Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial and Enterprise Affairs
Global finance is the perfect example of a complex system, consisting as it does of a highly interconnected system of sub-systems featuring tipping points, emergence, asymmetries, unintended consequences, a “parts-within-parts” structure (to quote Herbert Simon), and all the other defining characteristics of complexity. It is shaped by numerous internal and external trends and shocks that it also influences and generates in turn. And as the system (in most parts) also reacts to predictions about it, it can be called a “level two” chaotic system (as described, e.g. by Yuval Harari)
Numerous developments combined to contribute to the 2008 crisis and several of them led to structures and institutions that might pose problems again. Two important trends that would play a huge role in the crisis were the opening up of OECD economies to international trade and investment after 1945, and rapid advances in digital technology and networks. These trends brought a greater complexity of financial products and structures needed to navigate this new world, going well beyond the needs to meet the increased demand for cross-border banking to include new products that would facilitate hedging of exchange rate and credit default risks; financial engineering to match maturities required by savers and investors, and to take advantage of different tax and regulatory regimes; mergers and acquisitions not only of businesses, but of stock exchanges and related markets with global capabilities; and new platforms and technological developments to handle the trading of volatile new products.
The freeing up of financial markets followed the opening of goods markets, and in some respects was the necessary counterpart of it. However, the process went very far, and by the end of the 1990s policies encouraged the “financial supermarket” model, and by 2004 bank capital rules became materially more favourable to bank leverage as did rule changes for investment banks. The banking system became the epicentre of the global financial crisis, because of the under-pricing of risk, essentially due to poor micro-prudential regulation, excessive leverage, and too-big-to-fail business models. The rise of the institutional investor, the expansion of leverage and derivatives, the general deepening of financial markets and technological advances led to innovations not only in products but also in how securities are traded, for example high-frequency trading. The increasing separation of owners from the governance of companies also added a new layer of complexity compounding some of these issues (passive funds, ETFs, lending agents custody, re-hypothecation, advisors and consultants are all in the mix).
The trends towards openness in OECD economies were not mirrored in emerging market economies (EMEs) generally, and in Asia in particular. Capital controls remained strong in some EMEs despite a strengthening and better regulated domestic financial system. Furthermore, capital control measures have often supported a managed exchange rate regime in relation to the US dollar. When countries intervene to fix their currencies versus the dollar, they acquire US dollars and typically recycle these into holdings of US Treasuries, very liquid and low-risk securities . There are two important effects of the increasingly large size of “dollar bloc” EME’s: first, they compress Treasury yields as the stock of their holdings grows, second, their foreign exchange intervention means that the US economy faces a misalignment of its exchange rates vis-à-vis these trading partners.
Low interest rates, together with the more compressed yields on Treasury securities, have encouraged investors to search for higher-risk and higher-yield products. In “risk-on” periods this contributes to increased inflows into EME high-yield credit which, in turn, contributes to more foreign exchange intervention and increased capital control measures. The potential danger is that in “risk-off” periods, the attempt to sell these illiquid assets will result in huge pressures on EME funding and a great deal of volatility in financial markets.
The euro affects financial stability too, often in unexpected ways.. European countries trade not only with each other but with the rest of the world. However, the north of Europe is, through global value chains, more vertically integrated into strongly growing Asia due to the demands for high-quality technology, infrastructure, and other investment goods, while the south of Europe is competing with EMEs to a greater degree in lower-level manufacturing trade. Asymmetric real shocks to different euro area regions, such as divergent fiscal policy or changes in EME competitiveness, mean that a one-size-fits-all approach to monetary policy creates economic divergence. Resulting bad loans feed back into financial fragility issues, and interconnectedness adds to the complexity of the problem.
Population ageing adds to these concerns, notably due to the interactions among longer life spans, low yields on the government bonds that underpin pension funds, and lack of saving by the less wealthy who were hardest hit by the crisis and may also suffer from future changes in employment and career structures. To meet yield targets, institutions have taken on more risk in products that are often less transparent and where providers are trying to create “artificial liquidity” that does not exist in the underlying securities and assets.
However big and complex the financial system, though, it is not an end in itself. Its role should be to help fund the economic growth and jobs that will contribute to well-being. But despite all the interconnectedness, paradoxically, as the OECD Business and Finance Outlook 2016 argues, fragmentation is blocking business investment and productivity growth.
In financial markets, information technology and regulatory reforms have paved the way for fragmentation with respect to an increased number of stock trading venues and created so-called “dark trading” pools. Differences in regulatory requirements and disclosure among trading venues raise concerns about stock market transparency and equal treatment of investors. Also, corporations may be affected negatively if speed and complexity is rewarded over long-term investing.
Different legal regimes across countries and in the growing network of international investment treaties also fragment the business environment. National laws in different countries sanction foreign bribery with uneven and often insufficient severity, and many investment treaties have created rules that can fragment companies with respect to their investors and disrupt established rules on corporate governance and corporate finance.
Complexity is in the nature of the financial system, but if we want this system to play its role in funding inclusive, sustainable growth, we need to put these fragmented pieces back together in a more harmonious way.