Joining up the financial world for people

After the collapse of the Soviet Union and the reunification of Germany, the world experienced an exceptional period of globalisation and liberalisation. Barriers to international trade were reduced and regional alliances such as the creation of the Eurozone and NAFTA brought neighbouring nations closer together. The result was positive for the global economy and helped to lift about a billion people out of poverty as international trade flourished.

However, since the financial crisis of 2008-09, globalisation has faced headwinds. Nationalism and populism have increased. Challenges to the established political order have strengthened, from Brexit, to Italy’s Five Star movement, to France’s Gilets Jaunes. The reasons are complex, but one factor is undeniable: globalisation is perceived to have benefited some, but not all, in our society.

Financial markets have become significantly more interconnected, especially in the years before the financial crisis – a period sometimes known as the ‘Greenspan era’. Capital moved around the world with ever-increasing speed as investors moved into new and growing markets. Risk was distributed around the world, and across the balance sheets of ever-more globalised financial institutions, in an increasingly wide array of financial instruments.

Sub-prime mortgage debt from the US rust belt – packaged into complex instruments which were often AAA-rated – might end up in a pension fund thousands of miles away. Risk in the system became less visible. As the price of risk came down, debt levels – of households, businesses, banks and nations – went up.

We know what happened next. In an increasingly interconnected global financial system, ripples from the failure of a single bank, Lehman Brothers, spread across the world with remarkable speed. A highly unusual global recession ensued. It took unprecedented and concerted action by G20 governments to avert an even greater shock to the world economy. As policymakers, regulators, central bankers and business leaders worked to stabilise the global financial system, interconnectedness became synonymous with contagion.

The post-crisis decade: interconnectedness in a digital era

The past decade has seen an unprecedented wave of financial regulation. The aim has been to prevent a repeat of the events of 2008-09 by tackling their perceived root causes. Capital bases have been restored, balance sheets and leverage have been cut, minimum standards have been laid down for liquidity and stable sources of funding, and constraints have been placed on proprietary trading.

In addition, regulators and financial leaders have worked to build firebreaks against contagion risk arising from interconnectedness. Policymakers have sought to minimise the impact of a single bank failure on the wider system. A clearly defined list of the world’s most interconnected banks – so-called Global, Systemically Important Banks or ‘G-SIBs’ – added capital buffers and other requirements. Derivative instruments are now cleared by central counterparties. Total Loss Absorption Capacity, or ‘TLAC,’ is prescribed in order to protect depositors and taxpayers in the scenario of a bank needing to be wound up.