Global Financial Architecture


Excerpt From: Rischard, Jean-Francois.

“High Noon: 20 Global Problems, 20 Years To Solve Them.” iBooks.


“This complex issue has many subparts. Simplifying a bit, four main areas require stepped-up global problem-solving: managing international financial crises, strengthening financial systems at large, dealing with financial abuse, and preparing for the future consequences of e-money. Despite progress on the first three, particularly in the last three years, none of the four has been addressed in a convincing, reassuring way.



What looked like a manageable problem in Thailand in August 1997 flared up into a two-year, continents-spanning financial crisis in the emerging markets of East Asia, and then even in Russia and Brazil. In late 1998, it threatened even broader damage. Seasoned observers were stunned by the speed and many channels of the contagion—capital flight, banks withdrawing their funds, declining commodity prices, abrupt and indiscriminate portfolio readjustments away from emerging markets, highly leveraged hedge funds suddenly reversing gears. The crisis inflicted a lot of damage, particularly in Indonesia, Thailand, Korea, the Philippines, and Malaysia; poor people were affected the most.

In 1997–1998, the IMF and others organized large rescue or “bailout” packages to help affected countries—the 1998 Korean package alone came to $57 billion. Those rescue packages, like that for Mexico a few years before, became the target of much criticism and debate. Many argued, for example, that the promise of such bailouts created incentives for private investors to take reckless risks once again in the future—the moral hazard problem.

Even today, there are wide-ranging views on how best to respond when such a crisis hits countries. There are two approaches in principle. One is to have lenders of last resort, like the IMF, put together large rescue packages to help crisis-affected countries for as long as the crisis lasts. The other is to allow these countries to temporarily stop payments on their debts and then renegotiate them. Despite much debate over the last four years, each of these options carries major unanswered questions:

The rich countries, and the new U.S. administration, have become even more reluctant to pour vast amounts of money into bail-outs. The rescue packages for Turkey and Argentina in 2001 were preceded by continued and nagging uncertainty over what the accepted principles of such packages are.

For a while, the rich countries thought the way forward was to put crisis lending on a more systematic footing by promoting a contingent credit line window at the IMF. Countries would prequalify for support and would signal private investors how much help they could draw on. But the window remains essentially unused.

Some thought the best way would be to expose weaknesses in countries’ financial systems early, but a true crisis alert system managed by the IMF would place that institution in a position where it could itself end up triggering panics.

If there’s little enthusiasm for multibillion-dollar bailouts, there has been even less progress on the other theoretical option—the one under which countries would be allowed to temporarily stop payment while they negotiate a reduction in debt. Related to this, the broader idea of “bailing in” private lenders and investors in a crisis—to oblige them to participate in the pain of crisis resolution—hasn’t gotten much further than very general debate. Most plans for formally roping in these players had run out of steam by mid–2000. There is, in short, still no equivalent for countries of the U.S. Chapter 11 rules that enable struggling debtors to temporarily suspend their payments—in spite of recent signs of greater enthusiasm for the idea on the part of some key U.S., European, and IMF officials, in the wake of the recent Argentina default.

There have been hundreds of debates, proposals, and committees since 1997—even a special G20 effort that I will discuss in Part Three. But one still cannot say, after several years of discussion and continued crises, that there is any structured, well-known set of rules and mechanisms for financial crisis management. The main principle that seems to have emerged is the case-by-case approach. Undeniably, there has been progress in some areas, but overall, as economist Joseph Stiglitz mused two years ago, “a mountain gave birth to a mouse.” A report by former central bankers and finance ministers from emerging countries and another one commissioned by the Commonwealth Secretariat, both released in the fall of 2001, similarly underline the insufficient progress over the last three years.



Worldwide, there have been more than 100 financial crises in the last forty years. Quite a few occurred in rich countries, like the United States, Spain, Sweden, and now Japan, to mention some spectacular ones. The cost of such crises, which in some countries are recurrent episodes, can be staggering: up to 40 percent of GDP in some developing countries, and even a remarkable 5 percent of GDP for the U.S. savings-and-loans crisis. Banking weaknesses have sometimes been the trigger for international contagion crises such as the one that broke out in Asia in 1997–1998, and even when they weren’t, they have always acted to amplify such crises. In that sense, strengthening domestic financial systems is also a global issue.

Yet here again, much remains to be done. Despite massive efforts by the IMF and the World Bank, too many countries still suffer from an accumulation of bad loans in the banking sector, weak banking supervision, weak corporate governance, and insufficiently developed securities markets (which, if they were more developed, would provide a healthy counterweight to the accident-prone banking sectors). In fact, the job of strengthening domestic financial sectors is so great—and countries are often so reluctant to let others peek into their banking sectors—that this remains an area ripe for a massive global drive to get the job done across some 100 countries, based on globally shared principles.

Part of that global action has to go beyond strengthening financial sectors within each individual country. There are some global, systemic issues that need to be tackled as well. Four examples:

Worldwide rules on minimum risk capital for banks are in a state of flux. An older “capital ratio” formula has now been phased out by a committee managed by the Bank for International Settlements (BIS) and is about to be replaced by a new setup that takes hundreds of pages to describe—raising quite a few controversies. There is still some unfinished business there.

Accounting rules for financial institutions remain oddly unclear in some major respects. One reason banking sectors are so opaque and able to hide serious problems for so long is that loans remain booked at their historical value. Serious accounting would imply, instead, that bankers constantly revalue their loans based on what has happened to interest rates or to the credit of borrowers. Tricky as it is, this “marking-to-market” is feasible—Danish banks do it. And oddly, the principle has been applied to the so-called swaps (derivative financial transactions through which two players exchange obligations), creating a real mess because loans aren’t so treated. At any rate, much work remains to be done on the accounting underpinnings of sound banking.

Hedge funds remain poorly known and monitored financial creatures. The Long-Term Capital Management debacle in late 1998 (Chapter 7) brought hedge funds into the public limelight, and they have never left it since. Hedge funds are private funds that borrow up to fifteen to thirty times their own resources and then further leverage up to often gigantic positions through futures, options, and other derivatives—tools enabling sophisticated bets on the prices or price differences of other assets. Long-Term Capital Management, with equity capital of less than $5 billion, had at times more than $1 trillion in derivatives exposure. These hedge funds are mostly in the business of chasing tiny pricing aberrations between pairs of financial assets, which they then exploit at the large scale made possible by their large leverage. But sometimes their positions are more like huge outright bets on the possible rise or fall of a financial asset’s price. In 1997, one hedge fund held positions on the Thai baht amounting to 20 percent of the Thai central bank’s reserves. An intriguing recent casualty was the U.S. energy company Enron, which turned out to have a large hedge fund operation inside its belly when it collapsed in December 2001. Worldwide, there are now some 6,000 to 7,000 hedge funds controlling assets worth $500 billion, not including less visible ones like in the Enron case.13 There is some work going on to develop some principles for stronger monitoring by governments of hedge funds and their potentially destabilizing activities, but it’s still early days.


Recent cases of sudden corporate collapse (Enron, Global Crossing, and several others within and outside the United States) have revealed major weaknesses in the world’s accounting and auditing setups for corporations. In some of these cases, proceeds from borrowings were made to look like operating cash flow, debts were hidden in special vehicles, a range of exceptional items was omitted from the bottom line, and auditors were allowed to get away with serious conflicts of interest. The resulting credibility crisis has also highlighted how badly the world needs a unified set of principles for financial reporting, unlike today’s different national approaches. For example, the U.S. accounting and financial reporting method is based on a very large number of detailed rules. This can encourage companies to comply with the letter of the law rather than its spirit. By contrast, some countries like the United Kingdom apply broader, more subjective principles that give more emphasis to the economic substance of companies’ activities than to detailed rules; companies must, for instance, publish details of any subsidiary over which they have a significant influence. It would be far more sensible to have a global set of principles shared by all countries, based on worldwide best practices.



The amount of dirty or even downright dangerous money being cleaned through the world’s financial system is huge—some $0.5 to $1.5 trillion a year, equivalent to 1.5 to 5 percent of the gross world product. Drug money, funds diverted by predatory rebel groups, government funds stolen by kleptocratic elites, flight capital and tax evasion proceeds of all kinds, and even terrorist networks’ funds all mingle with legitimate funds in the world’s enormous financial machinery. The parts of that machinery that wittingly or unwittingly facilitate money laundering are secrecy-promoting offshore banking centers; “shell” or “brassplate” banks that have no physical existence; and the “don’t ask, don’t tell” private banking practices followed to some extent everywhere. Even the world’s giant mesh of correspondent banking links—through which money can be shifted in seconds between banks in different parts of the world that have accounts with each other but may not even be aware of each other’s true nature—plays an unwitting part in this. As the world’s biggest banks have up to 5,000–10,000 or more correspondent banking links, hiding or not seeing things becomes very easy.

A task force of twenty-nine leading countries and two international bodies, launched by the G7 in 1989 and managed by the Organization for Economic Cooperation and Development (OECD), called the Financial Action Task Force (FATF), has come up with forty criteria covering financial regulation, law enforcement, and international collaboration. Based on these criteria, it has exposed more than a dozen countries suspected of tolerating money laundering, from Russia and Israel to the Marshall Islands. Within a year, half of these countries were busy passing legislation to try to get themselves off the list—a remarkable “reputation effect” discussed later in the book. But a recent revised list had nineteen countries again, and more are likely to be added.

Yet the FATF list, even with its prominent targets, is far from the kind of global effort the world’s money-laundering plague warrants. There are bigger problems to tackle across the whole family of nations. Just think of the correspondent banking system. In March 2001, no fewer than fifteen U.K. banks were found to have significant weaknesses in their money-laundering controls, letting $1.3 billion pass through accounts linked to the family of former Nigerian ruler Sani Abacha. Later that year, it was made known that the United States itself failed to comply with twenty-eight of the FATF’s forty criteria. And clearly, as the events of September 11, 2001, showed, there has been a major worldwide failure to detect major terrorist actions from suspect money movements and to curb terrorism finance itself.

Terrorism finance presents a special challenge: it amounts to “reverse money laundering,” as it takes legitimate-looking business or charitable funds and puts them into terrorist activities. It is therefore hard to track. There’s no alternative to asking banks worldwide to carefully check the identity of depositors; getting bank supervisors to share information between jurisdictions and to allow for cross-border police searches of suspect accounts; and prohibiting secretive money-forwarding, like the so-called hawala system used by the terrorists.14 And there’s no way around beefing up the existing global framework for monitoring all of this: at the beginning of September 2001, the FATF Secretariat had fewer than ten staff.

Financial abuse thus connects to many other global scourges—from drug trafficking to terrorism financing to kleptocratic government. And it is an inherently global issue: cracking down on domestic banks within individual countries, if it isn’t copied by jurisdictions elsewhere, may do little more than make those banks and countries uncompetitive in the new world economy. This is par excellence the free-rider and leakage theme that underlies so many issues in the third category.



This part of the global financial architecture issue is more futuristic but no less important. Today, the control by central banks over interest rates rests on the fact that households and firms need money for transactions—and that banks can create money only if they hold enough reserves at the central bank. But over the next twenty years, the new world economy is likely to move further into the direction of electronic money—a private form of money that could reduce the role of orthodox money and thus of central banks. E-money could consist of prepaid smart cards, where money is stored on a computer chip, and of software-based payment systems run by private e-money issuers. Households and firms would then accept and swap balances in the books of these e-money issuers—reducing the part of the flow of money that goes through banks and hence through central bank control.

In such a world, people could choose which currency bloc they want to belong to, and there would be an increasing disconnect between territorial nation-states and the money used to settle physical transactions conducted on their territory. The consequences for central banks’ monetary policy and even their role as lenders of last resort would be tremendous. And this is not just a wild speculation: for several years, Singapore has been devising ways to replace cash and checks with electronic payments, in the hope of eliminating coins and bills by 2008. Even if Singapore weren’t to meet its deadline, the question is not whether e-money will happen, but when. Why? Because e-money is driven by a powerful logic that has to do with the elimination of the usual time lag between transactions and their final settlement—so a seller will no longer have to worry about the other party’s creditworthiness. Eliminate that, and you eliminate much of the raison d’être for traditional money and banking intermediation, with all that rides on it, including the central bank’s gatekeeping role.

You might therefore imagine that e-money is the subject of many in depth global debates and preparations, but you would be wrong. In this “dog years” area, little global debate has occurred as yet—as with rethinking taxation.

With its four parts, the challenge of improving the global financial architecture amounts to an urgent global issue—unresolved, it leaves the new world economy with a serious weakness.17 It also raises free-rider and leakage issues. And despite many efforts since the 1997–1998 financial crisis, it is far from having been definitively tackled.”

Excerpt From: Rischard, Jean-Francois.

“High Noon: 20 Global Problems, 20 Years To Solve Them.” iBooks.