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International Financial Architecture

International Financial Architecture

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Published by: Muthu Nainar on Dec 10, 2012
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INTERNATIONAL FINANCIAL ARCHITECTURE: In the wake of recent crises, the international community embarked on a range of initiatives to strengthen the

international financial architecture. While there is no agreed definition of what constitutes international financial architecture, it refers broadly to the framework and set of measures that can help prevent crises and manage them better in the more integrated international financial environment. Several aspects of the agenda for crisis prevention and crisis resolution deal with weaknesses in the international financial system that potentially contribute to the propensity and magnitude of global instability, hence requiring collective action at the international level. But there is widespread recognition that global financial stability also rests on robust national systems and hence requires enhanced measures at the country level as well. The World Bank Group's role in this agenda is determined by its mandate of poverty reduction, its familiarity with and involvement in developing countries given its role as a global development institution, and its comparative strengths on social and structural issues:    First and foremost, the World Bank is helping countries assess the social and structural sources of vulnerability and address underlying policy and institutional weaknesses. Second, the World Bank is contributing to efforts to strengthen economic and financial governance at the global level in its areas of comparative advantage, and to help bring developing country experience and perspectives to the discussions that are underway on reform. Third, the World Bank is helping countries respond to and manage the consequences of financial crises.

Three important initiatives are underway with the IMF pertaining to international financial architecture (a) the Reports on the Observance of Standards and Codes; (b) the Financial Sector Assessment Program; and (c) the preparation of Public Debt Management Guidelines and a complementary Practitioner's Manual on the development of domestic markets for government debt. The World Bank also has strengthened partnerships with the relevant standard setting bodies and other institutions in the areas of corporate governance, accounting and auditing and insolvency regimes to forge a consensus and catalyze concerted actions. In addition, the World Bank is especially concerned with managing the social dimension of economic crises, and supporting social protection to help poor people manage the effect of economic shocks. REPORTS ON THE OBSERVANCE OF STANDARDS AND CODES: The international community has emphasized the important role of international standards in strengthening the international financial architecture. In a world of integrated capital markets, financial crises in individual countries can imperil international financial stability. This provides a basic public goods rationale for minimum international standards which would benefit both international and individual national systems. At the international level, international standards enhance transparency as well as multilateral surveillance. They help to better identify weaknesses that may contribute to economic and financial vulnerability, foster market efficiency and discipline, and ultimately contribute to a global economy which is more robust and less prone to crisis. At the national level, international standards provide a benchmark that can help identify vulnerabilities as well as guide policy reform. To best serve these objectives, however, the scope and application of such standards needs to be assessed in the context of a country's overall development strategy and tailored to individual country circumstances. In this connection, the IMF has invited the World Bank to embark on a joint pilot exercise preparing "Reports of the Observance of Standards and Codes" (ROSCs). In this exercise, the two institutions are undertaking a large number of summary assessments of the observance of selected standards relevant to private and financial sector development and stability. These assessments are being collected as "modules" in country binders constituting the "ROSCs." Under this modular approach, the Fund takes the lead in preparing modules in the area of data dissemination and fiscal transparency. Modules for the

The third option is a world of discretionary interventions. 4)step up the involvement o f more international agencies and MDBs in ROSCs assessments and follow up activities. Components of the IFA IFA at National Level At the national level there are three goals which are impossible to attain simultaneously (the "impossible trinity" of sustainability of foreign currency debt. The World Bank has been asked to take the lead in three areas covered by ROSCs: (i) corporate governance.financial sector (monetary and financial policy transparency. having deregulated access to the domestic financial sector. and (iii) helping countries respond to and manage the consequences of crises. securities market regulation. There are very few countries that follow this model.Executive Directors-in February 2001 and in March 2003 . payment systems. and central bank supervision). PROGRESS IN THE INTERNATIONAL FINANCIAL ARCHITECTURE AGENDA: Given it’s role as a development institution and it’s mandate to reduce poverty. banking supervision. TA and lending instruments). and (iii) insolvency regimes and creditor rights. at the same time. free access to the domestic financial sector goes along with supervision (of a discretionary nature) by . a deregulated domestic financial sector. 2)engagement in industrialized country assessments in Bank-led ROSC areas andmechanisms to finance.and i s scheduled for review. (ii) accounting and auditing. the main objectives of the World Bank Group’s involvement in the International Financial Architecture agenda are: (i)contributing to efforts in strengthening economic and financial governance at the global level. in this world. deposit insurance) are mostly derived as by-products from a parallel BankFund Financial Sector Assessment Program (FSAP). but also with the goal of a supervision of financial transactions by the central bank. In their discussion o f the March 2003 review. The first policy option is a world of no controls and no intervention which is compatible with attaining a sustainable foreign currency debt and. given scarce capacity. The Reports on the Observance of Standards and Codes (ROSC) Progress under the ROSC initiative has been reviewed twice by Bank and Fund. A second option consists of a world of strict regular controls which is consistent with the goal of a sustainable foreign currency debt.again in July 200512. 3)better prioritization o f ROSC recommendations for reform and better incorporation of the assessments in the Bank’s country work (CASs. and bringing developing country experience and perspectives to the discussions that are underway on reform (ii)helping countries assess the structural and social sources of vulnerability and address the underlying policy and institutional weaknesses. the Boards raised thefollowing key issues: 1)greater selectivity and prioritization o f assessments.

offers an alternative where independent monetary policy is not feasible. as well as the member’s access to the IMF’s financial resources. Both the extent of the crisis and the way it spread to the rest of the world capital markets created an awareness of the risks that financial liberalization has for the stability of the global economy.the central bank/ qualified agencies. This third option was chosen by many of the emerging economies that ran into financial turmoil in the last decade of the last century. which act as the IMF’s unit of account. crawling pegs or simply some sort of ‘managed floating’. a currency board is not a perfect insulator against speculative attacks and hence against the onset and contagion of financial crises. to pursue a strategy of a stable exchange rate and to pursue autonomy in its monetary policy simultaneously. IFA at Supranational level The main International Financial Institutions (IFIs) intermediating in the international sphere are the Bretton Woods Institutions (the IMF and the World Bank). THE RECONSTRUCTION PROJECT FOR THE INTERNATIONAL FINANCIAL ARCHITECTURE The Asian crisis in 1997 and 1998 was not just a period of financial instability that the world economy goes through regularly. the number of crises that had international repercussions increased. It was a crisis of the whole financial system. The International Monetary Fund John Maynard Keynes was the intellectual mentor of both the IMF and the World Bank.s. The second option. and the modern day derivative of this regime. The IMF began operating in 1947 with a fund of $9 billion in gold and currency. The first policy option is flexible exchange rates. IFA at International level The classical dilemma of stabilization policy is that it is not feasible for a government to allow free movement of capital. In 1969 the IMF created a type of reserve assets called Special Drawing Rights (SDRs). that of a fixed exchange rate as exemplified by the historical Gold Standard. As a matter of fact. the currency board. Each country’s IMF quota. This justified the urgent need for a new international architecture. A context of systemic crises Throughout the 90. which reflects the relative size of the member country’s economy. Rarely in the course of history had the international financial markets experienced . the Regional Development Banks (RDBs) and the Bank of International Settlements. However. determines the member’s voting power. many countries did not maintain flexible exchange rates but instead opted for currency pegs (usually against the US dollar) organized as adjustable pegs.

especially in developing economies which are still marked. The Asian crisis is a perfect illustration of this type of scenario. Whereas the crisis of the peso in Mexico in 19941995 was interpreted in terms of the unsustainablility of the current account deficits. the crisis in Turkey and in Argentina at the beginning of 6 2001 and so on. in the area of prudential standard. But was this loss of confidence justified by the fundamentals in Thailand. referring to the illiquidity crisis brought about by the self-fulfilling expectations of international investors. 1998). the international mobility of capital accentuates and multiplies the sources of instability and crisis. the latter guaranteeing the stability of the financial commitments. Indonesia. It should rather. On the other hand. Korea or in the Philippines? Some would say it was. the Asian stock market crash in the autumn of 1997.such violent adjustments as those that have taken place in recent years: considerable tension on the bonds market in 1994. 1999). financial difficulties in Russia from May to August 1998. Corsetti et al. the Asian crisis is seen more as a wave of panic which cannot be directly linked to a sudden worsening of the macroeconomic imbalances. and have been for years. They did not have . the Asian crisis in 1997-1998 led economists to give greater importance to factors of vulnerability.. particularly the fragility of the international financial systems and the rationality of the investors which could lead to an increase in the general insecurity and to a rapid transformation of a local shock into a global liquidity crisis. the Asian crisis has been interpreted in various ways. be analyzed in terms of self-fulfilling prophecies or sunspots (Krugman. several things became obvious. even if the scope and extent of the crisis in the region indicates a lack of discernment and an irrational knock-on effect. but rather to the fact that the liberalization of capital movements has usually resulted in a sharp increase in liquid liabilities and notably in short-term currency borrowing through the intermediary of the banks. The crisis was a response to a dramatic increase in risk as perceived by international investors resulting in a dramatic loss of confidence. by very close links between banks and governments. the crisis in Brazil between November 1998 and January 1999. However. 1998. On these occasions. Most Asian countries had more or less balanced budgets. in the context of the fragility of the domestic financial markets (Dornbusch. These anomalies cannot be attributed to financial competition per se. Because of this. for other economists. They extended the variables which might explain the crisis to include weaknesses in the financial and banking systems. the collapse of Baring Brothers in February 1995. They consider this crisis as the culmination of an unsustainable deterioration in the macro-economic fundamentals and the inevitable consequence of inappropriate policies. the Mexican crisis between December 1994 and February 1995. or to a shock in the evaluation of risk by international investors. they say. This has made the economies concerned much more vulnerable to a change in the state of confidence.

to pursue a more clearly expansionist monetary policy requiring a relaxing of their exchange objectives. the extension of securitization. sudden changes of opinion on the financial markets are rarely a response to an unreasonable analysis of a country. If a cause for worry appears on a market. bonds market. very often reveals the short-sighted nature of forecasts and a real lack of discernment in the way they are used. predictions are established which spread a feeling of mistrust towards other markets and other countries in the form of volatility spillovers or shifts in the price of assets. But it also includes factors that are not taken into account by those who support the theories of the efficiency of the markets or rational expectations: failure to see disaster coming.expansionary monetary policies that could be considered as irresponsible and their rates of inflation were not very high. There are two types of argument for this. Of course. uncertainty over the efficiency of the modes of governance of the banks coupled with short-sightedness imposed by the . 1998. 2000. a conventional currency crisis. However. an excessive preference for liquid assets. Finally. the notion of a systemic crisis obviously involves the spread of a local shock on a regional or global level. theoretical arguments and empirical ones.s situation or a particular kind of assets. (Cartapanis. the generalization of the external convertibility of currency. the overshooting of the markets. had the kind of high unemployment levels that might have encouraged them. therefore. besides the vulnerability that it causes for the traders themselves. accentuated by the conviction of a lender of last resort intervention. 1994. before the crisis. subsequently. even at the World Bank and the IMF. The argument in favour of financial liberalization was based on the theory of the efficiency of the financial markets and on the assumption that information was totally accurate. and the liberalization of the modes in which interest rates are fixed. 1993). Aglietta et Moutot. Although it has been defined in various ways (De Bandt and Hartmann. when information is not perfectly reliable and markets are incomplete. radical uncertainty. 1999): adverse selections and inordinate risk-taking in the presence of asymmetrical information. though it may be considered to be of short duration or even to have no objective justification in the eyes of the traders. It is more like a deep financial crisis containing all the ingredients of a systemic crisis. which raises the problem of moral risk. They were not experiencing a rise in current accounts deficits which seemed to be at an acceptable level. global interdependence and the spreading of the crisis among the different types of financial markets (exchange market. All this explains why the Washington consensus. unbridled competition is no longer pareto-efficient and government intervention must be maintained in order to control certain sources of inefficiency or fragility (Stiglitz. mimetic effects. The Asian crisis is not. credit market) or on a global scale. advocating the rapid modernization of financial systems. none of them. is no longer in fashion. stock markets. 1998). However.

At the same time. the risk of a herd mentality causing the irrational spread of speculative crises and banking crises and so on. 1998). experience shows that the liberalization of international capital movements significantly increases the risk of a financial crisis although there is no proven correlation with the level of investment or the rate of growth (Rodrik.8 shareholders. This overall situation justifies the fact that the architecture of the global financial system is indeed today a relevant issue .

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