Financial system

The financial system conveys resources from lenders to borrowers, and transfers risks from those who wish to avoid them to those who are willing to take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. There are also complex interactions between financial transactions and other forms of economic activity, as consequence of which a malfunction of the financial system can cause a malfunction of the economy, and vice-versa. The system has evolved by adaptation and innovation, and the conduct of its participants has been modified from time to time by regulations designed to preserve its stability. Further modifications are under consideration in light of the crash of 2008.

(The termninology used in this article is largely based upon The American Banker Bankers Glossary [6]. Terms shown in italics are defined in the glossary on the related articles subpage)

Overview

The principal participants in the system are financial intermediaries whose functions are to transfer resources from those who own them but do not wish to use them to those who wish to use them but do not own them; and to transfer risk from those who wish to limit their exposure to it to those willing to accept it. It performs those functions by trading in financial instruments that represent promises to perform services in return for payment. The promises that they represent include promises to make fixed payments (represented by bonds); promises to pay dividends (represented by shares); promises to provide retirement income (represented by pension agreements); promises to bear some of the costs of accidents or financial losses (represented by insurance policies), promises to provide a cash flow, such as mortgage repayments (represented by securitised assets) - and promises, such as options, concerning transactions in other promises (represented by "derivatives"). The system includes specialised markets, regulated by custom, rules and legislation, that provide for trading in financial instruments and in the currencies in which they are denominated; and it is supported by information-providing services from analysts, advisors and rating agencies.

(for the historical sequence of events in the evolution of the system, see the timelines subpage)

Components

Instruments

Bonds

Term "bond" is used in this article to mean an instrument that is issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year. Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer. Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.

The simplest form of bond is the "straight" (or "plain vanilla") bond, that makes a regular fixed interest payment and is repaid (or "redeemed") on a predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's coupon divided by its market price is called its "current yield" and its internal rate of return taking account of the eventual repayment is termed its "yield to maturity".

Other forms of bond can be categorised as particular adaptations of those payment conditions. An "irredeemable bond" (or "perpetual bond" or "consol") is not, strictly speaking, a loan, but only an undertaking to make stipulated and indefinitely continuing fixed interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer. Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity. The interest rate paid on a “tracker bond” is related to the bank or Treasury bond rate, and the redemption payment of an “index-linked” bond is related to the current level of a consumer price index.

Bonds can also be categorised according to the degree of security provided to their purchasers. A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the United Kingdom the term "debenture" refers to a company loan secured by a claim on the company's assets, but in the United States the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government. The term "default risk means the risk that the issuer will be unable to repay the loan and the "risk premium" (or "spread") is the difference between the yield on a bond and the yield on a government bond – except that “sovereign spread” is the difference between the yield on a government bond and the yield on the least risky government bond that is available. Default risk premia are linked to risk ratings issued by credit risk agencies (see below). Bonds that are rated below a minimum credit risk level (Baa for Moody’s or BBB for Standard and Poor) are termed "junk bonds" (or "high-yielding bonds") and bonds rated above that level are termed "investment-grade bonds".

Finally, bonds can be categorised according to their currency of denomination. The term "eurobond" (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.

Money market securities

Money market securities are short term loan instruments issued by governments banks and businesses. Those that can be bought and sold during the period between issue and repayment are termed “negotiable”. Those that a marketed on a “yield basis” are repaid on the due date by the amount invested, together with a stipulated interest payment. The category of money market security that are marketed on a yield basis includes "money market deposits" which are repayable after intervals ranging from one day to one year and are not negotiable, and “certificates of deposit” which are receipts from banks for deposits made with them, and are negotiable. Money market securities that are marketed on a “discount basis” are sold at a price "below par" (– ie below the amount to be repaid), but without any additional interest payment. That category includes Treasury bills, which are promises to repay loans to the government – usually after 90 days; "bills of exchange" (or "trade bills", or "commercial bills") which are similar to Treasury bills but are issued by companies; and "bankers acceptances" which are negotiable, and "commercial paper" which consists of unsecured promissory notes issued by companies.

Shares

A share in a corporation is evidence of a share in the ownership (or "equity") of that corporation, and represents a claim on its assets and its profits. The shares in a company are referred to collectively as its "stock" or its "equity". The term "equity" is also used to mean the value of the firm after all its debts and other obligations have been paid. Except for "non-voting shares" the possession of a share carries the right to vote on matters raised at its general meetings. Holders of "preference shares" are entitled to a specified form of preferential treatment compared with holders of "ordinary shares" - sometimes a guaranteed dividend, sometimes a guaranteed repayment if the company were liquidated. The "par value" of a share sometimes denotes the amount due on liquidation to the holder of a preference share, and it is unrelated to the share's market value.

Derivatives

A derivative is financial instrument whose value depends upon the value of another instrument. The principal categories of derivative are "forward contracts", "futures", "options", and "swaps". A forward contract is an agreement to buy or sell a specified quantity of an asset on a specified date, at a specified price. An option is an agreement that gives the holder the right, but not the obligation, to buy ("call option") or sell ("put option") an asset, on or before a specified date . A swap is an agreement to exchange a series of cashflows from one asset with a series of cashflows from another asset. Swaps are widely used as credit risk transfers (see below). Some derivatives are used to create leverage, as a means of speculation, or for hedging against risk.

Mortgages

A mortgage is a loan secured on property - usually real estate, although ships and aircraft are commonly mortgaged. A mortgage may be used to help finance the purchase of the property or to obtain money for other purposes.
Mortgage interest payments may be fixed or may be varied by the provider of the loan - usually in response to changes in the general level of interest rates. The term "adjustable rate mortgage" (ARM) is used in the United States to denote a mortgage for which the interest rate payable is related to a published index, and a "hybrid mortgage" is one in which the interest rate is fixed for a period, and then varied. "Subprime mortgages" are designed for the use of borrowers with low credit ratings (typically below a FICO rating of 620 in the United States). They are offered at higher interest rates than for other mortgages, but may provide for reduced payments in their early years.
If the market value of the property that is mortgaged falls below the amount of the loan, the borrower is said to have "negative equity" in the property and thus to cease benefiting from the mortgage agreement.
Failure to make the agreed payments is termed "default" and usually entitles the provider of the loan to "repossess" the property.
A mortgage loan may be financed by its provider by selling claims to its repayments - a procedure known as "securitisation".

Structured finance

The term "structured finance" refers to assets created by "securitising" cash flows such as debt repayments by converting them into marketable securities that are structured according to their maturity and risk rating, and among which priorities concerning payments and liabilities for losses are stipulated in "waterfall clauses" . The cash flows that are securitised may be income from corporate bonds, in which case the assets that are created are termed "collateralised debt obligations (CDOs)" or "asset-backed securities (ABSs)", or they may be mortgage repayments, in which case the assets are termed "collateralised mortgage obligations (CMOs)". CMOs are normally segregated into "tranches", each with its own maturity date and risk rating.

Credit risk transfer

A "credit default swap" (CDS), enables a "protection buyer" to transfer the credit risk from holding a security to a "protection seller" in return for an annual percentage charge, known as the "CDS spread", that is determined by the credit rating of the protected security. Credit default swaps can be combined to create a "synthetic CDO," in which credit losses are allocated to tranches according to stated priority rules. A "total return swap" transfers market risk as well as credit risk. Another form of risk transfer is a bank guarantee which is an undertaking to pay compensation if there is a specified form of default by a third party.

Participants

(for links to, and notes on, selected financial institutions go to the addendum subpage)

Categorisation

Some participants in the financial system specialise in trading in a single category of financial instrument while some find it necessary or advantageous to combine different trading or advisory activities; and interaction between different activities can occur even when they are performed by different participants. The attribution in the following paragraphs of a single activity to each participant is a simplification adopted for the sake of clarity.

There is no functional difference between investment banks and other finance providers: both use short-term borrowing to pay for long-term loans and the use of leverage by banks is often emulated by other providers of finance. But the deposit facility provided by commercial banks places them in a different functional category. In some contexts it is obvious that the term "bank" is used to denote a commercial bank, but it is normally used to denote either type or a combination of both.

Financial intermediaries

Banks

"Commercial banks" accept payments from depositors and lend money to personal and commercial borrowers. In addition to the money they get from depositors, they can get short-term loans from their central bank's "discount window", or from the money market or from other banks via the "interbank market". They make profits by charging higher interest rates to their borrowers than they pay to their lenders - a difference that is known as their "spread".

The banks that lend money to borrowers but do not accept deposits from the public, include "wholesale banks" that deal with other banks or financial companies; "investment banks", that raise money for companies by finding buyers for their equity and bonds; and "universal banks" that combine all of those activities. Other institutions that lend money to personal or commercial borrowers are referred to collectively as the "shadow banking system".

The practice of retaining only a fraction of the money deposited with it as a "reserve" and lending out the rest is known as "fractional reserve banking". That practice, together with the fact that borrowed money can be deposited in commercial banks and repeatedly used for the provision of further loans, gives commercial banks an unique role in the expansion and contraction of the supply of credit.

Other finance providers

Loans to consumers are on offer from a number of cooperative (or “mutual”) providers, including savings and loans associations ("building societies" in the UK), credit unions, and friendly societies; and from several types of commercial organisation including pawnbrokers , and providers of hire purchase ("instalment plans" in the United States).

Equity capital is raised by the larger firms through the services of investment banks, "securities brokers" and "flotation companies" and, through other intermediaries, by "initial public offerings" (IPOs) of shares to the public, and it is made available to firms that are too small to qualify for stock exchange listing by "venture capital companies" (termed "private equity companies" in the UK). Long-term loan finance is obtained by the issue of corporate bonds, and short-term borrowing by the sale of commercial paper on the money market. Companies also raise capital by selling the rights to their receipts from invoices and "accounts receivable" to "factoring companies" (or "invoice finance brokers"). They often finance capital equipment purchases by hire purchase, or leasing, and otherwise raise capital by the sale and leaseback of equipment that they own.

Financial services

Analysts and investment managers

The function of transferring resources and risks, attributed above to financial intermediaries, is augmented by the activities of analysts and financial advisors, operating within and outwith the financial intermediary organisations. They collect and analyse financial information and use their findings, either to inform and advise their clients, or to manage a package of financial assets known as a "fund", or to manage their clients' investment portfolios. Financial advisors may be independent of the organisations on whose products they advise, or may be related to them directly or by commission payments , and are sometimes provided by companies with information not available to the general public. Among the funds that are so managed are "mutual funds" (called "unit trusts" in the UK), which are collectively owned by their investors, including "hedge funds". Company-owned trusts include "unit trusts" (in the USA) and "investment trusts". Investment trusts and unit trusts invest in bonds, shares and money market assets, are widely marketed, and are closely controlled by regulatory authorities, hedge funds are offered only to small groups of wealthy investors, adopt unorthodox investment strategies, often employ very high levels of leverage, and often escape regulation.

Credit rating agencies

Credit ratings reflect their authors' estimates of borrowers' ability to repay what they have borrowed and if accepted, relieve their creditors of the problem of judging the risk of default. Some agencies provide such ratings for individuals, others for the issuers of debt instruments and their derivatives. For bonds, the highest ratings are assigned to issuers who are expected never to default - such as the United States Treasury - and prospective buyers of other issuers' bonds respond to the assignment of a lower rating by demanding a higher yield than that obtainable on Treasury bonds in order to compensate for the greater risk of default. The yield to be expected of a structured finance instrument such as a "collateralised mortgage obligation" (see above) depends entirely upon the credit rating of its tranche. Following the crash of 2008 the methods used by the major credit rating agencies are under review .

Markets

Stock exchanges

Trading in the different categories of instrument takes place in different types of market. "Primary markets" for pensions and insurance policies take the form of one-to-one "over-the-counter" (OTC) transactions with their suppliers, and there is seldom any further trading because those instruments are considered to be "non-negotiable". The primary markets in stocks and shares and bonds usually start with an "initial public offering" (IPO) in which the issuers deal directly with professional traders, and through them with the public. Subsequent trading in those instruments can take place, either as over-the-counter deals between dealers and individual customers, or in "auction markets" in which numbers of holders trade with each other, or in "dealers' markets" in which numbers of holders trade with dealers. The traditional way of making deals on an exchange is by "open outcry" in which sellers/buyers shout an offer and buyers/sellers shout an acceptance. Few financial exchanges now use that method and those that do plan to change to an electronic trading system such as London's "Stock Exchange Electronic Transfer System" (SETS), (augmented by clearing and settlement systems that provide the buyer with his stock and the seller with his payment). A company's shares may be traded on a stock exchange only if it is granted a "listing", the granting of which is typically subject to rules concerning the meeting of a minimum capital value requirement, and concerning the qualifications and conduct of its directors. Most stock exchanges also provide for trading in other financial instruments including structured products, and some provide a second-level market for the shares of smaller firms (such as London's "Alternative Investment Market). Conventional stock exchanges publish frequent listings of the ruling price for each traded security, but there has been a recent growth in the number of less transparent trading systems known as dark pools .

The foreign exchange market

National currencies are traded against each other in countries all over the world and the transactions are facilitated by multiple clearance systems. The activities of the traders in the different countries interact so strongly that the system behaves as though all trading were done in one centrally-administered exchange. The system is referred to as the foreign exchange (or "Forex") market although there is no central market to coordinate its transactions. The central banks of countries with "fixed exchange rates" buy and sell their countries' currencies in order to keep its exchange rate with the dollar (or other reference currency) within an intended range. Otherwise, most trading is done by banks, on there own account or on behalf of private-sector clients. Other central banks do not normally intervene in the forex market (although they sometimes act to sterilise the domestic effects of foreign exchange movements).

Exchange rate movements influence other international financial transactions and - because of the interactive character of the global financial system - they influence, and are influenced by, financial activities within trading countries.

Regulators

Governments have sought to regulate the conduct of participants in their financial systems in view of the influence of that conduct upon other sectors. The main purpose of financial regulation has typically been to preserve the financial system from the danger of systemic failure, and it has sometimes been used to further its efficient operation, for example by requiring open access to financial information, but an important secondary purpose has been to protect investors against fraud and the misuse of inside information.

Regulation has usually developed piecemeal in response to a sequence of problems - starting with the banks, and getting applied elsewhere as the need seemed to arise. A study of the structures of international regulatory systems has identified four different approaches, as described in paragraph 2 of the addendum subpage. Also, in the United States, federal governments have, over time, appointed six regulatory bodies, together covering all of the participants in its financial system except the non-bank lenders, the hedge funds and the traders in OTC derivatives. , and, until 2000, Britain's financial industry was regulated by nine different bodies. In the 1990s, however, unified systems of financial regulation were adopted by Norway, Denmark and Sweden, followed in 2000 after intensive all-party investigation, by Britain. Also, Australia adopted a "twin peaks" structure in which regulation was unified under one agency, except for separate prudential supervision of the banks, and in March 2009 the US Treasury announced plans to create "a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems" .

The crash of 2008 has led to generally agreement that current regulatory systems are inadequate for the purposes that they are intended to serve.

(the rôles of the financial regulators are examined further in paragraph 5 of the article on financial economics)

The central banks

A central bank normally implements its country’s monetary policy, manages its gold and foreign currency reserves, acts as the government’s banker and as lender of last-resort to its country’s banks. In some countries the central bank also regulates the banking system and in countries with fixed-rate currencies, it manages the exchange rate by operating in the foreign exchange market. Within that general framework, national practices differ. In the United States, the Federal Reserve Board regulates only the member banks of the Federal Reserve System, and in the United Kingdom, and neither the Bank of England nor the European Central Bank have any regulatory responsibilities.

Global finance

Exchange rates

The gold standard was a commitment to fix the price of a national currency in terms of a specified amount of gold. It was adopted de facto by England in 1717, by the United States in 1834 and by other major countries in the 1870s. It broke down during World War I and was reinstated from 1925 to 1931 as the Gold Exchange Standard. That version broke down in 1931, and between 1946 and 1971 most countries operated the Bretton Woods system under which their exchange rates were fixed in terms of the United States dollar, which was convertible to gold. Convertability of the dollar was abandoned in 1971 and most countries then adopted a “floating exchange rate” system under which exchange rates were determined by transactions in the foreign exchange market (but some currencies continued to be linked to the dollar).

International capital flows

As a matter of logical necessity, for every borrower there must be a lender and the total amount borrowed must be the same as the total amount lent - or in other words, the total amount of debt must be the same as the total amount of savings. In accountancy terms that means that the sum of the balances of payments of all the world's countries must be zero. If savers and borrowers were spread randomly around the world, that would also be true of each country viewed individually. As a matter of observation, that is not true and there have, from time to time, been very large national balance of payments surpluses and deficits (termed "imbalances"). And, as a matter of logical necessity, those surpluses and deficits must be due to national differences in their inhabitants' propensities to save. Such differences may be attributable to differences in prosperity, to social norms, or to different government interest rate, exchange rate, monetary or fiscal policies.

The international capital flows that create those imbalances are mainly made up of foreign direct investment, private portfolio investment, and credit transfers by the banking and shadow banking systems, and there are some "official flows" involving national governments and sovereign wealth funds.

International institutions

The Bank for International Settlements (BIS) was established in 1930 to deal with the reparation payments imposed on Germany by the Treaty of Versailles. Nowadays it serves as the central banks’ bank and provides a forum to promote discussion and policy analysis among central bank governors and senior executives. It has five standing committees: the Basel Committee on Banking Supervision, the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, the Markets Committee and the Irving Fisher Committee on Central Bank Statistics. Although not binding upon its members, the Basel Accords of 1988 and 2004, (known as Basel I and Basel II) are the standards for banking supervision that have been adopted by central banks in developed countries worldwide.

The International Monetary Fund (IMF) was set up by the Bretton Woods Conference in 1944, mainly to provide loans to member governments in support of policies to deal with balance of payments problems. In recent years it has also devoted its resources to the strengthening of the international financial system and relieving financial crises. It also advises member governments about their economic problems and, when necessary, it grants loans to help resolve them.

The World Bank was also set up by the Bretton Woods Conference. Its purpose is to reduce global poverty and improve living standards by providing low-interest loans, interest-free credit and grants to developing countries. It includes the International Bank for Reconstruction and Development, which provides loans to middle-income countries; the International Development Association, which gives interest-free loans to the poorest countries; the International Finance Corporation, which finances private-sector projects; the Multilateral Investment Guarantee Agency, which guarantees foreign investors against non-commercial risks; and the International Center for the Settlement of Investment Disputes, which seeks to settle disputes between foreign investors and host countries.

The International Organization of Securities Commissions (IOSCO) is an international organisation representing national regulators of securities markets, that has agreed a set of principles concerning the regulation of securities markets, made a number of further recommendations and is represented on most of the other international organisations that are concerned with the maintenance of financial stability.

The Financial Stability Forum is made up of senior representatives of central banks and finance ministries and international financial institutions including the International Monetary Fund , the World Bank and the Bank for International Settlements. It was set up 1999 to promote international financial stability, improve the functioning of financial markets and reduce the tendency for financial shocks to propagate from country to country. At working level it includes the Working Group on Market and Institutional Resilience whose task is to identify institutional vulnerabilities and recommend action to tackle them. It is serviced by a small secretariat housed at the Bank for International Settlements

Trends and innovations

From the early years of modern commercial history, the banks have been the core element of the financial system, and their relationship with their national governments has had a significant influence on its development. In the nineteenth and early twentieth centuries, it was essentially an arms-length relationship, despite frequent bank failures and several financial panics, culminating in the crash of 2009 and the Great Depression; but the price that the United States banking system then paid for its rescue from threatened extinction was a regime of tight regulation that was emulated by other industrialised countries. The regulations that were then imposed required banks to limit the extent to which their loans exceeded the funds provided by their shareholders by the imposition of minimum "reserve ratios" and placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing excessive economic penalties, and there was a general move toward "deregulation" . Restrictions upon the range of financial activities open to banks and providers of housing finance were dropped, and reserve requirements were relaxed or removed.

After the 1980s there was a dramatic surge in financial activity and a transformation of its character. The volume of financial assets grew from just over over 100 per cent of global GDP in 1980 to over 300 per cent in 2005, the total value of financial derivaties in use grew from 2½ per cent of global GDP in 1996 to over 8½ per cent in 2006, and by 2006 the volume foreign exchange trading wa s over 12 times its 1986 level . Among innovations introduced during that period were the adoption of the strategy known as "originate and distribute", under which securitised bonds, many of them mortgage-based, were sold to pension funds, insurance companies and banks a change in the funding of bank lending, away from deposits towards short-term interbank and money market borrowing, and large increases of leverage , . There was also a massive expansion of the unregulated hedge funds – to the point at which they are estimated to have accounted for 40 to 50 per cent of stock exchange activity by 2005 - many of which dealt in high-risk, high-return investments, and some of which depended upon borrowed money amounting to over twenty times their capital. The period from 1986 to 2006 was also characterised by a substantial upward trend in household debt, particularly in the United Kingdom and the United States.

In parallel with the expansion in financial activity was a series of new developments in the previously neglected discipline of financial economics, that were then applied to the quantitative analysis of investment decisions. The theoretical basis for most of those developments was the treatment of investment risks as the consequence of random fluctuations conforming to mathematically defined "probability distributions" that could be quantified by statistical analysis of available historical records. Their application involved the formulation and application of highly sophisticated computer models operated by experts that came to be known as "quants". Those developments tended to relieve investment managers of the reponsibility for judging the risks involved in their companies' investment decisions.

The increase in domestic financial activity was accompanied by a massive growth in the volume of international transactions, with the development of large payments imbalances and correspondingly large international capital flows. For most of the 20th century capital flowed mainly from the developed economies to the emerging economies, notably bank lending to Latin American countries in the 1970s and direct and portfolio investment in Asian countries in the 1990s . During the first 7 years of the 21st century, however, the balance of capital flows was from the emerging economies to the developed economies and there was a corresponding development of balance of payments surpluses and deficits. China's current account balance, for example, grew from $9 bn in 1995-6 to $970 billion in 2000-07, and annual capiital outflows from Asian emerging economies increased from $51 bn in 1990-97 to $502 bn in 2007 . The counterparts of the payments imbalances were differences in national savings rates, which in 2006 ranged from 14 percent of GDP for the United States to 60% for China

(for the sequence of major developments, and links to more information on those developments, see the timelines subpage)

Performance

Benefits

Economic theory suggests that benefits should accrue from a well-functioning financial system. The theorems of welfare economics establish that a system governed by perfect competition is Pareto-efficient, meaning that no better system is possible, and the efficient market hypothesis suggests that stock markets meet its information requirements. Empirical support for that hypothesis was provided by studies undertaken and summarised by the economist Eugene Fama and others. Fama concluded that there is no important evidence to suggest that prices do not adjust to publicly available information, and only limited evidence of privileged access to information about prices. Joseph Schumpeter had argued in 1911 that the services provided by financial intermediaries - mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions - stimulate technological innovation and economic development , World Bank economists, Robert King and Ross Levine provided empirical support for that proposition in 1993 , and it has become the consensus view among economists. (However, a critical survey of the empirical evidence has noted that the proposition was not universally accepted and that, although the evidence wass generally supportive of the proposition, the connection between finance and growth is not fully understood .)

Systemic instability

The theory underlying those conclusions embodies the assumption that the people concerned always behave rationally, and it is thus regarded - like most economic theory - as providing a working approximation rather than a universal truth. Similarly the empirical evidence reveals what usually happens, not what always happens. Thus an occasional departure from their findings (resulting, for example, from panic or herding) is to be expected. Such departures are usually transitory and of little importancet, but in a tightly-coupled interactive system, such as the current financial system, they can be crucial. The tightly-coupled characteristic of such a system means that the failure of one component can trigger the failure of a component that has feedback links with the originator. If the feedback is positive, the effect can be explosive, and if there are other such links it can lead to the destruction of segments of the system, or even of the system as a whole. The complexity of the system implies its ability to develop a mix of positive and negative feedback links - and possibly to experience long periods of stability, interspersed with systemic failures. It also implies the impossiblity of identifying the crucial triggers, or of predicting their timing.

Complexity is increased by the fact that financial system is not closed: that it has active two-way linkages with the economic system and with the political system, both nationally and internationally. Among the interactions that link the financial system to the economic system are the fact that a reduction in the availability of credit can affect economic activity by reducing consumers' purchasing power, and the fact that a reduction of in economic activity can reduce the financial system's ability to supply credit - facts that together constitute a destabilising positive feedback known as a liquidity spiral. An interaction that links the financial system with the political system is the tendency of democratic governments to defend the interests of those who elect them, by intervening in their financial systems, either to restrict the conduct of its participants or to rescue them from threatened insolvency. vernment Restrictions tend to increase domestic stability at the expense of efficiency, and rescues tend to reduce stability by enabling banks to "appropriate their gains and socialise their losses" thus reducing their motive to avoid risks.

Costs

In any assessment of the net benefits from the current financial system, account has to be taken of the fact that the cost of a systemic crisis is apt to be devastating: even before the crash of 2008 they were often more than 10 per cent of GDP, and sometimes much more. The global costs of the early stages of the 2008 crash were estimated by IMF economists as over $500 billion , and its ultimate cost promises to amount to tens of $trillion. A balanced assessment is hampered by the fact that the a collapse on the scale of the 2008 crisis is unprecedented (with the possible exception of the crash of 1929) and the fact that their expected incidence in any single country is otherwise low (the IMF economists have identified only 42 systemic crises in 37 countries during the period from 1970 to 2007}.

Reform

The historical record shows that proposals to reform the financial system have made little political progress except at times when events had raised awareness of the dangers of breakdown, and that the system had otherwise developed by evolution rather than design . The consideration of measures designed to reduce the instability of the system returned to the political agenda during the crash of 2008, however, and a measure of agreement concerning regulatory reform began to develop in the course of 2009.

An analytical study, prepared for an international conference in Geneva in January 2009 , derives some guiding principles for the regulation of the financial institutions. The study draws a distinction between "macroprudential" regulation, which is concerned with the integrity of the system as a whole, and "microprudential" regulation, which is concerned with the integrity of its component institutions; and demonstrates that improvements in microprudential regulation may not contribute to the integrity of the financial system. Microprudential regulation is taken to apply to all but the smaller financial institutions, and macroprudential regulation only to institutions (or groups of institutions that are prone to herding) whose failure could threaten the integrity of the financial system. Different approaches are required in view of the different risks to be taken into account, and the authors recommend the separation of the two functions, with the assignment of macroprudential regulation to central banks, and that of microprudential regulation to the financial services regulators.

The Integrated Model and the Twin Peaks Model may more rationally reflect the changes that have taken place in the financial services business…

(links to proposals for regulatory reform that are under consideration are available on the addendum subpage)

Prospects

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