Financial Stability

1. World Bank Financial Stability Stijn Claessens World Bank and University of Amsterdam October 25, 2006

2. Slide 1: Outline World Bank • Anatomy • Global financial integration is a long-run trend • But more two-way diversification in the 21st century • Dynamics • Globalization, deregulation and technology • Actions • International financial architecture: approach & players • Consequences • In a narrow sense and broader sense • The challenge: balance of influences

3. Slide 2: Anatomy: Long-run trends in financial integration (according to Obstfeld) • Stylized facts (ca. 1860-2000):

4. Slide 3: Anatomy: price and quantity metrics • Deviations from covered interest parity

5. Slide 4: World total foreign assets and liabilities 1970-2003

6. Slide 5:Two-way diversification accelerated in the 21st century World Bank • Massive 2-way diversification differentiates the current from the earlier period of globalized capital markets • In the 19th century, most flows were “development” rather than “diversification” flows • This phenomenon finds one expression in the fact that today, most capital flows from rich to other rich countries • In the 19th century, there was a relatively greater flow from rich to poorer

7. Slide 6: Anatomy: Foreign assets, then and now World Bank

8. Slide 7: Dynamics: Three Major Forces World Bank • Globalization • All product markets and financial markets • Technology • Telecommunications, Internet • Deregulation • Capital account & financial services liberalization

9. Slide 8:Globalization and Technology World Bank • Globalization • Increased economic integration in all aspects • Greater specialization and economies of scale • Resulting in greater trade, also in financial services, through both capital flows and cross-border entry • Technology • Facilitating remote delivery, better telecommunications • Providing new distribution and access channels • Revamping industrial structures for financial services, by allowing entry of non-bank entities (telecoms/utilities)

10. Slide 9: Deregulation • Product, market and geography • Integrated banks offering a broad array of services • Entry of new providers. Increased (foreign) presence in many markets, more cross border FDI, M&A, etc. activity

11. Slide 10:Actions: Overview World Bank • General changes in development policies: Washington consensus being revisited, also in international finance • Financial crises in 1990s (Mexico, East Asia, Brazil, Russia) start debate on international financial architecture • Approach keeps market orientation, but adds: • Focus on enhancing attractiveness and stability of emerging markets for developed countries’ investors • Reduced risk of spillovers to the global economy • Has been called new international financial architecture

12. Slide 11: IFA has focused on standards and enhanced surveillance World Bank • Introduced many (new) standards • Basle Core 25 Principles of Banking Supervision; OECD Corporate Governance; Fiscal/Monetary Transparency; National bankruptcy procedures, etc. Newly added: Anti-Money Laundering and Counter Terrorist Financing • Altogether more than 60 standards, of which 12 core • Strengthened national financial systems especially • Overseen by World Bank/IMF • Conducted through FSAP/ROSC process and regular surveillance

13. Slide 12: The proposals were largely shaped by developed countries World Bank • G-7 and G-10 institutions, private and public, dominate discussions and control agenda setting • Strong financial sector lobbying and liberalization bias maintained • Emerging markets’ influence in IMF, World Bank, BIS etc. already limited and remained so • G-20 newly created, but role/input unclear • Few emerging markets represented in Financial Stability Forum

14. Slide 13: The onus has consequently been on poor countries to adapt World Bank • Policy reflects investors’ preferences, not national development objectives • Openness to foreign financial institutions encouraged, constraints of capital mobility discouraged • Standards constrain national autonomy, but not developed countries’ and investors’ choices • One-size-fits-all solutions do not always work • Extensive legal and institutional adaptation faces political constraints

15. Slide 14: Consequences in a narrow way… World Bank • New institutional changes, such as Sovereign Debt Reduction Mechanisms (SDRM) failed in part due to lack of support from emerging markets • Financial crises have not been avoided, e.g., Argentina, Turkey. Other near misses • Solutions continue to be ad-hoc, e.g., Argentina • Risks remain still considerable • Countries continue to adopt own solutions, e.g., foreign exchange reserves very large in Asia

16. World Bank Slide 15:Foreign Exchange Reserves: Asia (U.S. $ billion) End-97 End-01 Latest

17. Slide 16:Consequences in a broader way… World Bank • Policies not developed with development needs in mind, leading to inappropriate policies • Insufficient attention to longer run difficulties of adjustment and institutional/legal adaptation • G-7/G-10 private sectors better represented than developing countries in international organizations/fora • Legitimacy of the system affected, bad as well as good elements questioned. E.g., external monitoring, standards, review and sanctions can help countries adopt first best, but requires legitimacy to be acceptable