Taking Stock of Financial Sector Reform
Delivered at Depository Trust and Clearance Corporation Executive Forum
Monday, September 27, 2010
As Prepared for Delivery
It is an honor and a pleasure to have the opportunity to address this distinguished and expert audience. I very much appreciate the opportunity to discuss with you today the progress to date on global financial sector reform.
Of course, this topic is very relevant to the DTCC—and vice versa. As an important element of the global financial infrastructure, the DTCC is directly involved in the global reform effort. This organization—among many other things—provides central counterparties with the information they need to be effective in clearing over-the-counter derivatives, a function that will assume increasing importance in the near future. The DTCC also acts as an important data repository, helping to form an essential foundation for effective market oversight.
In my remarks today, I will discuss the IMF’s views on the global economic outlook, and then turn to my principal focus: our assessment of the progress to date in the global financial sector reform effort, and our views on the tasks that remain to be accomplished in this critical area.
New Challenges
It is worth recalling how current circumstances developed, both in order to re-emphasize the underpinnings for the unprecedented financial reform effort now underway, but also to recall what is at stake. After all, financial sector failures and fragilities formed the epicenter of the 2008/2009 Great Recession. Both the failures themselves and the speed with which their impact was propagated globally are still shocking.
I am sure that you are aware of the by-now conventional wisdom that economic downturns accompanied by financial crises are deeper, longer lasting and leave more residual damage than more “conventional” downturns—those that typically are triggered by overheating demand growth and accelerating inflation. This worrisome conclusion derives from our own research, and that of others. But it also appears reasonable from a common-sense point of view.
Some important implications flow from this conclusion about downturns accompanied by financial crises. First, it should not be surprising that the current post-Great Recession recovery has been unusually anemic. Second, the process of financial sector repair will have an important bearing on the speed and strength of the recovery. Third, the key policy challenges that we confront today will differ from past experience, when the principal task was to support the more-or-less organic rekindling of demand. Fourth and finally, the degree of global economic and financial interconnectedness mandates that in order to be successful, efforts at policy-led remediation of both economic and financial challenges will work best if they are coherent and consistent at a global level.
The Post-Recession Global Outlook
Turning to the IMF staff and management’s view of near-term global economic and financial prospects, this moment is just a bit awkward in an institutional sense: The latest editions of our semi-annual flagship forecast publications—the World Economic Outlook and the Global Financial Stability Report—are slated for publication next Tuesday and Wednesday, respectively. Their new companion—The Fiscal Monitor—will be released a few weeks later.
But it will not come as any surprise that our base case outlook is for a continued moderate global recovery. In the first half of this year, global growth reached an annual rate of about 4-3/4%—actually a bit stronger than we had expected. Particularly notable was emerging economy growth of about 7-1/4% at an annual rate. More recent developments, however, indicate that growth has slowed in this year's second half, and that this sluggishness will persist into early 2011. Thus, the global expansion likely will fall somewhat short of the 3-3/4% annual rate that we had anticipated previously for the second half of this year.
While we expect this slowdown to be temporary, the downside risks to advanced economy growth are evident. They include the risk of renewed strains in sovereign debt markets that could trigger a new round of pressure on financial institutions. In this case, financial strains once again could spill over to the real economy. Additional weakness in real property markets could have a similar impact, especially considering the unfinished deleveraging process still underway in many economies for both private individuals and businesses.
A key point here is obvious: The process of finical sector repair is unfinished, but successful repair will be critical to opening a path toward the stronger and sustained growth needed to make a meaningful dent in the current high rates of unemployment in many advanced economies, including the United States.
The Global Policy Response
At this juncture, three broad observations are in order. First, the global crisis has been and is being met by an unprecedented global policy response. This includes the creation of the G-20 Leaders Summit process that is providing high-level political impetus to a cooperative approach to addressing the principal economic and financial challenges. Concrete results of the G-20 Leaders include the establishment of the Mutual Assessment Process (or G-20 MAP) for implementing the Framework for Strong, Sustainable and Balanced Growth that was promulgated at the September 2009 Pittsburgh Leaders Summit. In addition, the conversion of the Financial Stability Forum (FSF) into the Financial Stability Board (FSB) brought the key emerging market economies directly into the financial reform process. The IMF is an active member of the FSB, as was the case for the FSF. At the mid-November Seoul Leaders Summit, the Leaders will evaluate the progress that has been made to date on implementing the Framework, and on financial sector reform, among other issues.
Second, despite the widespread and understandable frustration with the sluggish advanced economy recovery, notable progress has been made in many areas. It's easy to forget that the G-20 Leaders process only dates back to the first Leaders Summit in November 2008. I’m sure that this audience is aware that it took more than a decade to develop the Basel II Accord on bank capital standards, while Basel III has been agreed in about 18 months. The need to make real progress on financial reform has been recognized, and the responses have been serious.
Most likely you can anticipate my third point: Despite the progress to date, there is much that remains to be done before it will be possible to conclude that the underlying goal of strong, sustainable and balanced growth has been secured.
Financial Reform
In assessing the forward-looking reform agenda, I will use as an organizing principle the Four Pillars of financial reform endorsed by the G-20 Leaders. These comprise: (i), a strengthened regulatory system; (ii), a more effective supervisory system; (iii), development of a resolution mechanism for systemically important financial institutions (SIFIs); and (iv), improving the process for assessing the implementation of new standards. Parenthetically, my IMF colleagues will be publishing in the next few days a Staff Position Note that will provide a rather more detailed discussion of the remaining challenges for financial reform than I will have time to provide today. It will be available on our imf.org website, and I recommend it highly.
The first pillar of a reformed system is an effective regulatory framework. This is the area where most effort and progress has been made. Everyone present today no doubt is well aware of the revised rules on bank capital standards agreed recently by the Basel Committee on Banking Supervision. This agreement represents a significant improvement in the quality and quantity of bank capital, and when implemented will enhance banking systems' resilience.
In broad terms, the regulatory reform efforts so far mainly have aimed at making individual banks less likely to fail. The key provisions include actions to make capital and liquidity buffers larger and more robust, to reduce leverage, and to limit maturity mismatches. These are all critical elements of reform, and deserve support. In fact, since the onset of the crisis, my IMF specialist colleagues have been providing independent assessments of the prospective size of bank write-downs, in an effort to keep the international agenda focused on insuring that banks have sufficient capital to engender confidence and to support the renewed credit growth that will be required for the recovery and ensuing expansion.
We understand the inherent difficulty of boosting capital while not inhibiting credit growth. Happily, our analysis suggests that if our World Economic Outlook forecast is more or less correct, a shorter phase-in period for the new Basel capital standards could be considered—as well as an eventual elimination of the intangible capital provisions—without constricting the credit expansion necessary to support expansion.
At the same time, the regulatory reform effort to date has focused mainly on the banking system, and on micro-prudential issues. As we all know, the most dramatic financial failures during the crisis took place among regulated institutions. Nonetheless, poorly drawn regulatory perimeters in some cases allowed institutions to shield risks from regulatory oversight, and apparently even confounding the workings of their own risk management systems. Thus, care needs to be taken that all systemically important financial institutions fall within the perimeter of regulation, and that purpose-built legal entities can't be utilized to obscure risks from appropriate oversight. In fact, we are working with the Bank for International Settlements and the FSB to develop an agreed methodology for defining SIFIs, as an aid to this process. Much more needs to done, however.
Another conclusion from the crisis is that regulations need to take into account both systemic issues and the impact of the business cycle on financial institutions’ ability to bear risk. In other words, regulations need to encompass macro-prudential considerations. Despite broad agreement that this is a good idea, there is little consensus so far regarding exactly what should be done, and by whom, in order to implement—and not just discuss—such regulations. As an institution charged with helping to establish and sustain international economic and financial stability, the challenge of developing macro prudential regulations is a particular concern of the IMF. Thus, I am going to return to this topic later in a bit more detail.
The second pillar of the G-20 reform agenda is effective supervision. We all know that since the outset of the crisis, the highest priority has been placed on strengthening the regulatory framework. This has been both understandable and appropriate—up to a point. Hopefully, it is well understood that flawed regulations were only part of the problem that produced the crisis, and that strengthened regulations represent only part of the solution. In fact, it is our conclusion that weakness in supervision was as responsible as flawed regulation for ushering in the crisis. The specific analysis underlying this conclusion is contained in an IMF Staff Position Note—provocatively titled "Learning to Say No”—that was published last May, and is available on our imf.org website.
Of course, it is through supervision that authorities actually enforce compliance with regulations. As we point out in "Learning to Say No", effective supervision requires the ability and the will to act—both of which often were missing prior to the crisis, when too many risks went undetected or else were not understood. Of course, the need for strengthened supervision is relevant for the broader financial system, and not just for banks. In fact, our experience indicates that it is all too common to find that supervisory practices in enforcing compliance or sanctioning non-compliance are sub-standard, and that timely corrective action often is lacking. These topics are addressed in detail in our note.
Up to now, there has been only limited post-crisis progress in enhancing the effectiveness of supervision. This may be changing, however. At their June Toronto Summit, the G-20 Leaders tasked the IMF and the FSB with collaborating on a report to Ministers for their October meeting with recommendations to strengthen oversight and supervision. Already, efforts have been underway to improve cooperation internationally, as the growth of cross-border exposures has made it clear that improved collaboration will be important in making supervision more effective.
The third pillar of the G-20 agenda is addressing the resolution of systemic institutions. The failure of Lehman Brothers and the near-failure of other large, cross-border firms demonstrated clearly the need for effective policies and procedures for this purpose. Establishing an effective resolution framework would reduce moral hazard and help to bolster global financial stability. Ideally, such a mechanism would ensure that no institutions would be viewed as too big or too important to fail. The creation of recovery and resolution plans would represent an important step forward in this regard. If executed properly, they would improve individual firm's contingency planning, while creating effective resolution powers for the relevant authorities.
Still, despite the importance of these issues, reform work on resolution frameworks has yet to gain critical momentum among key authorities. This is particularly the case with respect to the difficult but critical challenge represented by cases of cross-border resolution that is for systemically important institutions operating in multiple jurisdictions. In the hopes of helping to encourage constructive engagement, the IMF recently proposed a “pragmatic approach” to creating a cross-border resolution framework, including for nonbanks. In our view, initial progress could be achieved through a voluntary agreement among the relatively small set of countries that are home to most of the relevant cross-border financial institutions. Such an agreement would aim at removing barriers to coordination embedded in national regimes (e.g. requirements to ring-fence local assets of foreign bank branches); defining the tools to deal early and effectively with failing institutions, and agreeing on broad principles of burden-sharing across countries. Given the complexity of cross-border resolution issues, moving this work forward will require meaningful political endorsement.
More progress in developing resolution mechanisms is being made at the individual country level, however. For example, both the United Kingdom and the United States recently have enhanced their resolution arrangements for systemically important financial institutions. Another option that has been discussed in this regard would be the implementation of “living wills” for large and complex financial groups. Of course, it is easier to envision the creation of such a document than it is to actually draft one.
The final pillar of the G-20 agenda is international assessment and peer review. Here I can report some concrete progress. Just last week, our Executive Board adopted a more risk-based approach to financial sector surveillance by designating the FSAP financial stability assessment to be a mandatory element of our annual Article IV surveillance exercise for all members with systemically important financial sectors. For those not familiar with them, the FSAPs represent an in-depth, independent assessment of whether financial regulations meet agreed international standards and gauges how effectively they being applied. The goal is to establish an effective dialogue about how the regulatory/supervisory system can be improved—in the interest of bolstering the financial sector's ability to contribute to strong and stable growth.
In fact, the IMF recently concluded the first FSAP for the US financial system, and the relevant documents are available publically. The FSAP analysis showed pockets of vulnerabilities in the system, and considerable interdependencies among institutions. While bolder action could have been envisaged—especially with regard to streamlining the complexity of the regulatory architecture—most of the major provisions of the Dodd-Frank regulatory reform legislation are broadly in line with FSAP recommendations. Of course, a major element yet to be defined is the fate of the GSEs that today are involved in about 90% of all US residential mortgage originations.
In addition to the initiative with regard to the independent analysis provided by FSAPs, peer reviews of regulatory and supervisory practices are being undertaken under the auspices of the Financial Stability Board. These reviews will promote an enhanced dialogue among regulators and supervisors regarding the implementation of international best practice. The goal is to enhance efficiency, promote a level playing field internationally, and to help monitor potential new vulnerabilities.
More Macro Prudential Issues
In the balance of my remarks, I would like to return to the issue of macro-prudential reforms, and then conclude by briefly addressing the challenges in strengthening market infrastructure.
As I mentioned earlier, a first step in approaching macro-prudential issues is to identify those institutions and markets that reasonably can be viewed as systemic. With the goal of advancing the policy dialogue in his area, the IMF—in partnership with the BIS and the FSB—has developed a framework for assessing an institution's systemic importance. The framework identifies three key criteria underpinning systemic importance. These include:
• size (the volume of financial services);
• substitutability (the extent to which other components of the system can provide the same services in the event of a failure); and
• Interconnectedness (linkages with other components of the system).
• Prudential requirements. These are measures that are assessed on an individual institution, scaled according to the relative risks these institutions pose to the financial system. Examples of such measures are systemic risk-based (solvency) capital surcharges and contingent capital instruments. The former uses a measure of an institution’s contribution to systemic risk to compute additional capital charges. The latter provides an institution with additional loss-bearing capacity by automatically converting debt into equity, with the conversion to take place under specified situations of systemic stress.
• Systemic levies. Another approach is to link a financial institution’s systemic importance to a levy. The receipts from such a levy either could accumulate in a resolution fund or be paid into general revenue. Such a levy—we've titled one form of this option a “financial stability contribution”—could be imposed at a rate that reflects an institution's contribution to systemic risk, and to variations in overall risk over time.
Systemic capital surcharges and levies can be structured to discourage activities that contribute to the build-up of systemic risk. Capital charges and risk-based taxes have unique but complementary characteristics. One differentiating factor is that capital surcharges remain on institutions’ balance sheets, thereby presumably strengthening the resilience of the banking sector. By contrast, funds collected under a systemic levy could be used to finance a resolution fund. The existence of such a resolution fund would tend to make more credible the G-20 Leaders' pledge that in future cases of financial failure, the cost of resolution will be borne by the financial sector itself, rather than by the public budget.
Regarding the use of contingent capital, the jury is still out on whether the prospective benefits of this tool outweigh the costs, since the trigger for converting debt to equity could cause adverse market dynamics, thereby inducing increased systemic stress, rather than the intended outcome. One option would be to base the conversion trigger on a combination of market conditions and supervisory stress tests. However, the rating and pricing of contingent capital instruments likely will be highly complex, reflecting the difficulty of predicting when a trigger event will occur. For sure, further analytical work is needed in this area.
In any case, contingent capital is, in our view, best viewed as a complement, not a substitute, for an effective resolution regime. That is, contingent capital instruments would likely be most effective if a credible resolution mechanism has already been established.
• Structural constraints. These proposals put constraints on size, legal structure, or activities of financial firms to limit the degree of complexity and risk taking. The goal is to reduce the probability and impact of an institution’s failure. One of the most prominent is the so-called “Volcker rule,” which would ban proprietary trading, private equity operations, and hedge funds being housed inside a bank.
In our view, “price-based” (capital and levy or tax) mechanisms generally would tend to be more effective than those that are “quantity-based” (structural constraints). Quantity constraints, regardless of their specifics, may generate larger economic efficiency losses and also be more subject to regulatory arbitrage.
In the broad area of strengthening systemic risk oversight, the United States has moved ahead quite aggressively, with the creation of the Financial Stability Oversight Council. The Council, with representation from the various financial regulatory agencies, will be responsible for identifying systemically important firms—both bank and nonbank—and these will be subject to more stringent oversight. Potential tools include higher standards for capital and liquidity buffers, more stress testing and reporting, and, in the event that weaknesses arise, more rigorous application of prompt corrective action. Moreover, those agencies with oversight responsibility for the selected firms could subject them to contingent capital requirements and other restraints on their business if needed.
The Infrastructure Challenge
One element that is not explicitly part of the G-20’s Four Pillar structure is the need for well-functioning market infrastructure. Confidence that trade contracts will be honored and that trades will take place at prices that are seen as “fair” is a critical component of a successful market economy. In the case of financial markets, the more transactions that take place via repositories, the more likely it is that there will be trust in counterparties’ ability to deliver on contracts and the more likely it will be that regulators would be able to spot a buildup in vulnerabilities. The Fund for some time has advocated that nearly all OTC trades should be recorded by trade repositories. This view is based on the notion that those contracts that are sufficiently liquid and can be risk-managed should be traded through central counterparties, allowing risk mitigation through multilateral netting and consistent margining and other risk management processes. It is gratifying to see that these initiatives are taking hold.
As you are no doubt aware, the Dodd-Frank bill mandates that standardized over-the-counter (or OTC) derivatives will be traded through central clearing facilities and eventually will trade on exchanges. It further specifies required collateralization for derivatives trades; and specifies improved transparency of OTC derivatives and securities markets. For these to work well, all OTC derivative transactions should be recorded and stored in regulated and supervised trade repositories, and detailed individual counterparty data should be available to all relevant regulators and supervisors. Thus, the role of the DTCC will become increasingly important.
Despite the many positive aspects, the market infrastructure reforms and the institution-specific reforms in the legislation are not coordinated and, so far, there has been little attention to the potential interaction of the various proposals. For instance, higher risk-weights for capital charges are to be applied to certain types of derivatives, and banks will compare them to the margins they will need to post at CCPs for the same transactions, before deciding whether to move their positions or not. Without more coordination, a critical mass of OTC contracts likely would fail to move to CCPs, and the desired reduction in systemic risk would not be attained.
In conclusion, the principal aim of my remarks today has been to underscore the vital importance of the financial reform effort, to welcome the substantial progress that has been made to date, and to emphasize the very significant work that remains in order to reach our common goals. The DTCC and its partners will play an increasingly important role in this process, and my IMF colleagues and I look forward to continuing our collaboration in fulfilling this demanding agenda.
Thank you very much for your attention.
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