Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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Author(s)
GERALD GRISSE1

The paper provides a very good and comprehensive summary of the various initiatives to strengthen the international financial system, so I see no need to add to this description. Therefore, I would rather prefer to focus my remarks on some general points and the issues for discussion contained in the paper.

General Remarks

It is fair to say that substantial progress has been achieved in efforts to enhance stability of the international financial system, and there are still many ongoing initiatives in the pipeline that will further contribute to crisis prevention. Indeed, as the paper correctly describes, remarkable progress has and is being made to improve the general framework of the international financial markets and to create a more transparent basis for investors’ decision making. However, when discussing international policy coordination, we should not forget that some very fundamental questions still remain somewhat open. For instance, is it sufficiently clear who is responsible for assessing, and on the basis of what criteria, whether a crisis is systemic in nature or just a local one? Similarly, more clarity with respect to various parties’ responsibilities and relevant contact points might be conducive to efficient crisis management. Without going into detail on these issues, I would just like to note that the IMF may well play a central role in this area. In the context of crisis management, the IMF should reinforce its catalytic role and combine its comparatively limited financial support with conditionality, which is instrumental in improving the situation for member countries and restoring market confidence.

In general, it seems to be the case that more progress has been made in the area of risk prevention (although a lot still remains to be done before we will have a comprehensive framework without excessive overlap) compared with the actual crisis management. However, in order to be fair, I do admit that some progress has been made in improving the coordination of the relevant parties in this area. The creation of the Financial Stability Forum is an obvious improvement in the coordination between the various international organizations that have a stake in the financial stability. But in addition, there remains a need to fully utilize private sector expertise in this area. Therefore, the Capital Markets Consultative Group, which will provide a forum for regular dialogue between the market participants and IMF’s management, marks an important step in the right direction.

Beyond that, I am convinced that we would benefit from even clearer rules for the precise handling of crisis situations. With some qualifications, one can use the argument about “constructive ambiguity” to defend the lack of clarity vis-à-vis the outside world, on the grounds that too much clarity might contribute to moral hazard. It could, indeed, be the case that moral hazard considerations become relevant if the rules are not demanding enough, or if market participants get the impression that the rules will not be applied consistently across countries.

However, even in this case, there should be no ambiguity among the decision makers regarding the criteria and the procedures to be used in the context of resolving financial crises.

Issues for Discussion

As the paper points out, many of the key issues for the future are related to the effective implementation of the agreed approaches, with implementation being more ambitious and complicated than developing an approach in theory.

As recognized in the first discussion point, the resource costs of the reform agenda are high. Therefore, it is essential that national authorities be convinced of the importance of assigning high enough priorities to these matters. Fortunately, there is very widespread international agreement on the importance of these issues. Nevertheless, we should not complacently assume that this will necessarily be the case for all future initiatives. We must constantly keep in mind the importance of convincing all involved parties of the necessity of the reforms. Indeed, there are already some signs of reform fatigue, not least in Europe where people involved in the implementation of the initiatives to strengthen financial systems have had to cope with some other major resource-intensive reforms such as the creation of the Economic and Monetary Union.

Although reform fatigue is not yet a serious obstacle for work in this area, it may become a significant factor if care is not taken to reduce the elements that have contributed to it. So what can be done to reduce it? Fortunately, one would expect that once the reform initiatives currently in the pipeline have been implemented, the pace of change will slow down. However, in the meantime, it is important to keep the pace of reforms manageable by avoiding new resource-intensive initiatives that offer only limited benefits. In particular, changes in already agreed-upon general frameworks (e.g., SDDS) should be minimized unless there are truly compelling reasons to implement these changes rapidly. It is also important to ensure that the people involved in the implementation at the national level fully understand the rationale behind the changes. Obviously, the quality and speed of the implementation depend heavily on the sense of ownership of the people doing the work. In this context, one should keep in mind that agreed international standards are by definition universal and are not designed with any particular country in mind. Therefore, the involved international parties should always consider which initiatives need to be implemented in a fully uniform manner in all countries and which could more effectively be implemented by allowing a certain degree of differentiation between different types of countries.

In general, I am of the view that, at the early stages of the financial system reforms, speed was of crucial importance because there clearly was a need to strengthen policies and improve information dissemination. However, as many of the initiatives have already been implemented, completely or at least in part, speed should be assigned a lower priority, and more emphasis should be placed on the quality and efficiency of the overall framework and its separate components. This means that a more critical approach is needed to assess the usefulness of each component and how it fits into the bigger picture. Ideally, some type of cost-benefit analysis would be helpful in this context, but at least we all should remain alert on the cost issue.

Obviously, as mentioned before, a clear definition of responsibilities between all those involved is a basic precondition to allow efficient resource utilization. At the international level, it would make sense to focus on each institution’s core areas of expertise and strengthen their responsibilities in these areas. There should be close cooperation between the IMF and recently created, informal international fora like the G-20 and the FSF. While these fora have an important role to play in proposing initiatives and developing consensus and ownership, the IMF should remain the central institution for monitoring observance of standards and codes within the context of its overall surveillance function, thereby contributing to greater international financial stability. Furthermore, the way the IMF is improving its bilateral and multilateral surveillance activity—for instance, by introducing more comparative multicountry studies—is instrumental in enhancing macroeconomic and financial stability.

Activities related to the implementation and monitoring of standards, codes, and transparency requirements would also benefit from appropriate prioritization. As noted in the paper, there is broad agreement that the IMF’s core responsibilities include a focus on financial sector risk assessment and policies, but the full integration of such risk analysis into the IMF’s surveillance, program, and technical assistance activities remains an uncompleted task. This is clearly one of the most challenging tasks for the IMF during the next few years. Let me just say that also in the process of deciding how to best integrate financial sector risk assessment into IMF surveillance, an appropriate balance must be found between the basic premise that IMF surveillance should continue to cover the whole membership, while some of its elements may have to be tailored further to the specific needs of individual members. The euro area is a case in point in this respect. As noted in the paper, special modalities were set up for regional surveillance over the euro area, involving annual consultations with individual member countries and semiannual discussions with the ECB and other European Union institutions responsible for common policies. Similarly, modalities for the financial sector risk assessment of the euro area need to be designed in a flexible manner that must take into account the specific features of the area, including the present division of competencies between the national authorities and EU institutions.

Let me turn to another point. Looking at the recent stock market developments immediately leads to the conclusion that even mature, efficient, and transparent markets in countries with sound banking system regulations, supervision, and legislation still suffer from episodes of extreme volatility.

Clearly, no one can argue that these markets would not be transparent: disclosure requirements that the publicly traded companies have to abide by are demanding and well enforced. As a result, potential investors have more or less simultaneous access to relevant, company-specific information. Similarly, anybody who is willing to pay a few hundred dollars can access all other relevant market information on an equal footing with market professionals. Furthermore, individual investors (e.g., day traders) can react to market news almost instantaneously, and more and more people can do this from anywhere via their mobile phones. Against this background, let me phrase my uneasiness in the form of a question: Are we really dealing with the potential risks arising from the volatility in mature markets? Or do we rather prefer to overlook these issues because the risks involved are so difficult to assess?

This type of increase in volatility that may be a result of changes in information technology is, I admit, not necessarily that harmful. However, there may be elements in it that may cause contagion effects and thus have far more serious consequences.

The questions related to asset-price bubbles and the role for the public sector in dealing with bursting bubbles are complicated, not only because it is difficult to define what a bubble is, even well after it has deflated, let alone when this is taking place. In fact, central banks are faced with another dilemma in this context. On one hand, asset market developments must clearly be taken into account in the conduct of monetary policy. However, it is clear that it would be inappropriate and counterproductive for central banks or any other public institutions to be perceived as being guarantors for a particular asset-price level. This could even contribute to a buildup of bubbles and would distort efficient allocation of resources by making equity investments seems less risky than they are.

We can expect a nondistorted decision-making process on the part of market participants only if they are not led to believe that a safety net will be extended to them by the international community to deal with crisis situations. Of course, one can’t categorically exclude the possibility that there will be some very extraordinary events that could call for the public sector to deal with market disturbances and crises. However, it would be counterproductive to create an impression that the public sector will stand ready to shoulder the consequences of bad investment decisions if losses are threatening to become large enough. Indeed, by doing so, we would just undermine the foundation of all the initiatives that have been taken to reduce the frequency and severity of financial crises.

I am grateful to Heikki Hatanpää for his contributions to an earlier draft of these remarks.

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