How risk-free is the global financial system? Too early to tell.

Author:El-Erian, Mohamed A.
 
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In recent weeks, policymakers on both sides of the Atlantic have affirmed that the financial system is sound and stable. The U.S. Federal Reserve announced in June that all U.S. banks passed its latest annual stress test. And Fed Chair Janet Yellen has now suggested that we might not experience another financial crisis "in our lifetimes."

At the same time, the Financial Stability Board--which monitors regulatory practices around the world to ensure that they meet globally agreed standards--has declared, in a letter to G-20 leaders, that "toxic forms of shadow banking" are being eliminated.

In short, ongoing measures to buttress the global financial system have undoubtedly paid off, especially when it comes to strengthening capital cushions and cleaning up balance sheets in important parts of the banking system. The latest assurances from policymakers are comforting to those of us who worry that not enough has been done to reduce systemic financial risk and to ensure that banks serve the real economy, rather than threaten its wellbeing.

Yet it is too soon to give the financial system as a whole a clean bill of health. Efforts to shore up the banking sector in some parts of Europe are still lagging far behind. And, more important, financial risks have continued to migrate to non-bank activities.

After irresponsible risk-taking almost tipped the global economy into a multi-year depression in 2007-2008, regulators and central banks in advanced economies launched a major effort to strengthen their financial systems. To that end, they focused initially on banks, which have since bolstered their risk-absorbing capital cushions, cleansed murky balance sheets, increased liquidity, enhanced transparency, narrowed the scope of high-risk activities, and partly realigned internal incentives to discourage reckless behavior. Moreover, the process for resolving failing and failed banks has been improved.

In addition to strengthening the banking sector, policymakers have also made progress toward standardizing derivative markets and making them more robust and transparent, which also reduces the risk of future taxpayer bailouts for irresponsible institutions. Moreover, the system for payment and settlement has been made safer, thereby lowering the threat of a "sudden stop" in economic activity, like the one that occurred in the fourth quarter of 2008.

It has been encouraging to watch national authorities coordinate their efforts under the auspices of the...

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