Globalisation has delivered significant benefits over recent decades. Consumers have a wider choice of goods and services, prices have fallen, productivity has increased and millions have been lifted out of poverty. However, globalisation also brings challenges such as climate change, unequal growth and widespread exposure to financial crises.

Increased global financial integration has enabled record financial flows. Firms are increasingly able to access capital from across the world. Investors are no longer limited to investing in domestic markets.

The US and some European countries responded to the significant increase in the world labour force (as large emerging markets became integrated into the global economy) with increased consumption and investment. As a result they ran large current account deficits, financed by external borrowing. At the same time, as many Asian economies expanded, these economies saved more than they invested domestically and, coupled with export-led growth strategies, generated surpluses that were invested abroad.

The search for yield

The entry of China, India and other emerging countries into the global trading system increased the global labour supply, increasing world trade and the supply of low-price goods. This change had a powerful disinflationary effect.

Low inflation coupled with record financial flows helped contribute to low interest rates across the world and pushed down returns in traditional assets. As yields across a range of assets fell, banks looked for new ways to increase their returns – the ‘search for yield’. This search sparked a wave of financial innovation.

Rather than relying on traditional retail deposits, banks increasingly used the wholesale money markets to provide funding. There was a dramatic increase in the use of complex forms of securitisation – where loans are packaged up and sold to third parties.

These new ways of working loosened the traditional limits on banks’ balance sheets. Banks had less incentive to apply as stringent credit checks on borrowers. As a result, banks were able to significantly increase lending volumes. Leverage – the ratio of lending to capital – dramatically increased.

In addition, banks – in a search for higher returns – started to trade and hold these structured products off-balance-sheet, thereby releasing capital to allow them to increase lending further.

Impact of financial innovation

Increased levels of lending and securitisation left banks exposed as the crisis unfolded. Complex securitisation reduced transparency. Banks were less worried about credit risk as the loans were subsequently sold on to third parties. Little or no account was taken of low-probability, high-impact events by the external credit rating agencies – on which investors increasingly relied.

Two-thirds of the growth in lending over the last decade was within the financial system, rather than the wider economy. In addition, it is apparent that the pay structure within banks encouraged short-term revenue generation, with little regard for the longer-term risks this could create. This combined with over-exuberance to perpetuate risks – at a cost to consumers and the resilience of the wider system. Coupled with strict conditions on those banks receiving Government support, the UK has set up a review of banks’ corporate governance to learn the lessons from these events.

Regulators around the world had not fully taken account of financial innovation and the rise of off-balance-sheet vehicles. Insufficient focus was given to the liquidity risks faced from increased reliance on wholesale funding. Increased trading between banks left the system over-leveraged, more interdependent and therefore less resilient to shocks. These systemic risks have significant implications, and demonstrate the need for stronger international coordination.

Overall, the regulatory framework had arguably become ‘pro-cyclical’ – encouraging excessive lending in the ‘good times’. The UK Government has asked Lord Turner to consider what reforms need to be made to financial regulation.