Abstract

“Space: the final frontier. These are the voyages of the starship Enterprise. Its five-year mission: to explore strange new worlds, to seek out new life and new civilizations, to boldly go where no man has gone before.”

Imagine a financial system where financial institutions help create growth and prosperity for the countries they operate in and for the individuals populating them. Only a financial system that is well managed and resilient to shocks would provide a solid foundation for strong and sustainable economic growth and the prosperity brought by such growth. The journey of policymakers through Basel II to Basel III, and the initiatives of the Group of Twenty (G-20), the Financial Stability Board (FSB), and national authorities have been no less exciting or challenging than the voyages of the starship Enterprise—to identify the contours of a new financial architecture and to seek out policies and practices that can create a stable and resilient financial system capable of achieving its important mission.

This is the financial system policymakers strive to achieve: a better-governed and more competitive financial system with transparent corporate structures and instruments and markets that allow for easy entry and exit; financial intermediation that delivers products better geared to satisfy the needs of households and firms; banks endowed with higher, better quality, and globally consistent capital and liquidity buffers that adequately weigh systemic risk and discourage procyclical lending behavior; and institutions—even systemically important ones—that can be resolved in timely fashion with minimum or no cost to taxpayers.

The ongoing global financial crisis—which has been assigned the “honor” of being the worst crisis since the Great Depression—has taken us miles away from such a vision. It led to an unprecedented dislocation in financial markets, with abrupt consequences for growth and unemployment, and prompted a rapid and sizable internationally coordinated public sector response. Behind this response was the acknowledgment that these costs have been imposed partly due to systemic weaknesses, or cracks, in the regulatory architecture and partly due to the failure of supervisors to rein in excessive private sector risk taking.

The global crisis has made these cracks in the financial architecture very visible. Incentives at both macro and micro levels (through low interest rates, abundant liquidity, a favorable macroeconomic environment, and compensation schemes) encouraged financial institutions to take greater risks than they could manage in an attempt to extract higher returns. When combined with inadequate regulation and supervision, insufficiently wide regulatory perimeters, poor disclosure, and poor risk management practices, these incentives resulted in a highly complex and opaque financial system, with overleveraged institutions dependent on short-term wholesale funding to finance risky investments, including the rapid growth of credit of dubious quality. In many cases, institutions moved away from their traditional banking model to become large and complex financial institutions (LCFIs) heavily interconnected within and across borders, making them, in turn, too important to fail (TITF).

A new architecture is urgently needed to take policymakers back to their envisioned world. This requires, first and foremost, addressing the market failures that planted the seeds of the crisis: the principle-agent problem fed by information asymmetries, externalities that individual institutions imposed on others, and irrational exuberance that amplified the impact of economic cycles. It calls for

  • tighter regulation to internalize the negative externalities caused by the risks individual firms take;

  • better supervision to effectively implement that regulation;

  • greater transparency and disclosure both to address the information gaps and, together with more “skin in the game” (e.g., through compensation practices and the sharing of losses in the event of a failure), to strengthen market discipline and limit incentives for risk taking;

  • better macroprudential policies and effective safety nets to dampen the impact of swings and failures on the rest of the financial system so that no institution is viewed as TITF; and

  • reforms to establish an infrastructure that could cope with large, complex, and interconnected institutions so that the financial system can still perform its essential functions when some of its parts are troubled.

Significant reforms are in the making along these lines internationally and domestically (Figure 1.1), and the IMF has been participating in the deliberations. The reforms have focused on microprudential measures that aim at reducing the probability or the cost of failure by making individual financial institutions more resilient and/or allowing them to fail in an orderly fashion in the event of severe stress. They have also focused on policies aimed at strengthening the resilience of the overall financial system by mitigating risks caused by systemically important financial institutions (SIFIs) and procyclicality. The chapters in this volume describe work undertaken at the IMF on the various reform proposals to address some of the key issues.

Figure 1.1

Financial Reform Proposals in the Aftermath of the Global Crisis

SHAPING THE NEW FINANCIAL SYSTEM

The overarching objective of the ongoing reforms is to create a financial system that provides a solid foundation for strong and sustainable economic growth. Chapter 2 provides a broad overview of the financial reform agenda and lays out a vision for a better future global financial system capable of delivering this objective. It acknowledges that the current reforms are moving in the right direction, including through the proposals of the Basel Committee on Banking Supervision (BCBS) to strengthen the quality and quantity of bank capital and liquidity, but many urgent and challenging policy choices lie ahead, nationally and internationally.

In dealing with the obstacles along the way and carrying out the reform agenda, policymakers need to focus on five key tasks: (1) ensure effective and globally consistent regulation, (2) improve the effectiveness of supervision, (3) develop coherent resolution mechanisms at national and international levels, (4) establish a comprehensive macroprudential framework, and (5) cast a wide net to cover risks in the entire financial system.

Private sector ownership of the reforms will be key to a successful implementation of the new rules. In particular, business models and practices will need to be aligned with the new financial structure, governance and risk measurement/management will need to be improved to rein in excessive risk taking, and market discipline will need to be restored along the lines discussed above by correcting misaligned incentives and enhancing transparency.

HOW WILL THE REFORMS AFFECT THE INSTITUTIONS? SURVIVAL OF THE MOST ADAPTABLE!

Financial institutions will adjust their business strategies as they try to meet the tighter requirements and mitigate their effects on the profitability of their business; in fact, they have already started doing so. Chapter 3 explores the likely effects of the ongoing regulatory reforms on a sample of LCFIs with a range of business models. It notes that the gradual phase-in period for higher and better quality capital and liquidity rules under Basel III would allow most banks to meet the requirements through earnings retention, assuming a modest economic and earnings outlook. Should banks generate strong earnings in the coming years and distribute lower dividends, they could in fact rebuild the required capital faster than under the current phase-in periods.

The new capital standards will have a greater effect on banks with significant investment-banking activities, compared with those that focus on traditional commercial banking. The former derive earnings primarily from trading, advisory, and asset management income and are therefore more affected by the higher risk weights for securitization and trading activities that came into effect in late 2011. In contrast, traditional banking institutions have a simpler business focus and are subject to a gradual phase-in period. Investment banking activities will also be impacted by a host of other regulatory initiatives, including those that limit the scope of their activities. Yet, because LCFIs with an investment banking focus have more flexible business models, they also can adjust more easily to mitigate the effects of the regulations. A key challenge, then, is to ensure that tighter bank regulations achieve material reductions in systemic risk while avoiding an unintended shift of risks to the shadows of less regulated sectors and locations. Chapter 3 discusses some safeguards (e.g., widening the regulatory perimeter, strengthening supervision, and coordinating policies) to mitigate these and other unintended consequences.

EXPANDING THE PERIMETER, BUT WHERE AND HOW, AND AT WHAT COST?

With the crisis showing how significant credit risks, often highly concentrated, had accumulated in unregulated entities, concerns have been expressed that the coverage of prudential regulation has been too narrow. In reviewing the scope of financial regulation, it was found that special emphasis is warranted in regulating institutions, instruments, and markets that are currently unregulated, including systemically important institutions (G-20, 2008). These concerns have gained greater importance with the possibility that tightening the regulation of banks would create new arbitrage opportunities and leave the risks within the broader financial system. The relatively unregulated financial activities that were a major part of the global crisis had, after all, grown in the shadow banking system, in large part to avoid regulatory requirements affecting banks.

Chapter 4 in this volume reviews the lessons learned from the crisis as to why the perimeter of regulation should be reconsidered and discusses the objectives, content, and scope of expanded regulation. It calls for wider scope in the regulation of institutions, products, and markets to ensure that all financial activities that may pose systemic risk are appropriately overseen, and discusses the modalities of doing so. However, it also warns that, even if new regulation is carefully designed to be proportionate to the risks in each new area, there will be increased costs to the system in the form of greater regulatory burden, which will also carry risks of unintended consequences. Nonetheless, it notes that the cost of the alternative is also high, as the current crisis has clearly shown.

GOOD REGULATION, EVEN EXTENDED, WOULD NOT BE ENOUGH WITHOUT GOOD SUPERVISION

Good regulation is essential, but it must be supplemented by effective supervision to enforce compliance with the rules. In fact, the quality of financial sector supervision has emerged as a key issue from the financial crisis. Although most countries operated broadly under the same regulatory standards before the crisis, there were differences in supervisory approaches.

Chapter 5 in this volume argues that to be effective supervision must be intensive, skeptical, proactive, adaptive, comprehensive, and conclusive. These key elements, in turn, require a willingness and ability to take timely and effective action, which then calls for appropriate resources, skills, mandate, operational independence, and accountability for supervisors. In a world of an ever-adapting industry, complex instruments, and interconnected markets and institutions, supervision must be proactive, anticipating that the adjustment of some banks’ business strategies in response to tighter regulation may increase systemic risk. These attributes gain even greater importance in the supervision of SIFIs.

ENHANCED TRANSPARENCY IS EQUALLY IMPORTANT TO MAKE FAILURES LESS LIKELY …

Regulators and supervisors cannot do their job effectively without access to adequate data and information. Transparency and disclosure are essential in enhancing the ability of supervisors to capture emerging risks on time, as well as in promoting market discipline. Disclosure of timely and accurate data on individual firms’ condition and exposures vis-à-vis other financial institutions and instruments also helps creditors, counterparties, and shareholders better assess and identify risks, thereby acting as a natural restraint on excessive risk taking. Enhanced disclosure is aimed at both banks and the shadow banking and nonbank universe. Its purpose is to limit the likelihood that activities and accompanying risks could migrate to less-regulated parts of the financial system following the tightening of standards for banks, which in the end would add to systemic risk.

Significant progress is needed to close the existing gaps in information and help identify the buildup of systemic risks (see Johnston and others, 2009, and IMF/FSB, 2010). Efforts are ongoing to fill these information gaps through the joint efforts of the Bank for International Settlements (BIS), the FSB, and the IMF, including through the design of a data template for global SIFIs that would contain information on the structure, exposures, and interconnectedness of their activities. These issues are discussed in greater detail later in this volume.

BUT NOT ALL FAILURES CAN BE ELIMINATED, SO EFFECTIVE RESOLUTION REGIMES ARE KEY

Severe problems in individual financial institutions, although hopefully infrequent, are inevitable, regardless of the quality of supervision and regulation. Well-designed resolution frameworks that allow authorities to deal smoothly with the insolvency of financial institutions are essential ingredients of any strategy to maintain financial stability, both at national and global levels, and to minimize the extent and cost of the disruption that failures can cause. Moreover, orderly resolution must be a credible option if market discipline is to work.

Although some progress has been made on resolution frameworks at the national level, many challenges remain, including at the international level. These challenges include the design of mechanisms to ensure that losses are borne by the creditors of the institutions, rather than by taxpayers, and the design of infrastructures to wind down systemically important nonbank financial institutions and banking groups that operate across borders. Much less progress has been made in agreeing on the design of resolution frameworks at the cross-border level. That lack of progress reflects, among other things, operational and legal impediments deriving from differences in national resolution frameworks, the absence of mutual recognition and agreements for coordinating home-host regimes, and the lack of enforceable burden-sharing arrangements.

Chapter 6 proposes a framework for enhanced coordination as an intermediate option for reaching global solutions on resolution regimes for cross-border banks. The framework recognizes the need for significant political will to surrender national sovereignty to an international treaty and the efficiency costs implied by some nationalistic approaches. It calls for amending national laws to remove existing legal impediments to international cooperation, allowing participation by only those countries that satisfy core coordination standards (e.g., measures to harmonize resolution laws, rescinding national legislation that discriminates against overseas creditors, developing effective resolution tools and creditor safeguards, and strengthening regulatory cooperation). These core standards would establish the principles for burden sharing between cooperating authorities, where a resolution required the use of funds, and for legal/operating procedures to facilitate the cross-border effects of national resolution actions.

WHAT DOES THIS ALL MEAN FOR SIFIs?

All the policies discussed above (effective regulation, supervision, disclosure, and resolution) are essential to fix the cracks in the financial system, but more needs to be done, particularly for its systemically important players. Although making progress, the global financial community is not yet equipped to allow SIFIs to fail when they are in trouble or save them without agonizing taxpayers. Before the crisis, implicit government backing permitted SIFIs to take on greater risks without adequate exposure to market discipline and to enjoy competitive advantage over systemically less important institutions. When the crisis broke, their size, complexity, lack of substitutability, and interconnectedness within and across borders proved too significant to let them fail. The large-scale public support provided during the crisis has reinforced moral hazard and allowed SIFIs to grow even more complex and larger (with some exceeding multiples of the size of their home economies—Figure 1.2).

Figure 1.2
Figure 1.2

Big Banks Getting Even Bigger

(Bank Assets in Percent of Domestic GDP)

Sources: Bankscope; and IMF, World Economic Outlook database.

Chapter 7 provides an overview of the various proposals put forward to mitigate the risks SIFIs pose and presents IMF staff views of these proposals. The proposed actions aim to make failures less likely, or at least less devastating when they occur, to eliminate the moral hazard that would nurture risk taking, and to restore a level playing field. They seek to limit firms’ ability to become systemic by restricting their size, structure, and scope of activities; or to lower firms’ odds of failing through stricter regulatory and supervisory rules; and/ or to enhance firms’ resolvability to reduce the cost/impact of their failures. The policy framework necessary to achieve these goals, the chapter argues, contains:

  • more stringent capital and liquidity requirements (compared with those required by Basel III), commensurate with institutions’ contributions to systemic risk;

  • intensive supervision consistent with institutions’ complexity and riskiness;

  • enhanced transparency and disclosure requirements to strengthen market discipline and the ability to capture risks in the broader financial system; and

  • effective resolution regimes to make failures a credible option, with resolution plans and tools to require creditors to share losses.

Additional efforts are needed to reinforce these elements and limit unintended consequences, including a better monitoring of the shadow banking system so that risks are not simply shifted to entities subject to less oversight; supervisory cooperation and information sharing to contain regulatory arbitrage across jurisdictions; and a realignment of management incentives with those of the banking group to discourage inappropriate risk taking (e.g., by effective compensation practices). Although work is progressing on these building blocks, implementation could take several years, so credible actions in the interim are called for, including significantly more loss-absorbing capital for SIFIs, combined with enhanced supervision and global coordination.

IS CONTINGENT CAPITAL PART OF THE SOLUTION?

Contingent capital instruments, the so-called contingent convertible bonds (CoCos), have gained some support as a potential (market-based) option to reduce the need for public bailouts. CoCos can be automatically converted into equity or written down upon a predetermined trigger event, enabling a fresh injection of capital into distressed banks to absorb ensuing losses.

Chapter 8 argues that, although not likely to be effective as a stand-alone tool, CoCos could be part of a comprehensive crisis management framework if they are designed properly, with appropriate conversion triggers and rates and in a way that avoids adding procyclicality during crises and complexity to the capital structure. Policies that support contingent capital should be geared toward reducing the risk and cost of systemic crises, for example, to be used where market access is difficult and to discourage excessive risk taking by financial institutions. Making SIFIs less likely to fail and increasing the possibility of burden sharing with the private sector in the event of a failure would also help improve market discipline. Still, these instruments are untested, so they need careful scrutiny to avoid potentially adverse effects on market dynamics.

LIVING WILLS—A KEY TO ENDING THE TITF PROBLEM OR ENSURING SIFI SURVIVAL?

A silver lining of the crisis has been the encouragement of policymakers to think outside of the box and offer some novel solutions to the TITF problem. Living wills, or recovery and resolution plans (RRPs), are one such idea. Applied to financial institutions, living wills “provide a guide for the undertaker [resolution authority] to handle the deceased [the bank] in a way that will stem any contagious effects across the broader population [the financial system]” (Bovenzi, 2010). Given that most large banks are highly interconnected with other financial companies and have complex internal operating structures that often cut across and obscure their own legal structures, living wills could help resolution authorities deal with the significant operational challenges they could face over a very short period of time during severe systemic stress.

Globally active SIFIs are now required to have sustained RRPs, or living wills, to improve their resolvability. Chapter 9 reviews living wills in more detail. It argues that such plans can make valuable contributions to effective resolution frameworks for SIFIs by requiring firms and regulators to jointly develop systematic and holistic plans that facilitate recovery and an orderly wind-down in the event of failure. Living wills can help individual firms prepare for contingencies and authorities prepare for effective resolutions, and they can provide essential information on a firm’s assets and liabilities, commitments, exposures, and legal/operational structure. This information can facilitate supervision and resolution efforts. However, living wills may also be challenging to implement, especially for complex cross-border firms, and this highlights the need for effective cross-border cooperation, information sharing, and decision making when dealing with a failing institution. Further work is needed on methods and criteria to assess institutions’ resolvability and to ensure consistent implementation across jurisdictions.

WHY NOT BREAK UP SIFIS TO PUT AN END TO THE TITF PROBLEM?

At first glance, the most obvious solution to dealing with the TITF problem is to prevent institutions from becoming systemic in the first place, including by breaking them up into smaller, more manageable pieces so that no individual institution is too big or too interconnected to be allowed to fail. Some of these direct measures to address the TITF problem are discussed in Chapter 7 and Chapter 10. For example, caps can be put on an institution’s future growth, or its current balance sheet can be reduced in absolute or relative terms by selling assets or breaking them up, so as to limit the impact its failure has on the financial system and the economy. Restrictions on a bank’s scope of activities attempt to separate its core activities from presumably riskier ones that could destabilize bank funding, making the system less interconnected, and/or avoiding the conflicts of interest that arise from bundling services together.

Although they provide a direct way of dealing with the TITF problem, such measures could be difficult to implement and adopt on a globally consistent basis. Neither capping banks’ size and breaking them up nor restricting their scope has gained broad international support. Some have argued that limiting size alone would not prevent “systemic-ness” and that it might cause fragmentation between many smaller market participants (e.g., FINMA, 2011). The measures could also be costly due to a loss of potential gains from diversification, as well as having large adjustment costs, if applied retroactively. And there may be nontrivial implementation challenges in separating the prohibited activities from legitimate ones. These activities, if moved to less regulated or unregulated parts of the financial sector, could leave the risks in the system if they resulted in systemically important nonbank institutions that maintain an umbilical cord connected to the banks.

COULD WE AT LEAST MAKE SIFIS SELF-SUFFICIENT?

If policymakers cannot break up SIFIs or constrain their activities, could they at least structure SIFIs to make them less interconnected and more self-sufficient so as to reduce the likelihood and impact of a failure? With these objectives, some policymakers have proposed to force large cross-border banks to operate outside their home markets as subsidiaries (the so-called subsidiarization), rather than as branches of the parent bank, as one part of the solution to dealing with the TITF problem. In the absence of effective cross-border coordination, adequate information exchange, and effective resolution and burden-sharing arrangements, some host authorities have chosen to isolate the local operations of foreign banks from possible problems in distressed foreign parents or affiliates. Measures include requiring subsidiaries to hold sufficient capital and liquidity and imposing tight limits on intragroup operations. More recently, the geographical subsidiarization concept has been applied to split groups by function, such as by ring-fencing retail from investment banking operations.

Chapter 11 examines the merits of such proposals from the perspectives of banking groups and home-host authorities, and argues that there is no one size that fits all. The subsidiary structure can shield a business from losses in the group, make it easier to spin off businesses and affiliates individually, facilitate implementation of RRPs by simplifying the legal and financial structure of the group, and help an orderly restructuring of the affiliates of a troubled entity. But imposing self-sufficiency constraints regardless of business models could be costly for some banks, such as those with a wholesale focus. It could also impose additional costs on a bank group’s ability to manage risks given the limits on intragroup operations. In fact, a bank forced to subsidiarize has been likened to a general fighting a battle in one country who cannot benefit from his own ample troops since they are locked up in other countries (see Ludwig, 2011). The chapter encourages policymakers to accelerate progress toward the first best solution—with harmonized cross-border resolution regimes accompanied by equitable burden-sharing mechanisms, adequate risk management, strong capital/liquidity buffers, and supervisory coordination—in order to limit the need for such nationalistic approaches.

HOW IS THE FINANCIAL SYSTEM LIKELY TO BE SHAPED BY THESE REGULATORY INITIATIVES?

As the numerous regulatory reform discussions take their course, some initiatives will assume their place in a pile of proposals that will never see daylight, whereas others will reshape the contours of a new financial system through the combined efforts of policymakers and the private sector’s responses to the probable outcomes. Global consistency in regulation and financial sector taxation will be essential to mitigate systemic risks, avoid unintended distortions, and help ensure a level playing field.

The last chapter in this volume discusses how the financial system is likely to be shaped by the probable changes in the regulatory environment. It suggests that the future contours of the financial system will likely include the following:

  • banks that are expected to return to their more traditional function as stricter regulation limits the risks and activities they can undertake;

  • a nonbanking sector that will likely have a greater competitive advantage—both in supplying credit and in providing investors with nonbank services—and will thus grow;

  • an expanded perimeter of regulation to take into account the risks in the nonbank sector;

  • a market infrastructure that is reinforced to protect investors and, consequently, must provide needed simplicity and transparency to make risks clearer and the financial system safer; and

  • a global financial system that is smaller and less leveraged than in the recent past and could well be less innovative and dynamic, at least for a while.

LOOKING AHEAD

Four years after the onset of the global financial crisis, much has been done to reform the financial system, but there is still much left to do. The authors of this book believe the current reforms are moving in the right direction toward the objective of restoring the stability and resilience of the financial system so it can support strong and sustainable economic growth, but further challenges lie ahead. This has not been an easy journey. The ride has certainly been bumpy, with many setbacks, as policymakers have attempted to boldly go where none had gone before, while fighting many fires along the way and striving to revive economies battered by the crisis.

Large, complex, integrated cross-border banking groups have been key players in this journey. Such groups are major components of the global financial system in many ways. They provide efficiency gains associated with the scale and diversification of their operations, but they also have a great capacity to transmit distress to the broader financial system and the global economy. It is with the objective of safeguarding these groups’ potential efficiency gains and ensuring their sustainability for the good of the economies in which they serve that one should seek measures that make them less likely to fail or that make such failures less painful and catastrophic when they occur.

To ensure that no institution is too big, too complex, or too interconnected (hence, too important to fail), the only way forward is to address the moral hazard risks such institutions pose, given their TITF status, and to restore market discipline. The features of being too big, too complex, or too interconnected have proven to be a deadly trio in the absence of a sound risk-management culture, market discipline, effective oversight, and safety nets to deal with failures. A variety of measures and proposals have been put on the table to deal with them. Some have failed to stimulate the appetite, whereas others have been swallowed but with a bitter aftertaste. Some still face many challenges to being effectively implemented in the fragile economic environment, with the threat of the shadows undermining their success. The authors of this book, where the various proposals are assessed, believe that swallowing the bitter medicine is the only road to recovery, to maintaining a healthy life going forward, and to avoiding exposure to further viruses, especially in an environment where even the doctors are falling sick and the willingness to take bitter medicine is diminishing.

Reforms in the Wake of the Global Crisis
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    Financial Reform Proposals in the Aftermath of the Global Crisis

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    Big Banks Getting Even Bigger

    (Bank Assets in Percent of Domestic GDP)

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