Unfinished Reform in the Global Financial System

This paper offers a perspective on the challenges that the global financial system will face in the course of the next decade. While there has been significant progress since the financial crisis of 2007-2009 and the slow and uneven pressure of recovery and reform, a great deal of important work lies ahead. Part I briefly reviews, for the purpose of general background, the context and causes of the financial crisis. Part II identifies the key lessons to be learned from the crisis, and Part III outlines the major reforms adopted to date in the United States, Europe and the G-20. Finally, Part IV highlights what I regard as the principal ongoing issues affecting the financial system and suggests some approaches for dealing with them.

With the benefit of hindsight, it is now widely agreed that the housing and mortgage market in the United States had developed in ways that set the stage for a bursting bubble. It is also clear that the impact of the Great Recession was exacerbated by structural changes in the economy, especially in the United States and Europe. Underlying structural weaknesses, including fiscal imbalances and labor market rigidity, slowed recovery in much of Europe. In the U.S., globalization and productivity improvements spurred by automation and innovations in robotics had progressively reduced the number of industrial jobs and diminished the wages and benefits available from many others. Budgetary constraints in the public sector had reduced investment in infrastructure, cutting job opportunities in construction and supplies and slowing corporate investment and growth.

The financial crisis revealed significant weaknesses in the roles and practices of both the financial institutions and their supervisors and regulators. Of equal or greater importance, it underscored the reality that core principles of the business, though well understood for centuries, may be eclipsed at times of stress, with disastrous results. First and foremost, the crisis vividly demonstrated that financial institutions depend for their survival on the trust and confidence of the customers, clients and other institutions that deal with them. If trust and confidence erode, little else matters. Second, the financial crisis laid bare an array of serious weaknesses in the internal processes of the major financial institutions—including particularly an urgent need to upgrade the quality, skills and practices of the risk management, compliance, audit, finance and legal functions, and the exercise of leadership in controls and compliance in their operating businesses. It also raised similar doubts about the resources, skills and capacity of the governing boards of the large institutions and of their supervisors and regulators in the major financial centers around the world. Third, the crisis underscored a series of misjudgments and missed opportunities by regulators. Regulators lacked the critical, system-wide information needed to detect an emerging crisis before it erupted and spread across the landscape. In the U.S. and Europe, and in the G-20 through the Basel Committee and the Financial Stability Board, the dialogue on regulatory change triggered by the financial crisis tended to focus on a handful of issues that became the principal targets of the reform efforts; these included stress tests to understand and manage systemic risk, increased capital and liquidity, specific plans for recovery and resolution, enhanced regulation and enforcement for protection of consumers, assured access to data and information about market activity needed by regulators to respond to crises, and limitations on activities by financial institutions unrelated to serving customers and clients.

By any reasonable standard, there has been significant progress on financial reforms in the U.S., Europe and the G-20 in the years since the onset of the financial crisis. Important work remains to be done to execute the reforms; to fill in the gaps, including, for example, controls on the financial services provided by unregulated “shadow” banks; and to drive convergence globally. But as the work proceeds to implement the reforms that have already been adopted, the participants in the financial system will also need to address other significant challenges that have recently received growing attention; these challenges center on issues of ethics, culture, compensation and talent, all of which are crucial to the overarching issue of rebuilding trust and are likely to dominate reform debate over the next decade.

The full paper is available for download here.