The Emerging Post-Crisis Financial Architecture: The Path-Dependency of Ideational Adverse Selection
| Author | Geoffrey R. D. Underhill |
| DOI | 10.1111/1467-856X.12056 |
| Date | 01 August 2015 |
| Published date | 01 August 2015 |
| Subject Matter | Article |
The Emerging Post-Crisis Financial
Architecture: The Path-Dependency of
Ideational Adverse Selection
Geoffrey R. D. Underhill
Research Highlights and Abstract
This article
• Contributes to the debate on policy change and economic ideas after the crisis,
finding ideas and material interests to be closely aligned and introducing the notion
of ‘ideational adverse selection’.
• Establishes that pre-crisis financial governance failed to provide financial stability yet
provided benefits to precisely those whose advocacy underpinned its emergence.
• Argues that despite the adoption of a ‘macroprudential approach’, the post-crisis
reform of financial governance promulgated by the Basel Commitee and IOSCO does
not (yet) admit of a ‘paradigm shift’.
• Concludes that if ideational change and a shift in policy approach is to take place, the
nature of the policy community as ‘input’ must also change.
This article focuses on two cases of transnational financial governance that confirm that ideas and
material interests are closely aligned in the construction of regulatory institutions at the interna-
tional level: the Basel-II/III international capital adequacy standards and the IOSCO-based regu-
latory processes that underpin cross-border securities markets. The article first establishes that the
pre-crisis system of financial regulation and supervision left public authorities dependent on private
sector expertise and information provision such that policy idea-sets became increasingly aligned
with private sector preferences. Secondly, this market-based system of financial governance provided
benefits to precisely those whose advocacy underpinned its emergence while facilitating neither
financial stability nor resolving the weaknesses of national-level governance in a context of cross-
border integration. Lastly, it remains unclear if either pre-crisis alternatives or the lessons of the
crisis itself have been applied properly to the reforms. The reform debate continues to pursue an
essentially market-based approach to the problem of financial governance at the national, regional
and global levels. Policy failure endogenous to a pre-crisis regulatory coalition has so far failed to
disturb the tenacity of material interests and inertia of institutional path dependency.
Keywords: economic ideas; financial governance; policy failure; regulatory
capture; Basel Committee; IOSCO
This article focuses on the post-crisis financial reform process at the global level and
assesses the extent and nature of the changes that have taken place. This analysis
is framed by the debate about the role of ideas in post-crisis policy change, the
theme of this special section of the British Journal of Politics and International Relations.
The pre-crisis global financial system was characterised by a system of ‘market-
based’ financial governance resting on ‘soft law’ mechanisms (Brummer 2012)
across national, regional, and global levels and that significantly enhanced the role
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doi: 10.1111/1467-856X.12056 BJPIR: 2015 VOL 17, 461–493
© 2014 The Author.British Journal of Politics and International Relations © 2014
Political Studies Association
and power of private market agents in these emerging national and international
policy processes. This response to the policy dilemmas of financial sector liberali-
sation was directly linked to corresponding ideas on market-led adjustment and
governance that became ascendant in policy circles in the wake of the previous
economic crisis of the 1970s (Hall 1993).
This policy approach was aimed at providing financial stability but led directly to
crisis. Both public and private sector actors built up a perceived community of
interest in the implementation of shared ideas that proved extremely costly. The
literature on financial governance provides a range of accounts of this process (e.g.
Moran 1991; Helleiner 1994a; Cohen 1996; Baker 2005). This article further refines
this debate by advancing the concept of ‘ideational adverse selection’ as a dynamic
that leads to sub-optimal or simply bad policy outcomes. This is defined as the
selection of ideas to accomplish a specific purpose in relation to public policy, in this
case the achievement of financial stability, but wherein these ideas better serve the
perceived interests of parties to the agreement rather than those of the public or the
ends they were meant to achieve. Ideational adverse selection would typically be
associated with relatively closed policy communities characterised by exclusionary
constituency inputs, such as occurs under conditions of policy capture. The litera-
ture also gives us reason to expect that this failure should call the policy consensus
into question. To what extent has this so far occurred? Has a new ideational
consensus emerged and do post-crisis reforms represent a shift that is likely to lead
to a greater degree of financial stability this time around?
The article advances its argument based on three claims about pre- and post-crisis
outcomes. Firstly, during the thirty-year process of financial market liberalisation
and cross-border integration, regulators and supervisors became more dependent
on market interests in determining the pattern of governance, aligning financial
governance with the preferences of powerful market players and strengthening the
power of private agents to shape and set rules, a general trend often encouraged by
states themselves (Cerny 1994; Helleiner 1994a, 1994b and 1995; Underhill 1997;
Sobel 1998). This ideational adverse selection did not take place in a vacuum. The
pre-crisis financial architecture produced substantial material benefits for precisely
those that had proposed the approach in the first place. The policy paradigm
became embedded in a transnational policy community charged with developing
and implementing global standards of financial supervision and regulation. This
ideational path-dependency institutionalised the material interests of private con-
stituencies helping themselves to ‘club’ goods (Cornes and Sandler 1996; Tsingou
2014) under official auspices.
Secondly, this occurred despite the long-standing availability of alternative idea-sets
combined with much historical evidence that provided grounds for scepticism that
the emerging system of governance would provide the financial stability at which
it was aimed. It was well known that employing price signals and financial market
‘disciplines’ in the service of risk management and an elusive financial stability was
fundamentally flawed (see Sections 1 and 2 below). Empirically, market-based
‘governance light’ was associated with serial episodes of crisis for many societies to
a degree that should have challenged the very foundations of this approach to
global financial governance itself. The long shadow of the 2007-08 financial crisis
462 GEOFFREY R. D. UNDERHILL
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BJPIR, 2015, 17(3)
further demonstrated that the market-based system of governance in its pre-crisis
form was singularly unsuccessful at providing either financial stability or efficient
financial governance. There were plenty of calls for fundamental change.
Thirdly, it is argued that the post-crisis reforms so far have failed to embody a new
approach to financial governance. While many ‘new’ ideas have been debated in
the relevant policy forums as well as more publicly, they have yet to be put
to practical use. The idea-set with the greatest promise for change, the
‘macroprudential approach’ to financial supervision, remains in a tentative phase of
development and the required institutional innovations to make it work are as yet
only under discussion (Baker 2013a; Helleiner 2014). The reforms continue to
implement the market-based approach, albeit with higher and (for financial insti-
tutions) more costly standards. This outcome is in important measure because the
constituents of the policy community itself are little changed. Until the balance of
preference ‘inputs’ into the policy process shifts substantively, it is likely that the
dominant idea-set will remain challenged but not superseded in the ongoing reform
process.
This article advances these propositions in three steps. First, the article establishes
alternative idea-set availability: what we knew from history and the literature that
underpinned the pre-crisis debate about financial architecture. A second section
examines the ideational underpinnings and emergence of the pre-crisis system of
market-based financial governance. Thirdly and most importantly, the article analy-
ses two significant global-level cases of financial supervision and regulation: the
Basel Committee on Banking Supervision (BC) and the International Organisation
of Securities Commissions (IOSCO). Each case begins with the establishment of the
pre-crisis ‘status quo’ and compares this to the (ongoing) post-crisis reform outputs,
with consistent reference to the contest of ideas and interests that underpin this
process. This analysis supports the claims enumerated above: that despite the
availability of alternative policy approaches, ideas and interests aligned in an
adverse selection process embedded in institutional path-dependency, and that this
pattern of ideational adverse selection has yet to be destabilised by the longest and
deepest crisis since the Great Depression of the 1930s.
1. Global Financial Integration and the Lessons of
the Literature
Global financial integration became a defining feature of the late 20th and early
21st centuries. This was part of a general market-oriented trend in economic policy
that followed the apparent exhaustion in the crises of the mid-1970s and early
1980s of the thirty years of post-war economic miracle. Neo-classical economic
ideas proposing market-led adjustment superseded the prevailing Keynesian para-
digm (Hall 1986; Helleiner 1994). The policy shift was in turn justified in terms of
broad, aggregate economic benefits for both the developed and the developing
world. This shift in policy approach was characterised as a ‘paradigm shift’ in a now
classic treatment by Peter Hall (1993). Hall’s hypothesis, linking policy failure and
crisis to the eventual emergence of new policy norms shaping the process of reform,
has been central to the literature on the role of ideas in governance ever since (see
Blyth 2002, ch. 2). Yet there remains the question as to why these market-friendly
POST-CRISIS FINANCIAL REFORM 463
© 2014 The Author.British Journal of Politics and International Relations © 2014 Political Studies Association
BJPIR, 2015, 17(3)
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