Following the eruption of the Asian crisis in mid-1997, the international community at large has increasingly focused on developing new mechanisms for financial-crisis prevention. These efforts respond to the realization that while globalization can bring significant benefits to countries undertaking transparent and sustainable policies, it also lead to severe disruptions in countries that liberalize their financial systems without having fully dealt with domestic economic and financial weaknesses and fragilities.
It is, therefore, no coincidence that the high frequency of financial crises observed in recent years throughout the world has happened in the context of the dramatic growth of international capital markets that followed the liberalization of financial systems and the development of new financial technology without adequate regulatory and supervisory frameworks.
But weak domestic financ ial systems have not been the only source of severe financial problems. In the absence of complete information about a country’s capabilities to deal with external shocks, market concerns about the financial stability of a country can result in deteriorated perceptions about the financial soundness of other countries broadly categorized as “similar” according to a number of factors, including geographical location (the so-called “neighborhood effect”) or analogous economic and/or financial ratios. “Contagion” is the term commonly used to describe this phenomenon.
The lesson learned from these episodes is that the intricate workings of global markets need new and better coordinated global regulatory and supervisory frameworks. While effective domestic regulatory frameworks are essential, they are not sufficient to ensure financial stability as they do not take into account the new interrelationships across countries created by the process of globalization in a world of imperfect information. Efforts to promote financial stabilization, therefore, must simultaneouslyfocus on strengthening both domestic financial markets as well as improving the international regulatory framework.
It was precisely the discontent with the capacity of the existing international architecture to prevent the eruption of financial sector crises that led to the creation of the Financial Stability Forum (FSF) in April 1999. The FSF was established for the specific purpose of promoting international financial stability by engaging the cooperation of governments, markets and international organizations in improving the process of financial supervision and surveillance. A major component of the activities of the FSF has been the coordination of a comprehensive set of “international standards and codes to strengthen financial systems.” In a nutshell, common standards attempt to tackle two main objectives. First, by being common, the standards aim at facilitating international comparisons and hence avoiding the negative externalities created by confusing and incomplete information on a country’s economic policies. Second, by setting them at high levels, the standards aim at enhancing the role of market discipline: countries that want to improve their access to international capital markets will have the incentive to enforce the standards; the standards can act as benchmarks to guide policymakers’ reform efforts.