The Need for a New International Financial Architecture
The international financial architecture is made up of institutions, practices and instruments. Most institutions were designed in the 1940’s, at the time when stable exchange rates were central and financing the reconstruction of the post war world, essential. Since then BWI demised in 1971 and the World Bank shifted in the 1980’s from project based financing to programme based financing, centring on economic policy and institutional reforms.
New financial instruments began to operate at least since 1995 on a risk elimination basis with no new international institutions on their side to overlook, supervise or regulate them. The operate by means of insurance operations such as credit default swaps, interest rate swaps and currency swaps, which make it possible for bankers to undertake greater risks, given the fact that each operation can have a derivative instrument attached that hedges risks. The derivative instrument essentially transfers property of the instrument from the creditor to the holder of such instrument in the event a credit, interest rate or exchange rate risk materializes. But in 2007 many economic agents stopped paying bad loans at the same time and soon derivatives were not able to cope. It was realized that derivatives serve to hedge individual operations but fail to hedge the system. Thus, it became public knowledge that first, there was no precise information regarding neither the size of the derivatives market nor who its holders were, and second, that the Bank for International Settlements in Basel registered the amount of $687 trillion which was twelve times higher than the world GDP and many times higher than the GDP of the United States and Great Britain which, being international financial centres, concentrate the bulk of these instruments.
All of a sudden, the world was facing a US financial crisis led by its own investment banks, which had carried out “very innovative”, hardly solid and, let alone, ethical operations, because the end customers did not know the risks involved in these new structured instruments, i.e. they did not know how their resources were being invested by pension or investment funds. It became evident that commercial banks were not performing very strong risk ratings before offering a credit since, being a transaction that was going to be sold almost immediately, there was no reason to do so. In this way, commercial banks did not have large heavy portfolios while a crisis of large proportions that ended up being spread to the rest of the world was unfolding.
The shift from a reserve-based finance to hedging in the 1990s released resources from commercial banks that no longer had to save reserves for bad debts. At the same time, it relieved bankers from their responsibility in loans since banking became an activity in which commissions, rather than the profits obtained from each loan, are the main source of revenue for banks and bankers. The latter no longer had to take responsibility for loans. The point of the IFA is to bring its institutions, practices and instruments not only into international borrowing and lending but also into debt problems and solutions including the new elements at play which has made the system more complicated.
Dealing with international financial problems has required policy conditionality since the 1970’s. The experience of the past thirty years is that policy conditionality is at the base of new lending in times of stress and that it is related to depressing consumption and churning the economies from consumer led into the export led model, even in Europe where consumption reflects about 70% of European GDP. The link between the new instruments and policy conditionality is unclear, not so between sovereign borrowing and new “rescue” lending. The problem is that in some cases the sovereign problem results from financial rescues derived from the use of new instruments that failed or simply from excess speculation that led to financial bubbles.
The debt problems faced by practically all countries at some time in their history before 1944 had mechanisms of resolution. They were not linked to any conditionality and were related to the London and Paris bond markets through what was known as the Corporation of Foreign Bondholders (1872-1955) that served to bring together all creditors holding bonds, with the debtor at the time of negotiations. After the creation of the concept of bilateral loans in World War I; multilateral loans, through BWI in the 1940’s; commercial bank sovereign loans in the 1960’s and the return of the bond market in the 1980’s, there is a mixture of types of creditors and loans not reflected in any way in the existing debt resolution mechanisms leading to the need for new mechanisms, some of which are now under discussion at the UN General Assembly.
As the crisis unfolded between 2007 and 2008, it became apparent that the international transfer of risks was almost epidemiological. So long as European and Japanese investment banks had purchased these instruments, they were also infected by the bad quality of sub-prime loans. They had purchased them in the belief that they were solid and it turned out that they were rubbish. Furthermore, evidence showed that there were no records as to who had purchased those instruments and little was known except from sensing that problems would arise with investment banks around the world affecting their profitability.
At the same time the economic problems facing the major G7 economies force a rethink into what is to be considered a reserve currency. Moreover, the concept of the SDR and its components must be reconsidered and so must its function as additional international liquidity and its workings. It is perhaps the time to rethink if BWI under a new voting structure could be of use or if under the circumstances it is time to explore new regional institutions with new regional SDRs or a global SDR with 192 member currencies assigned regionally according to world GDP and world trade weights.