Avoiding Another Crash: How Global Standards Set after the 2008 Crisis Prepared the Financial System to Weather COVID-19
In the mid-14th century, the Swiss city of Basel – already a significant urban center by medieval standards – was devastated by the Black Death. In 1919-21, the Spanish Flu wreaked almost as much destruction on the city, infecting half of the population as soldiers brought the disease back from the frontiers after World War One.
In its response to the modern-day pandemic of COVID-19, Switzerland has fared far better. It has achieved a relatively low rate of infections and deaths, and established an economic support package that leverages digital payment channels to ensure the survival of small businesses.
Yet there is another reason why Switzerland – and Basel in particular – are significant during this current crisis. Within its walls, the city hosts both the Bank for International Settlements – known as the bank for central banks – and the majority of the global standard setting bodies, such as the Basel Committee for Banking Supervision, that have spent much of the last decade working to strengthen global financial stability in the aftermath of the 2007-8 financial crisis.
Together with the Financial Action Task Force in Paris, which serves as the standard setter for anti-money laundering and countering the financing of terrorism, and the International Organization of Securities Commissions in Madrid, these Basel-based standard setting bodies have been playing low-key but vitally important roles in the global response to the coronavirus, in at least three key respects.
Strengthening financial sector resilience through global standards
The reforms of the last decade have strengthened the global financial system’s resilience to shocks, and we are now seeing the benefits. While the causes of the global financial crisis are still being debated, they include limited transparency of the risks bundled into certain innovative financial products, dangerously overleveraged financial institutions that lacked flexibility in a downturn, and systemic failures in corporate governance and oversight that failed to spot these risks as they accumulated.
The response from global standard setters and national regulators has been comprehensive. Under the Basel Committee’s latest reforms (known as Basel III), financial institutions are now required to hold minimum high-quality capital and liquidity buffers, with banks subjected to a regime of robust stress-testing to enable them to withstand shocks.
To understand the importance of these post-crisis reforms in today’s context, we only need to imagine how a global pandemic might have played out before these reforms took place. The highly leveraged financial institutions of the pre-2008 world would have been far less resilient to the havoc wrought by the onset of COVID-19. In short, without these measures to ensure the capital adequacy of financial institutions, crises in public health and the economy could very easily have snowballed into a severe financial crisis.
In other words, we could easily have experienced COVID-19, the worst recession since the Great Depression, and a global financial crisis simultaneously. Instead, while some smaller banks and microfinance institutions will certainly still face solvency challenges due to an expected rise in non-performing loans, the financial sector has – on the whole – been able to play a positive role in the COVID-19 response, including by channeling massive government loans and grant programs to corporations and small businesses.
Flexible financial standards serve the real economy
Although they prescribe rules for the level of capital that financial institutions must set aside in good times to build buffers, standards also have built-in flexibility. For instance, consider the countercyclical capital buffers in Basel III, which can now be readily utilized as part of countries’ economic and financial policy responses to COVID-19. Central banks around the world responded to the outbreak of the pandemic by immediately reducing reserve ratios, alongside their monetary policy interventions. This allowed financial institutions to reduce the capital buffers they’d built up in compliance with the global standards, ensuring that lending to the real economy could continue. This capital has enabled thousands of businesses that were solvent, but lacking liquidity, to receive economic lifelines.
The release of these excess buffers will also be essential in the recovery phase, to ensure that businesses restarting operations can access the working capital they so urgently need. Furthermore, to ensure that policymakers have room to maneuver, the Basel Committee extended the timeline for implementation of the Basel III reforms by one year, to 2023.
Likewise, in respect to the global standards for financial integrity, the Financial Action Task Force has emphasized the continuing importance of the risk-based approach for anti-money laundering and countering the financing of terrorism. The risk-based approach, as opposed to a rules-based approach, implies more stringent controls against money laundering and terrorism financing in cases of higher assessed risk, and less stringent controls in cases of lower risk, rather than the same rules across the board. This approach includes the use of simplified due diligence in cases where there is lower assessed risk, such as basic bank or mobile money accounts with capped transaction limits. This is critical to ensuring that government welfare and other emergency cash transfers can reach vulnerable populations without hindrance from excessive customer verification requirements. Some national regulators and commercial banks have taken advantage of this flexibility by introducing specific amendments to Know Your Customer (KYC) regulations and/or utilizing biometric identification methods for customer onboarding.
Technological innovations to increase financial stability
Instead of seeing technological innovations as a source of risk, standard setting bodies have recognized and even publicly called for their use – as long as they hold potential to strengthen financial stability and integrity. The Financial Action Task Force president, in a statement on April 1, called for the “fullest use of responsible digital onboarding and delivery of digital financial services” in the context of lockdowns and social distancing. If sustained beyond the pandemic, this trend towards digital onboarding could help establish a norm whereby paper documentation for KYC starts to become obsolete. This would be a major gain for financial inclusion, though achieving it will require policymakers to invest in digital identity infrastructure and to engage in peer learning on best practices in implementing remote customer verification (e-KYC).
Standard setters’ openness to relevant technological innovation in the context of crisis response has been in evidence as well. The Bank for International Settlements and the G20’s launch of a TechSprint Initiative highlighted innovative regulatory compliance and supervision technologies that can help identify vulnerabilities and enable the sharing of key real-time information across borders in the context of the pandemic.
Extending global standards to protect against future crises
Global standards established over the last decade have strengthened financial stability and integrity. This has ensured a more resilient financial sector that is far better equipped to play a positive role in supporting the real economy in the context of the COVID-19 pandemic, compared to the immediate aftermath of the global financial crisis of 2007-8.
Nevertheless, there are significant gaps in these standards, particularly when it comes to the implications of rapid digital transformation. Many high-level principles and frameworks address issues like cybersecurity, data protection and privacy, and consumer protection in digital financial services – as well as the systematic integration of climate change risks. But these frameworks lack the authority and legitimacy of dedicated sets of global standards.
Even at this early stage, these are signs that global standards for financial stability and integrity have helped mitigate the worst impacts of the COVID-19 crisis. Protection against the next crisis may also require the extension of these standards to include digital finance and other emerging areas of practice.
Photo courtesy of UN Geneva.