Why Global Financial Standards Matter in a Fragmented World

World Economic Forum.

The global financial crisis of 2007-12 reshaped the financial system, prompting nations to reassess the benefits and risks of financial globalization. In the aftermath, many countries sought to curb the excesses of globalization by implementing tighter regulations.

More recently, the push for strategic autonomy and the weaponization of finance, especially following the war in Ukraine, has added further fragmentation, which could result in more costs than benefits. Global financial standards are crucial to maintaining the benefits of free capital flows and preserving global financial stability.

The Global Financial Crisis and Its Aftermath

Before the global financial crisis, there was widespread consensus that free capital flows were beneficial for economies, allowing access to a broader pool of savings, increased market discipline, and diversified risks. However, the crisis exposed the vulnerabilities of countries heavily reliant on foreign financial systems. Spillovers from banking crises abroad forced many nations to rethink their approach to financial openness.

Countries that hosted branches of foreign banks took steps to protect themselves from the fallout of crises in parent banks. For example, the UK implemented ring-fencing measures in 2009, separating retail banking from riskier investment banking. This regulatory response was part of a broader trend of “intended” fragmentation, where nations sought to insulate themselves from external financial shocks.

New Shocks Fueling Fragmentation

More recently, other global events have intensified this fragmentation trend. The COVID-19 pandemic underscored the risks of over-reliance on foreign providers, driving a push for strategic autonomy in areas such as medical supplies, energy, and financial infrastructure. The war in Ukraine added further fuel to this shift, as the sanctions imposed on Russia highlighted vulnerabilities in essential financial infrastructures like wholesale payments and central bank reserves.

Emerging economies, in particular, have responded to this “weaponization of finance” by seeking alternative capital markets and currencies, further fragmenting the global financial system. This trend has led to a retreat of foreign banks from their overseas operations, either as a regulatory requirement or as a strategic decision to protect themselves from future crises. According to a McKinsey report on financial globalization, many foreign bank branches have been transformed into subsidiaries, allowing host countries greater control over local operations.

The Importance of Global Financial Standards

As fragmentation increases, the implications are significant. A more fragmented financial system leads to less efficient capital allocation and suboptimal risk diversification. Additionally, reduced competition in local banking sectors can create solvency issues, as inefficient banks become more vulnerable over time.

Fragmentation also weakens market discipline, especially as domestic financial markets become more isolated. This is particularly concerning in a world with rising public and private debt. While fragmentation may reduce contagion from financial crises in one country to the rest of the world, it also introduces new risks and inefficiencies.

In this context, global financial standards set by institutions like the Basel Committee on Banking Supervision and the Financial Stability Board (FSB) play a vital role in maintaining a common regulatory framework.

Without these international standards, the fragmentation of the global financial system would be even more pronounced. However, the trend towards subsidiarization—the transformation of foreign branches into subsidiaries—reduces national authorities’ interest in adhering to global standards. A recent example is the delay in finalizing Basel III regulations in the United States.

Expanding the Scope of Financial Standards

As the financial system becomes more fragmented, there is a need to expand the scope of global financial standards to address new challenges such as digital finance and sustainability. Common principles for regulating areas like artificial intelligence (AI) and financing the transition to a net-zero economy would provide consistency and stability.

The World Economic Forum has emphasized the importance of developing global frameworks to address these emerging issues, particularly as technology and sustainability become central to the future of finance.

Despite the importance of global financial standards, there are challenges in implementing them. The lack of global governance in areas like AI and data protection makes it difficult to create comprehensive regulatory frameworks. The G20, while a suitable platform for political debate, lacks the global membership needed for a truly universal approach. Similarly, the FSB does not have the mandate to address emerging issues like digitalization or climate-related risks.

Strengthening Existing Institutions

Given the reluctance to create new international regulatory bodies, a more realistic solution would be to expand the mandate of existing institutions like the FSB and the Bank for International Settlements (BIS). These organizations have the resources and capacity to address new challenges in the financial system. In a world with increasing fragmentation, international regulatory coordination is more critical than ever.

While the global financial crisis prompted necessary reforms to limit the excesses of financial globalization, recent trends toward strategic autonomy and the weaponization of finance have introduced additional fragmentation. This growing division in the global financial system could result in more costs than benefits, particularly for emerging economies.

Maintaining global financial standards and expanding them to cover new areas like digital finance and sustainability is essential to ensuring the benefits of free capital flows and preserving financial stability.