Chapter 7: Toward a New Financial Order: What Are the Key Issues?
- International Monetary Fund. Legal Dept.
- Published Date:
- February 2013
Today, I would like to take the opportunity to discuss the key issues of the new regulatory framework.
I would like to begin by noting that the most dangerous phrase in finance is: “Things will be different this time around.” The recent improvement in the health of the financial sector has led a number of observers, and some in the financial sector to conclude that there is no longer a need to adopt financial reforms. However, this would be a big mistake. The severe costs resulting from the recent failure of regulation and supervision have shown clearly the need to put in place reforms that lead to the permanent strengthening of the financial system.
This obviously requires achieving a delicate balance in getting the reforms to the financial structure “just right” to strengthen the financial system and to prevent the sort of crisis that we are experiencing.
Let me discuss the key issues in this regard from two dimensions:
First, I will describe what I think are necessary improvements to micro-prudential regulation in light of the failures in the oversight of individual financial institutions that have been brought to light by the crisis.
Then, I will turn to the area of macroprudential regulation, which attempts to address systemic—as opposed to individual institution—risks. This focus results from the realization that the goal of maintaining “safe and sound” institutions individually does not guarantee overall financial stability.
I will raise a number of questions along these dimensions that could be of help to frame the discussions in the next few days.
Microprudential Regulatory Reforms
Let me begin with microprudential regulation. We have seen from the crisis that the existing rules and their implementation proved inadequate to keep the financial system safe and sound.
I should stress that banking resilience must reside in the effective functioning of four fundamental pillars: first, a well-targeted and calibrated regulatory framework; second, an efficient and rigorous supervisory arrangement that ensures that banks are run safely and soundly on the basis of a comprehensive risk management system; third, the presence in banks of a seasoned and highly trained management team capable of identifying, measuring, and addressing risks on a timely basis, supported by well-designed prudent policies, early warning alerts and strict governance rules; and fourth, an appropriate resolution mechanisms for failing institutions, particularly to deal with systemically important firms.
Much of the current policy debate focuses on regulatory reform. However, insufficient progress in the enhancement of supervisory agencies, the upgrade of risk management and governance procedures in banks, and the improvement of resolution frameworks risks burdening the real sector with costly overregulation. To avoid overburdening any one of the pillars of financial stability with reform efforts it will be important to make progress in all of them.
In this context, it is clear that we need better rules to govern the financial sector. I would suggest the following priorities:
The first and foremost priority is more and higher quality capital and less leverage. Overall, financial institutions, not just banks, will need to have larger capital buffers and capital that has more “loss absorbing ability.” Capital will then have to be of higher quality, or have more equity-like characteristics. Financial institutions will also need to be less leveraged. To preclude the buildup in leverage, an overall leverage ratio—one that is simple and difficult to circumvent—will be helpful.
The second priority is better liquidity. Probably the defining characteristic of this crisis is the extent to which institutions with funding liquidity mismatches had grown dependent on continuous access to capital markets.
This leads me to my first question: How soon should these new and more conservative rules apply, and how high should new capital requirements be? Clearly, financial institutions want sufficient lead time to adjust their business models and balance sheets to meet these new requirements. At the same time, regulators and their political masters want to show concrete actions are being taken. However, time is needed to do proper impact studies and calibrate the detailed supervisory requirements to minimize unintended consequences.
In addition to better rules, we need better application of rules. Even the best-designed rules will not have an effect unless they are consistently enforced by adequate supervision. The crisis has shown that regulators and supervisors often did not have the necessary resources, tools, or incentives to adequately monitor and assess the rapid innovations occurring in the institutions under their watch.
This prompts my second question: How do we design better regulatory and supervisory structures to avoid capture and complacency? This is a key question that policymakers and other interested observers should address in the future.
It is necessary to recognize that we also need better risk management by financial institutions. While it is true that inadequate regulation allowed imprudent behavior on the part of financial institutions, it was the decisions taken by the private sector that led to the crisis. In recognition of this fact, many institutions are changing their risk management models to rely on underlying data that are “through the cycle.” However, beyond just tinkering with the models, these firms need to improve their fundamental governance structures, while enhancing accountability and oversight. And here compensation schemes play an important role.
This raises a third question: How do we align compensation and incentive schemes with complex risks management challenges in a way that is conducive for financial stability?
If all preventative efforts have failed and we are facing a crisis, we need to have appropriate resolution mechanisms for failing institutions in place, particularly to deal with systemically important firms. While there is broad agreement on the undesirable moral hazard issues that very large systemic institutions pose, there is less agreement on how they should be dealt with both in preventing crises and in their resolution. There are many suggestions being made on this issue: regulators could find ways to “discourage” institutions from becoming “too important to fail” by either imposing additional capital requirements based on their contribution to systemic risk, or by applying a leverage ratio on a group-wide basis and heightened supervisory oversight.
The issue becomes more complex because where systemic institutions have stability implications across borders, both supervision and resolution challenges are further complicated by national interests. The problem has become even bigger because the process of addressing the crisis in some countries has resulted in the creation of some very large institutions through assisted mergers and acquisitions. One of the suggestions under discussion is that systemic institutions should be required to maintain a plan for their orderly breakup—approved by supervisors—so that group structures can be dismantled and penalties for failure are credible.
This brings me to my fourth question: How can systemically important institution be resolved effectively without deepening a crisis?
Macroprudential Regulatory Reforms
Turning now to macroprudential regulation, we must take a macroprudential approach to financial policy. But what exactly does this involve?
A first step is to observe that institutions are connected in ways that are unanticipated. We understand from the failure of Lehman that greater attention needs to be paid to “interconnectedness” rather than just “size” as an element of what makes an institution systemically important. We also understand that market infrastructures have an implication for system risks as demonstrated by the over-the-counter credit default swap market that allowed counterparty uncertainty to breed. In this context, the Fund, alongside the BIS and FSB, has developed a framework to help identify systemically important institutions and markets using a broad set of criteria.
The regulation of systemically important institutions has triggered significant discussion. There appears to be an emerging consensus that such institutions should be subject to increasing levels and quality of capital that reduces the need for bailouts, and gives shareholders a greater incentive to monitor the risk taking of these institutions. Improved disclosures and governance arrangements should help assist this monitoring. Nonetheless, since bank failure cannot be prevented, these institutions should periodically submit to their national authorities a plan for their orderly resolution particularly because they are indeed “too important to fail.”
The issue of systemically important institutions has also raised other questions:
How should we define the regulatory perimeter around systemically important institutions, so that regulators have adequate information and tools at their disposal to oversee the most important players in the financial system, and to prevent regulatory arbitrage?
How do we avoid designating a class of institutions that are too important to fail, and creating a host of moral hazard problems?
How do we discourage unfettered increases in the size of institutions?
Systemic liquidity management is another dimension of the macroprudential approach that we need to consider. The notion is that central bank policies need to change, perhaps permanently, to accommodate the externalities caused by private under-provision of liquidity during times of stress.
The macroprudential dimension to policy making should also adopt policies to help mitigate procyclicality or the element that makes the amplitude of cycles larger. While most of the discussion revolves around countercyclical capital requirements and provisioning rules, we cannot forget accounting rules and regulations, and, as I mentioned earlier, private sector risk management and compensation schemes.
It is also necessary to improve cooperation and coordination across national borders. This is relevant for the regulation, supervision and resolution of cross-border financial institutions. Having a separate insolvency code for financial institutions that facilitates orderly resolutions would help in this regard. The latest upgrade of supervisory colleges involving the supervisors of the key countries in which a global institution operates opens the way for an improvement in coordination.
Getting Things Just Right
So having considered both the micro- and macroprudential approaches to regulatory reform, I would like to turn to my final question: What will be the growth impact of all the regulatory changes we are proposing, when properly considered in a general equilibrium context? In moving to a new, and hopefully safer environment, the benefits to a less risky system are clear—fewer crises and financial institution failures, more stable financial markets, and, most likely, more sustainable, less volatile economic growth. However, there may be a cost: the long-term growth path of the economy could be lower. But this need not be the outcome. The financial sector may have gotten too big, and some of its activities may provide little value to the real economy. If so, the reallocation of valuable human resources and capital to other sectors of the economy may ultimately promote higher growth in other sectors, and offset the lower growth from the financial sector. This is an issue that requires further study.
Clearly, in moving to get things just right, we have to avoid two risks:
—the risk that our reforms overburden the financial system with excessive regulation and unintended consequences; and
—the risk that the reform agenda is too timid or is stalled, as the financial sector and the real economy begin to normalize and the momentum for reform losses steam.
In closing, let me say that we face many difficult questions as a result of the crisis. It is certainly an exciting time to be an economist and a policymaker as we grapple with these complex issues. This is a challenge because we have to get some of the answers right as we confront this once in a lifetime challenge.