictions, and limited enforcement mechanisms and sanctions for non-compliance
• Balancing national sovereignty and global financial stability involves tensions between domestic policy objectives and international commitments, and resistance to ceding control over financial sector policies to supranational bodies
• Capacity constraints and resource limitations, particularly in developing countries, with inadequate technical expertise and institutional capacity, and insufficient funding and resources for effective implementation and supervision of financial reforms