The world in 2019 is still reckoning with the legacy of the global financial crisis, which is hardly surprising given its scale and lasting impact. Ten years on from the Lehman Brothers collapse, one question about the financial system keeps coming up: Are we safer than we were in 2008? The short answer is yes—but not safe enough. While there has been marked progress, more needs to be done, including keeping pace with potential new risks from a rapidly evolving financial landscape.
First, the progress. Banks have bigger and better capital buffers and more liquidity. Countries have taken steps to address systemic risks posed by institutions seen as too big to fail. Regulation and supervision have been strengthened; many countries have stepped up their focus on monitoring financial stability, and many now also conduct regular stress tests to check banks’ health. A substantial portion of trading in over-the-counter derivatives has shifted to safer central clearing systems.
For its part, the International Monetary Fund (IMF) has improved its ability to analyze and monitor sources of systemic risk. It has partnered with national authorities to help them identify potential trouble spots, such as excessive consumer or corporate debt; develop tools to curb risks; and strengthen analysis of their financial systems.
What about areas where progress has been inadequate or where new risks have emerged?
Let’s start with debt. Globally, nonfinancial debt ballooned to a record $182 trillion in 2017—224 percent of global GDP, an increase of almost 60 percent over 2007. In the United States, investor demand for debt issued by highly leveraged companies has led to worryingly loose underwriting standards, increasing the risk of default by weaker borrowers. In emerging markets, public debt is at levels last seen during the 1980s debt crisis. And if recent trends continue, many low-income countries will face unsustainable debt burdens.
Nonbank finance, also known as shadow banking because it takes place beyond the perimeter of traditional bank regulation, is another source of risk. Regulators must develop and deploy new tools to address it, particularly in those emerging markets where it has expanded rapidly.
At the same time, new challenges have emerged, including the danger of cyberattacks on banks and stock exchanges. Financial innovation and technology hold out the promise of better, cheaper, and more accessible services but also pose risks for consumers, investors, and the economy’s overall financial stability—risks that are not always easy to understand or anticipate.
And for all the progress to strengthen the financial sector, the revamped architecture remains untested. If financial conditions were to tighten sharply—for example, via unexpectedly higher interest rates or a sharp drop in asset prices—this could expose areas of vulnerability that have built up during a decade of record-low interest rates. In the last year, we have already seen some investors pull money out of emerging markets in response to a stronger dollar, rising U.S. interest rates, and trade tensions. IMF calculations show that with an abrupt tightening, there is a chance—albeit a small one—that capital outflows from these economies (excluding China) could reach $100 billion. That would broadly match outflows during the financial crisis.
Looking at the economic context, there are several sources of risk that could shake investor sentiment. Global growth, while still strong, is leveling off. Support is waning for the open, rules-based international system that has fueled global prosperity, and trade tensions could escalate. Uncertainty about fiscal policy in Europe is reviving worries about the self-reinforcing nexus of government and bank debt that shook the eurozone in the first years of this decade. Finally, central banks must navigate the end of an unprecedented monetary experiment. In the United States, the Federal Reserve may need to raise interest rates higher than currently anticipated if tax cuts combined with fiscal stimulus fuel faster-than-expected inflation.
So how should policymakers respond? First, they must complete financial regulatory reforms and, just as important, resist pressure to roll them back. Bank capital should be raised even further in places where buffers remain low. “Too big to fail” remains a problem as banks grow larger and more complex. More progress is needed on procedures for resolving, or winding down, failing banks, especially those that are active across borders. Regulators should encourage banks with weak business models and high levels of nonperforming loans to clean up their balance sheets.
[The world’s authoritarians are on the march—and the West helped pave the way, Robert Kagan writes.]
Second, policymakers should rebuild their fiscal and monetary arsenals, which were weakened as they contended with the 2008 crisis and its aftermath. Doing so will require reducing budget deficits and gradually bringing interest rates back to normal levels as economic conditions permit. Governments should also work together to reduce excessive global imbalances in a way that supports sustainable growth. Flexible exchange rates can help absorb shocks. Steps to boost lagging productivity would counter demographic headwinds and raise growth, which in turn would support efforts to bolster fiscal and monetary room for maneuver.
Finally, as we consider the lessons of the crisis and the path forward, we must also recognize and confront more profound, longer-term risks to financial—and social—stability. Climate change is one that threatens all of us, low-income countries in particular. Advanced economies must ensure that prosperity is more widely shared, by dealing with rising inequality and stagnant wage growth. All countries need to educate and train workers for automation and the fast-changing workplace of the future.
Many of the measures that might make the world safer than it was before the last crisis depend on international cooperation—on matters of trade and finance but also on a number of global public-good problems, including the environment and refugees. The stakes are just as high as they were in 2008.
This article originally appeared in the Winter 2019 issue of Foreign Policy magazine.
Christine Lagarde is the managing director and chairwoman of the International Monetary Fund. @Lagarde
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