Preventing the next financial crisis

The rapid uptake of non-traditional banking services could prove a threat to global financial equilibrium if market segmentation is not addressed by world leaders, writes Chiara Oldani, professor of economics, University of Viterbo ‘La Tuscia’

The current risk to the global financial system and its stability in 2019 is growing market segmentation that could substantially modify the delicate equilibrium achieved after the 2007–09 crisis. Corporate and public debts in some G7 countries are vulnerable because of the growth of non-traditional banking, which reduces the effectiveness of monitoring and consumer protection (such as measures to combat money laundering and fraud and to protect data). They are also vulnerable because of the long-term effects of the sub-prime crisis, which include increased unemployment, reduced consumption and growing distrust.

Since 2009, efforts by G7 countries to control risks have come at a high price: extraordinary expansionary monetary policies lead to zero-interest rates, to alleviate the credit crunch, but they also lead to reduced revenues in the finance industry, driving the need to innovate, find new businesses and circumvent rules. The Financial Stability Board has substantially contributed to improving the resilience of the global finance sector, but its duties are not over under its new governor, Randal Quarles. By December 2018, the notional value of over-the-counter derivatives had reached $544 trillion and two thirds of contracts were cleared by central counterparties, the most important of which are often systemically important banks. In fact, the introduction of central counterparties for OTC derivatives in 2008 reduced the risk, but increased concentration in the industry. Higher market concentration can represent a new source of systemic risk, because the relationship between banks and central counterparties is highly symbiotic.

The sub-prime crisis forced western countries to cooperate and improve financial regulation to restore confidence and trust. Global financial regulation in the European Union, with its common market and prudent and stringent rules, and the United States converged until the United Kingdom voted to leave the European Union in 2016. In 2017, US president-elect Donald Trump announced the dismissal of the Dodd Frank Wall Street Consumer Protection Act. In May 2018, the US Congress approved a substantial change to the prudential rules that had been introduced in 2010, according to which a financial institution with total assets in excess of $250 billion – instead of $50 billion – should be considered systemically important; this higher level allowed many institutions to lend and trade, with less supervision and capitalisation. This freedom is considered necessary to gain market share, especially as digital banking and fintech services are spreading throughout the global financial system.

The rise of fintech

The growth of non-bank financing deeply modifies the structure of markets and also the finance industry. Fintech doubled its volume up to $112 billion in 2018. Credit volumes are greater in countries with less stringent banking regulation, in particular China, the United States and the United Kingdom. The sustained demand for digital currencies, such as Bitcoin, Ethereum and probably Facebook’s Libra after 2020 is also the result of reduced regulatory coordination among countries that does not substantially impede the trade of such cryptocurrencies, and indirectly contributes to their development.

G7 leaders at the Biarritz Summit should actively promote financial stability. In particular, they should reduce market fragmentation in traditional finance, because fragmentation can weaken supervision and monitoring. History teaches us that heavier regulation pushes further innovation, yet the most efficient and feasible way to address the growth of non-traditional banking cannot be a ‘global financial regulator’; instead, leaders at Biarritz should identify common incentives to encourage efficiency and competition in the non-traditional banking and finance sectors, to drive future policy proposals and achieve stability.