The catastrophic effect of the 2008 financial crisis on growth, trade and jobs across the globe exposed fundamental weaknesses in the financial sector. It also provided the impetus for a major overhaul. Are we making the most of this opportunity to fix the system? Are we building a financial system that is ethical and serves society, and not the other way round?
What’s the good side of finance?
Financial systems play a key role in facilitating shared prosperity. Just about any important activity requires finance, be it personal health, owning a home, investing in education, starting up and growing a business, or taking care of the elderly. Many financial products – such as installment loans or mortgages – are particularly important for low and middle-income people, and help them smooth and increase their lifetime income.
In a functioning market, money flows freely, information is broadly shared and investors get adequate returns for the risks they take through equity or debt instruments, capital flows to profitable companies, projects and investment opportunities. In an ideal world, the financial system helps society allocate resources and manage risks. Finance works.
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But when finance loses its way…
As we have seen time and again, the financial system can become distorted. When decision-makers don’t internalize the impact of their decisions on other stakeholders, outcomes can be harmful. Finance seems to have moved from a profession where fiduciary responsibility mattered, to one where making money seems to matter most. Excessive deregulation of the financial services industry also contributed greatly to the dysfunction that underpinned the financial crisis.
Opaqueness is another threat to the underlying integrity of the financial system. Financial innovation can help market participants hedge exposure or reduce risks but only if these innovations are appropriately regulated and transparent. Financial service providers have too often engaged in complex activities that were detrimental to society at large.
The ugly side
Unfortunately, participants in the financial system have been known to behave unethically; to seek personal gain by not providing better services or breaking the spirit (if not the letter) of the law; to take advantage of the less informed and, especially, less prosperous members of society. Since the crisis, the largest 20 banks have ended up paying a hefty $235 billion in fines and compensation (amounting to 60% of some of their profits). The depletion of public trust in the financial sector, regulators and the markets has had substantial implications for financial stability, economic growth and social cohesion.
What needs to be done?
- We need a good regulatory framework that is not overly complex. Regulations to improve the resilience of individual institutions must be accompanied by regulations to strengthen the resilience of the financial system as a whole. This requires continued global coordination to minimize the scope for regulatory arbitrage.
- We need effective supervision to prevent excessive leveraging. Supervision needs to be intensive, intrusive and more focused on cross-border exposures. And supervisors should be able and willing to say no.
- We need effective national and cross-border resolution. This is critical for addressing the problem of “too important to fail”. In 2012, the implicit subsidy given to global systemically important banks represented up to $70 billion in the United States, and up to $300 billion in the euro area.
- We need more accountability at the level of financial institutions. Deficiencies in culture and lack of trust can be just as destabilizing for financial markets as problems of capital or liquidity. A strong tone needs to be set at the top of the institution that rewards ethical behaviour and encourages better risk measurement and management.
- Finally, we need a more inclusive financial sector. Financial access and the underlying financial infrastructure are taken for granted in most advanced economies, such as savings accounts, debit or credit cards, as well as the payment systems on which they operate. Yet, 2 billion adults remain without a bank account. Broader access to the financial system can boost job creation, increase investments in education, and help people manage risk and absorb financial shocks. Recent analysis shows that if supported by good regulation and supervision, financial inclusion can actually go hand in hand with financial stability.
In conclusion, building a sustainable and inclusive financial sector that serves society requires collaboration. The 2008 crisis triggered an unprecedented effort to reform the global financial system – but we are not there yet. No effort should be spared by banks and regulators to regain public trust by addressing the too-big-to-fail challenge.
And most importantly, we must enable banks to contribute fully to growth and serve the needs of the society. The World Bank Group has partnered with public and private stakeholders to reach 2 billion people in the next five years through the Universal Financial Access 2020 (UFA2020) initiative. This is a major challenge and an opportunity of a lifetime. We need to work together and deliver.
The Summit on the Global Agenda 2015 takes place in Abu Dhabi from 25-27 October
Author: Ceyla Pazarbasioglu, Senior Adviser, Finance & Markets Global Practice, The World Bank Group. Member of the World Economic Forum Global Agenda Council on Global Financial System
Image: A man passes the Swiss RE building, also known as the Gherkin, in the financial district City of London June 22, 2010. REUTERS/Luke MacGregor