By Santiago Fernández de Lis, Global Head of Regulation, BBVA
Multiple signs of fragmentation are evident in the global economy and financial system, from the use of SWIFT in sanctions against Russia in the context of the Ukraine war to the UK Government’s pressure tosubsidiarization of certain bank branches to facilitate their resolution (after the crisis of Silicon Valley Bank [SVB] in the United States) and the withdrawal of several global banks from their overseas activities. In this article, I will explore the reasons for this trend, its implications and to what extent it should be seen as temporary or more permanent, as well as the role of international standards in financial regulation. The main conclusion is that although regulation is one source of fragmentation, international coordination in global standard-setting bodies is more necessary than ever to limit this trend in a world of strong centripetal forces.
The Global Financial Crisis (GFC), initiated in 2007 and aggravated by the Lehman Brothers crisis in 2008, led to a reevaluation of the benefits of globalization, including in finance. The previous consensus among economists on the desirability of free capital flows was replaced by a more nuanced view that included the need to correct some of the excesses of financial globalization. The experiences of many countries that had suffered the consequences of spillovers from banking crises originating abroad led their authorities to reassess the benefits of financial openness. In particular, countries that were host to branches or subsidiaries of foreign banks tried to protect themselves from the contagion of crises in the parent bank. Home authorities also saw their banks suffer losses in their overseas operations, which triggered reactions to limit the desired degree of openness of home-country regulations. All these reactions may be characterized as “intended” fragmentation.
In global capital markets, issuers moved toward greater reliance on domestic-currency-denominated debt to the detriment of foreign-currency-denominated debt. Local-currency shares in foreign bond portfolios grew from 33 percent in 2005 to 52 percent in 2021. The rationale for this shift was to protect local debtors, including the government, from exchange-rate volatility. In this regard, this “de-dollarization” could be seen as a healthy development that allowed some countries to overcome the “original sin”, which hindered certain countries with weak economic fundamentals and institutions from borrowing in local currencies. More recently, however, some countries may have resorted to a different, less healthy de-dollarization resulting from their attempts to escape sanctions on Russia.
There is ample anecdotal evidence of the withdrawal of foreign banks from their establishments abroad in the form of branches and subsidiaries. In some cases it was a retreat to their winter quarters to protect themselves from the global financial crisis. In other cases, it was a government or regulatory requirement in the context ofthe public aid these banks received. And in some cases, banks reacted to regulatory tightening in host countries that penalized particularly foreign branches funded with local deposits, since local authorities felt they were exposed to financial-instability problems without having the necessary tools to prevent or address potential crises. Foreign banks’ subsidiaries, especially in the case of international banks with decentralized business models, suffered less from this ring-fencing.
The extraterritoriality of regulations from jurisdictions that are home to global banks (especially the United States and the European Union [EU]) was also a source of fragmentation, to the extent that more stringent home-country regulations applied to their banks’ subsidiaries abroad, reducing their abilities to compete with local players and thus fuelling the trend toward retrenchment of global banks.
Simultaneously, other forces acted in the opposite direction, especially in the digital arena. The emergence of big technological companies (big techs) that provided common infrastructure (for example, cloud computing), common customer-facing devices and interfaces (e.g., mobile banking and payments) and/or common tools (such as artificial intelligence [AI]) led to a certain degree of homogeneity in the global infrastructures in a series of sectors (including finance), complicating the task of creating barriers to protect national markets. Using the example of the cloud, the concentration of these services among a handful of global providers located in a few jurisdictions limited the ability of local authorities to impose reliance on local providers, even though they were inclined to do so for resilience and sovereignty reasons.
The development of cryptoassets also facilitated the expansion of a truly global form of shadow banking that was particularly attractive in emerging countries with weak macroeconomic fundamentals and a certain degree of financial repression. Regulatory arbitrage incentivized financial flows to move from increasingly fragmented traditional-banking systems to integrated shadow-banking system, although this only happened to a limited extent. These trends were not strong enough to counteract the dominating trend toward fragmentation, but they probably limited its scope.
The link between the sustainability discussion and fragmentation is more complex. In principle, sustainability and climate change are global by nature, and action should ideally be a common response to a common challenge in the form of harmonized regulations. But action so far has mostly been isolated, focusing on a few jurisdictions, with little international coordination. Furthermore, part of the reaction has taken the form of massive subsidies attached to local production requirements, as in the Inflation Reduction Act of 2022 (IRA) in the US. These subsidies have been imitated elsewhere, adding to the protectionist spiral. What is worse, in some cases, the subsidies are designed in a way that delays the necessary adjustments to achieve net-zero-emissions objectives.
Other shocks in recent years have fuelled the fragmentation trend. The pandemic highlighted domestic economies’ vulnerabilities due to excessive reliance on foreign supplies and/or infrastructures, increasing the value of strategic autonomy in providing certain key supplies. The war in Ukraine accelerated this trend. Sanctions on Russia were seen in many (especially emerging) countries as a wake-up call exposing their vulnerabilities in providing essential financial infrastructures in areas such as wholesale payments and central bank reserves’ management. This “weaponization of finance” led many emerging-market economies to look at alternative capital markets, currencies or infrastructures, which compounded the fragmentation trend. The creation of the New Development Bank (NDB, the bank of the BRICS — Brazil, Russia, India, China, and South Africa) as a competitor to the World Bank should also be seen in this context. All this happened against the background of an exacerbation of the US-China confrontation and other geopolitical centripetal forces such as Brexit. More recently, the EU developed the “open strategic autonomy” notion, which aims at “ensuring the capacity to cope alone if necessary but without ruling out cooperation whenever possible”.
All these trends have been accompanied by a strengthening of “zero-sum thinking”, according to which “my gain is your loss” and vice versa, a mindset that tends to dominate in crisis periods. It is revealing that it coincided with a contraction of world trade in 2023, an event that has happened only six times in the last sixty-five years (since such statistics have been available).
What are the implications of these trends? The first and most evident is less efficient capital allocation and suboptimal risk diversification. This is accompanied by lower competition (and less efficiency) in local financial and banking sectors, eventually creating solvency problems since inefficient banks develop weaknesses that, little by little, erode their soundness. As domestic financial markets become more isolated, market discipline is weakened, which is especially harmful in the context of increasing public- and private-debt volumes. On the positive side, all these trends point to a world in which there will probably be less contagion of financial crises from one country or region to the rest.
A particularly worrying impact of geopolitical fragmentation is the heightened difficulty in providing debt relief to developing countries severely affected by shocks such as the pandemic and food-supply problems due to the Ukraine war. Over recent years, China has become a major creditor to many such countries, especially in Africa. However, China is not a member of the Paris Club and does not participate in its debt-relief exercises. This, together with the claims of traditional donors about the lack of transparency in the data on the indebtedness of these countries to China, is generating accusations of free-riding and complicating efforts to provide debt relief.
It is difficult to assess how permanent is this fragmentation trend. Trends toward openness versus fragmentation in the world economy seem to follow long cycles that change only as a result of major geopolitical events. It is difficult to foresee which elements may counteract the recent fragmentation trends. One major determinant of cooperation in the global economy is the degree of mutual trust between the main international players. Current signals do not point to an improvement in this respect.
The evidence of fragmentation in the global financial system seems to contradict the ongoing work of global standard setters such as the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB), which continue developing common regulatory frameworks in key areas. A cynical view may depict regulators gathering in Basel to agree on standards they undo (together with their legislators) when drafting national legislations back home. Despite the impression of the futility of these exercises, it seems clear that without the efforts of national authorities gathering in international standard-setting bodies to ensure a degree of convergence in regulations, the fragmentation of the global financial system would have been considerably worse. A synthetic indicator of the degree of compliance with international financial standards compiled by the FSB and referred to G20 (Group of Twenty) countries shows an increase of 15 percent from 2018 to 2023, an increase that ran in parallel to a significant expansion in the scope of these standards, despite the fragmentation trends described above.
Expanding these standard-setting exercises to the new areas identified above, particularly in the digital and sustainability arenas, would be desirable. Common principles on regulating artificial intelligence or financing the transition to a net-zero economy would provide much-needed consistency in the efforts of national authorities. These exercises face, however, considerable difficulties, partly because of the lack of proper global governance in these new areas. The umbrella of the G20 as a political debate forum and the FSB as its technical arm is adequate for some of these exercises, but the G20 lacks global membership, and the FSB does not have a mandate in areas such as data protection and artificial intelligence. The international regulatory community needs to work further on designing appropriate bodies to discuss common approaches to these new challenges. It is precisely in a world with strong centripetal forces that international regulatory coordination is more necessary than ever.