For three decades, financial globalization had seemedinevitable. New information technologies made it possible to conducttransactions halfway around the world in the blink of an eye. Savers gained theability to diversify, while the largest borrowers could tap global pools ofcapital. As national financial markets grew more intertwined, cross-bordercapital flows rose from $0.5 trillion in 1980 to a peak of$11.8 trillion in 2007.

But the 2008 crisis exposed thedangers, with the globalized financial system’s intricate web of connections becoming a conduit for contagion. Cross-bordercapital flows abruptly collapsed. Almost five years later, they remain 60%below their pre-crisis peak.

This pullback incross-border activity has been accompanied by muted growth in global financial assets (despitethe recent rallies in stock markets around the world). Global financial assetshave grown by just 1.9% annually since the crisis, down from 7.9% averageannual growth from 1990 to 2007.

Should the world beworried by this decline in cross-border capital flows and slowdown infinancing? Yes and no.

After the outsize risks of thebubble years, these trends could be a sign that the system is reverting to historicalnorms. As we now know, much of the growth in financial assets prior to thecrisis reflected leverage of the financial sector itself, and some of the growthin cross-border flows reflected governments tapping global capital pools tofund chronic budget deficits. Retrenchment of these sources of financialglobalization is to be welcomed.

But not all of thecurrent retreat is healthy. Surprisingly, emerging economies are alsoexperiencing a slowdown; the development of their financial markets is barelykeeping pace with GDP growth. Most of these countries have very small financialsystems relative to the size of their economies, and, with small andmedium-size enterprises (SMEs), households, and infrastructure projects facingcredit constraints, they certainly have ample room for sustainable market deepening.

A powerful factorunderlying the drop in cross-border capital flows is the dramatic reversal ofEuropean financial integration. Once in the vanguard of financial globalization, Europeancountries are now turning inward.

After expandingacross national borders with the creation of the euro, eurozone banks have nowreduced cross-border lending and other claims within the eurozone by$2.8 trillion since the end of 2007. Other types of cross-borderinvestment in Europe have fallen by more than half. The rationale for theeuro’s creation – the financial and economic integration of Europe – is nowbeing undermined.

Current trends seemto be leading toward a more fragmented global financial system in whichcountries rely primarily on domestic capital formation. Sharper regionaldisparities in the availability and cost of capital could emerge, particularlyfor smaller businesses and consumers, constraining investment and growth insome countries. And, while a more balkanized financial system does reduce the likelihood of globalshocks creating volatility in far-flung markets, it may also concentrate riskswithin local banking systems and increase the chance of domestic financialcrises.

So, is it possible to“reset” financial globalization while avoiding the excesses of the past?

Successfullyconcluding the regulatory reform initiatives currently under way is the firstimperative. That means working out the final details of the Basel III bankingstandards, creating clear processes for cross-border bank resolution andrecovery, and building macro-prudential supervisory capabilities. These steps wouldgo a long way toward erecting safeguards that create a more stable system.

But additional measuresare needed. The spring meetings of the World Bank and the InternationalMonetary Fund represent a pivotal moment for shifting the debate toward asecond phase of post-crisis reform efforts – one that focuses on ensuring ahealthy flow of financing to the real economy.

A crucial part ofthis agenda is the removal of constraints on foreign direct investment andforeign investor purchases of equities and bonds, which are far more stabletypes of capital flows than bank lending. Many countries continue to limitforeign investment and ownership in specific sectors, restrict their pensionfunds’ foreign-investment positions, and limit foreign investors’ access tolocal stock markets. Eliminating these barriers would increase the availability of long-termfinancing for business expansion.

More broadly,officials in emerging economies should restart reforms that enable further domesticfinancial-market development. Most countries have the basic market infrastructureand regulations, but enforcement and supervision is often weak. Progress onthis front would enable equity and bond markets to provide an importantalternative to bank lending for the largest companies – and free up capital for banksto lend to SMEs and consumers. Deepening capital markets would also benefitlocal savers and open new channels for foreign investors to diversify.

Given that Europe ledthe recent rise and fall of financial globalization, any effort to reset thesystem should focus on measures to restore confidence and put Europeanfinancial integration back on track. The recent crisis in Cyprus underscoresthe urgency of establishing a banking union that includes not only commonsupervision, but also resolution mechanisms and deposit insurance.

Determining the rightdegree of openness is a thornyand complex issue for every country. Policymakers must weigh the risks ofvolatility, exchange-rate pressures, and vulnerability to sudden reversals incapital flows against the benefits of wider access to credit and enhancedcompetition. The right balance may vary depending on the size of the economy,the efficiency of domestic funding sources, and the strength of regulation andsupervision.

But the objective ofbuilding a competitive, diverse, and open financial sector deserves to be a centralpart of the policy agenda. The ties that bind global markets together have frayed, but it is not toolate to mend them.