Abstract
The current economic crisis has revealed the shortcomings of the current global financial system, and it is clear that there must be a fundamental shift in the approaches to global financial governance. The seeds for a more comprehensive global system have been sown, as evidenced by the increasing amount of international dialogue, not only amongst the global economic giants but also amongst emerging economies. However, there is a need to develop mechanisms for high-quality regulation rather than falling into the trap of reacting to the current crisis.
Introduction
International and regional cooperation and national political leadership are essential components for achieving global financial reforms. It is ultimately national and regional legislatures, accountable to their voters, which must decide and implement reforms.
The recent strains in the global financial system have eased considerably in the last twelve months: the banks are once again raising funds and asset write-downs have diminished. Nevertheless, elements of fragility are still present in various parts of the financial system, leaving it vulnerable to the deterioration of traditional loan books, the bunching of refinancing needs in the next few years, and new sources of risk, such as sovereign risk. It is essential that we can count, in the years to come, on the fully restored ability of the banking sector to perform its essential tasks in the economy.
We have come a long way towards strengthening the financial system since this crisis began. But we have hard work ahead of us in completing the task. Here, I will focus mainly on these future challenges. But let me start by taking stock of what brings us to this point.
Three things have been important in getting us to where we are now: first, the recognition that, in a closely integrated system, we are all in the same boat; second, the leadership of the G-20 process, in which the EU has played an important role in establishing agreed objectives and timelines for substantial reform; and third, the establishment of mechanisms, such as the Financial Stability Board (FSB), to hasten and coordinate the policy development needed to meet these objectives.
When I say we have come far, I am referring to an unprecedented amount of international dialogue and cooperation on important financial system issues, and to the resulting substantive changes that have been achieved or are about to fall into place. While many issues remain to be resolved in Europe, the US and elsewhere, collectively we are fundamentally reshaping the framework for systemic financial oversight.
First, top-down, system-wide oversight arrangements are being put in place at the national, regional and international levels. These include more comprehensive surveillance with broadened macro-prudential perspectives, as well as mechanisms for triggering action on identified risks. Examples include the European Systemic Risk Board and related arrangements, the US Financial Services Oversight Council, the IMF-FSB Early Warning Exercise and the establishment of the FSB itself.
Second, as part of this, major jurisdictions and regions are overhauling their regulatory and supervisory structures to strengthen responsiveness to systemic risks, improve coordination and close gaps. The FSB is in many ways the international manifestation of these efforts.
Third, the regulatory perimeter is being expanded. Major jurisdictions are finalising legislation that for the first time establishes formal oversight of the over-the-counter (OTC) derivatives markets and their major dealers, hedge funds and credit rating agencies. In each of these areas, principles for what regulation should achieve have been internationally agreed to.
Fourth, cross-border oversight and crisis management contingency planning has been put in place for the largest and most complex global financial institutions, each of which now have functioning core supervisory colleges and crisis management groups.
At the level of essential regulatory policies that buttress financial stability, let me recall a few important points. First, we are in the process of calibrating a fundamentally revised global bank capital framework that will establish stronger protection through improved risk coverage, more and higher-quality capital, a counter-cyclical buffer and a constraint on the build-up of banking sector leverage. Second, we have developed and will implement a global liquidity standard for banks that will promote higher liquidity buffers and constrain the maturity mismatching that created the conditions for the recent crisis. Third, we are making progress in developing a policy framework and tools to overcome the moral hazards danger posed by institutions that are vitally important. Fourth, we have eliminated the perverse incentives that pervaded securitisation, including the scope for leverage to develop in opaque off-balance sheet vehicles through changes to accounting standards and regulatory and prudential rules. Fifth, we have developed a series of supervisory tools to raise standards of governance, risk management and capital conservation at core financial institutions.
In this context, we are making strong progress towards a forward-looking provisioning regime for expected credit losses—a regime that will dampen pro-cyclicality and align accounting and prudential objectives in this key area. Moreover, we are making good headway towards establishing compensation regimes that are better aligned with risks taken in significant financial institutions.
I have been selective in my enumeration. The point I want to make, however, is that we should not underestimate what has been accomplished. Each of the aforementioned developments is difficult in its own right. That we have achieved broad progress in global policy development—and in some cases implementation—while fighting a very serious financial crisis, is something that has never happened before.
The direction in which we are moving internationally, therefore, is encouraging. But as we hit the home stretch in these areas, political leadership will determine whether we accomplish credible and robust global reforms that deliver the protections that our citizens rightly demand, while preserving the enormous advantages of an internationally integrated financial system. We must not only reaffirm our commitment to global solutions, but also demonstrate our willingness to reach agreement on the issues that stand in their way, recognising that each of us may need to make concessions for the common good.
In the process, we must guard against pressures to water down the stringency of global reforms. That such pressures originate within a financial industry concerned with preserving competitive advantages is not a surprise. But such pressures are also evident in the hesitation of some countries concerned about the impact of reforms on their own financial institutions. This hesitation is stronger where the starting point is weaker. However, it would be a very serious and unfortunate mistake to allow these different starting points to result in weaker standards than we need for the future.
Given the economic and social costs of this crisis, we simply cannot afford sub-standard outcomes. Were we to fail, the risk is that countries and regions will go their own way and the system will fragment, with very significant global costs. Hence, we must keep our focus on achieving global standards that are credible and agree on transition and phase-in arrangements that enable all of us to reach that goal. I will come back to this point.
Let me speak to the key areas where we need to make headway in the months ahead. First and foremost, we must complete the revamp of the Basel capital framework and the liquidity standard, along with the complementary changes, including provisioning, that address the problems of pro-cyclicality that we have seen in this crisis. We took a major step forward on this issue in December, when the Basel Committee released—on schedule—its full package of reform proposals. Comprehensive impact assessments are now underway to assess the consequences of these capital and liquidity proposals for the banking sector. This is complemented by a top-down assessment to calibrate the new minimum requirements, taking account of, among other things, the experience of loss during this crisis, the impact on the role of banks in the financial system, and the benefits and costs of the new requirements in a context of stability.
As I mentioned earlier, it will be critical that we do not let current strained conditions shape the standards, but instead keep our focus on the rigorous framework needed to ensure balanced, sustainable banking in the years ahead. While the banking sector has already made significant progress in raising the level and quality of its capital and liquidity, immediately implementing in full the more stringent minimum requirements could have negative effects. To rule this out, we will design appropriate transition and grandfathering arrangements. Together with the Basel Committee, and with the IMF as a key partner, we have set in motion a thorough macroeconomic impact assessment to inform these phase-in and implementation arrangements. Preliminary results on all assessment streams will be available in June or July. Calibration work will continue into the autumn, and the broad features of the framework, along with the transition arrangements, will be ready by the G-20 Summit in November. Countries will need to pass any necessary legislation to implement the reform according to the agreed timetable, and the EU is at the forefront of this.
Second, this year we must agree on measures to credibly reduce the moral hazards and systemic risks that arise when firms are ‘too big to fail’ (TBTF). Such firms are first and foremost a national problem, especially when they are too big to save. But we are all affected by the moral consequences of not addressing the problem. There is no silver bullet or one-size-fits-all solution here. One focus of our work, therefore, is to provide supervisors with tools that enable them to take action in national contexts, under existing authority—tools such as governance, intensity of supervision, structural simplification and capital surcharges. Systemically important financial institutions have to be resilient even in periods of broad financial system stress. Capital, liquidity and leverage expectations should reflect this. But we will never be able to fully eliminate the potential for failures; a key requirement across all jurisdictions, therefore, is the establishment of effective resolution frameworks that allow all types and sizes of institutions to fail, as well as adequate coordination of these frameworks across borders. This is a tall order, as we all know. However, should an effective cross-border resolution prove out of reach, it will strengthen the case for alternative solutions: to place restrictions on activities, size and structure that make all institutions solvent, or to increase capital and other requirements on essential institutions to the point where the likelihood and impact of default is reduced to a very low level. These measures will come at a cost to intermediation and global financial integration.
Given the diversity of institutions and financial systems involved, a key challenge will be to avoid inconsistencies in what results. We must achieve consistent design and implementation of new measures to ensure a level playing field and to address potential concerns about market fragmentation. Our aim is to reduce systemic risks globally by having standards for TBTF firms that establish common ground rules and actions across countries—measures that are sufficiently coordinated to avoid regulatory arbitrage. We will provide an interim report on these issues to the G-20 Summit in June, and final recommendations to the November Summit.
Third, we must finalise reforms that will regulate and make transparent a substantial portion of the OTC derivatives markets and thus reduce their scope to act as channels of contagion. Legislation is advancing in the US and the EU to establish the requisite frameworks for this. Among critical questions to resolve are the following:
Which derivatives products can and should be standardised and subject to a mandatory central clearing requirement?
Should commercial end-users be exempted from these requirements, and if so, how should the end-users and their types be defined?
We must be careful to avoid inconsistencies here; not to do so will drive regulatory arbitrage in this global market. To accomplish meaningful systemic risk reduction, we need robust, globally agreed standards of soundness for all of the central counterparties to the agreement. And governments should ensure that the determination of which derivatives are subject to central clearing is not left to the central counterparties alone. We also need harmonised definitions of standardised derivatives, and to that end we are setting in motion work across the US and the EU. It is also imperative that regulators have the information available to them to police the market for potential manipulative abuses. This is why there must be mandatory trade reporting of all OTC derivatives transactions, regardless of whether they are centrally cleared or bilaterally negotiated.
Fourth, we must firmly embed reforms in the compensation practices of financial institutions. Last year, the FSB set out Principles and Implementation Standards for Sound Compensation arrangements. In December, we launched a detailed assessment of the implementation of these standards. This is a very important task, not just because this is the FSB's first peer review but also because of the importance and the political dimension of these measures. We are on schedule to conclude this review later this month. The review sends a clear message—that a lot has been done by national authorities and change is taking place in the major firms. However, differences remain in the manner and the pace of implementation. Greater progress has been achieved in the areas of governance, supervisory oversight and disclosure of compensation, while much more work needs to be done on pay structures and risk alignment. We will be setting out additional recommendations in these areas later in March.
Conclusion
International cooperation and political leadership at the national and regional levels are complementary drivers of global financial reform. Together, we have come a long way. But 2010 will be a critical year as we press ahead with global financial reforms. Indeed, internationally coordinated reforms cannot be agreed to nor implemented without the support of national political leaders and those who are in a position to make final decisions. Their decisions will determine whether we are able to build a more robust and consistent global financial order necessary to preserve the advantages of an integrated financial system. Beyond the policy development work, full and consistent implementation will take time and perseverance. We must keep our eyes on the final objective, and we will develop transition paths to take us there.