Financial Reform: What Must Be Done

By José Viñals

Financial system reform has reached a critical point around the world. Pressure is building from the financial industry to slow reform and concerns about fiscal conditions risk drawing public and political energies away from the need to act on financial sector problems. Fortunately, the Group of Twenty (G-20) reaffirmed its commitment at a summit in Toronto on June 26-27 to a comprehensive reform agenda—and we must seize the moment.

We face five challenges:

First, we have to address both the micro-prudential and macro-prudential dimensions of financial reform. The micro-prudential framework―aimed at making individual financial institutions healthier―has to be set right. The Basel Committee is working on strengthening the bank capital and liquidity framework for this purpose and we cannot let these efforts be diluted by political pressures. Visible progress needs to be made by the time of the November G-20 summit in Seoul.

At the same time, a framework of macro-prudential regulation has to be created to deal with systemic risks that reflect interconnectedness and cyclicality. Its successful implementation, however, will depend critically on addressing the flaws in the micro-prudential framework.  This important work is only just beginning and must be intensified.

Second, we must look beyond banks to nonbank financial institutions. Reforms need to make the entire financial system―not only the banks―safer. The reform agenda has so far focused on banks; in the area of nonbanks and the shadow banking system, the risk lies in not acting soon enough. Regulators, policy makers, and standard setters must speed up their work on markets and products, and nonbank financial actors.

Third, we must strike the right balance among three competing objectives—safety, efficiency, and regulatory certainty. We have to move ahead and finalize the core rules governing capital and liquidity. This is essential not just for making the financial system safer but also for providing more certainty to the market.  At the same time, the actual calibration of the required levels of capital and liquidity must proceed cautiously to ensure that, before they are finalized, the impact of the various changes, both individually and collectively, on the financial system and the overall economy have been assessed.

Getting the calibration of the steady state impact right will prevent ending up with a system that is either inherently unstable, or that imposes an excessive burden on the financial sector, and ultimately on the economy.

Fourth, regulations must be both nationally appropriate and internationally consistent. There is a danger that the regulatory framework emerging from current discussions will not be adopted evenly.  Some countries that were less affected by the crisis may not see the need for implementing some of the new reforms. In a financially globalized world, however, uneven regulations across borders will inevitably lead to a migration of risky activities to those countries with the easiest requirements. This would put their financial systems at risk and, in turn, endanger the global financial system.

Last but not least, in addition to regulation, we must reform supervision. A rule is only of value if implemented correctly. The quality of implementation in turn depends on strong supervision.

Unfortunately, supervision has come up short in this crisis. There are many examples where supervisors did not take effective and timely action. Supervisors need both the ability―powers, mandate, appropriate skills, and resources―to act and the will to act. I have written a separate blog on this.

In the lead up to the crisis, many supervisors lacked either an understanding of the risks being assumed by financial institutions and/or the will to challenge institutions. They were too deferential to industry, unwilling to interfere, and not sufficiently objective and skeptical about the industry’s ability to manage its own risks. We must learn from this experience.

Given the task before them, supervisors require the support of the broader community of policymakers, government, and the public. There must be political support and a public expectation that supervisors will take decisions independently. These decisions will not always be popular. The supervisor’s job is precisely to take away the proverbial punch bowl just as the party is getting started, and to require more conservative underwriting of loans to a sector when it is becoming “frothy.” We must be in agreement on this.

If expectations and consensus do not exist, supervisors may not have the necessary moral, political or legal support to do what is required: to be rigorous and thorough, to be skeptical, to follow through with unpopular judgments and actions.

We have to work together to build the support among governments and the public for a commitment to strong supervision. This is something that must come out of this crisis. The IMF has intensified its focus on the quality of supervision in its regular financial sector surveillance and will work with the Financial Stability Board (FSB) and others to develop specific recommendations to strengthen oversight and supervision.

The G-20 has declared enhanced supervision to be the second pillar of financial reform; their support and focus on supervision will give an important emphasis to this work.

The financial crisis has exposed the need for reform of the financial sector. Under the leadership of the FSB, the IMF, the World Bank, and the standard setters, FSB member countries have embarked on an ambitious agenda to reduce the likelihood and costs of future financial crises. We must stay focused on this important goal and not allow the challenges before us to overwhelm us.

5 Responses

  1. This is all well and good but let’s look at the facts.
    The Dodd-Frank Act signed by Barack Obama on July 15th is directed at one of the main causes of the Great Recession: the banks. It’s not clear whether the new law will meet its proponents’ expectations since it focuses on the symptoms rather than the roots of the crisis. Twelve known personalities, interviewed by The Wall Street Journal, gave it an average C+. One can hardly be satisfied with such a mediocre grade. The reform is analytically deficient. Let’s go back in time to understand why.

    The banking sector has undergone a profound mutation since the 1960’s with the emergence of the market which progressively robbed the bank of one of its main functions: financing the economy. The starting point was the Regulation Q forbidding banks, under the Glass-Steagull Act, to pay interest on current accounts. The ban gave birth to money market funds, which deprived banks of a stable source of funds. The buoyancy of the economy in the 60’s encouraged companies and households to borrow which led banks to hunt for new funding sources. Certificates of deposit were created. They were FDIC guaranteed, much like regular bank deposits, without however, being subjected to “Reg. Q”. New instruments such as commercial paper, repurchase agreements, etc. progressively displaced the center of gravity away from the banks towards the market. A company could thus finance itself directly by issuing commercial paper. The mutation of the sector cut into the banks’ profit.

    Banks were fighting on two fronts: the funding of their operations on the liability side and the retention of their lending functions on the asset side. They reacted along two axes: by developing their international operations with mitigated success (c.f. the Mexican, Asian and Argentine crises) and by engaging in proprietary trading, that is by playing the markets for their own account. With time, it became clear that the mutation was not as negative as first thought. It offered the banks numerous arbitrage opportunities. In addition, banks were no longer dependant on their sole client deposits, expensively collected through their branch networks, they could now refinance themselves at will through the market. The Glass-Steagall Act of 1933 which severely constrained their scope of action, did not prohibit them from trading loans. This activity, better known as securitization, gave birth to the subprime crisis. Without lively capital markets, the exponential growth of securitization would have been impossible. The Gramm-Leach-Bliley Act of 1999 ended the Glass-Steagall Act but the breaking point which allowed the excesses we all know, dates back to the 1960’s. In allowing the merger of Citibank with Travelers, the new law encouraged the creation of entities too big to fail which forced American authorities in the middle of the crisis to take extraordinary steps to save them from bankruptcy.

    In 1978, Congress voted The Full Employment and Growth Act or Humphrey-Hawkins Act. The law notified the Federal Reserve Bank (Fed) to take appropriate actions to insure that unemployment would not exceed 4%, and inflation would remain below 3%. The reform imposes a third objective on the Fed: financial stability, that is the assurance that no banking crisis will ever turn into a recession. Yet, to achieve these three objectives, the Fed only has two levers: monetary policy (the interest rate) and macroprudential regulation (overseeing banks). This is a new version of Mundell’s inconsistency triangle. The objectives conflict with one another. Full-time employment is inflationary by nature, and regulation induces monetary laxity, as demonstrated by the“Greenspan put”. Alan Greenspan, chairman of the Fed for nineteen years, hastily lowered interest rates after the October 1987 Crash, and then again in 2001 following the burst of the Internet bubble. Each time, his intent was to head-off a recession but in the process he created what economists call a moral hazard, that is the perception that no matter what happens, whatever mistakes are made by management, the Fed will rescue banks.

    Commenting on the reform, analysts have focused on its main points: remuneration, derivatives, debt ratios, the Volcker’s rule, etc., whereas the cause of the crisis lays in the structure of the sector and its evolution over the past 50 years. Worst, the reform gives the Fed added authority while it is known that it is its laxity (monetary and regulatory) which facilitated the emergence of the real estate bubble. This reform is nothing other than an accumulation of measures, some of which might be useful. In no case, is it the result of a coherent, well-thought-out analysis likely to help the United States to confront its main foes (a fragile recovery, persistent unemployment, the twin deficit, etc.). Under these circumstances, it is hard to see how the Fed will be able to meet Congress’s expectations.

  2. The financial reform law is oriented to protecting consumers, which is good, and cleaning up future spills, which is also good, but what about the very existence of the institutions deemed too big to fail? That is, what about their market/political power? The law leaves them to widen the loopholes.

    See: http://euandus3.wordpress.com/2010/07/15/financial-reform-prevention-medicine-or-selling-out/

  3. […] Jose Vinals of IMF on Financial Reform: What Must Be Done […]

    • In regard to financial system reform, I wonder if, in North America, our legislative approaches are not missing the main point.

      What is primarily needed, in my opinion, is a way to lessen the attraction of trading in outrageously risky futures contracts, especially synthetic ones. Those were the particualar kinds of transactions that fuelled the derivatives boom, a boom that eventually went so bust that taxpayers around the world were required by governments to stem/repair the credit crisis that ensued and to lessen the pain of the unemployment and bankruptcies that the credit crisis triggered. This is not just my opinion. It is the opinion also of both George Soros and Warren Buffet.

      A differential speculative finanancial transactions tax (dsFTT) is an FTT that is targeted ONLY at just such boom/bust inducing transactions. It would both address the current primary need and also obviate the legitimate criticisms of people worried that an undifferentated financial transactions tax would inhibit healthy trading activity.

      How exactly would a dsFTT work?

      From the trial of Societe Generale trader Jerome Kerviel, whose outstanding derivative book lost SocGen $7 bn in 2008, we can see how incompetent, unfocused INTERNAL supervision failed the trading houses and their sponsors whose job it is to make sure that “overexcited trader horses don’t kick down their stable doors”.

      Telling trading house managers how to do that job seems to have been been the major focus so far of Washington’s pending bill for overhaul of financial regulations. But that focus seems to me to be missing the primary objective of overhauling the most significant dysfunctions that we know exist in the financial industry. Seeking and finding a practical way to make extremely imprudent futures contracts PROSPECTIVELY much less profitable, because, of course, sometimes such contracts turn out to be extremely profitable, has now to be our primary focus.

      In the stable analogy that would mean feeding less oats and more hay to the horses, for it is the oats/hay mix which determines the excitability of horses.

      Can we accomplish that with a differentiated financial transactions tax, i.e. one targeted at just the transactions that are least likely to be constructive contributions to the real economy and most likely to be bubble makers and bursters in the derivative “economy”? Well, both traders and economists agree that those transactions are much more likely to be ones in which shorter-term futures and the more wildly synthetic derivatives are traded. Longer term futures and ones not mixed into synthetics are less likely to trigger boom/bust cycles.

      A differentiated speculative Financial Transactions Tax (dsFTT) has not, to my knowledge, ever before been seriously considered. I like the concept for the following 5 reasons:

      1. It’s NOT the “Robin Hood” tax. The undifferentiated FTT, now called the “Robin Hood” tax by populist marketers, was first proposed, I understand, by Maynard Keynes in the 1930s. It went nowhere. Then in the 1990s James Tobin resurrected the idea, and it then began to take on with some academics but never affected the decisions of any leading politicians

      2. A dsFTT addresses the ROOT problem, which is grossly imprudent transactions in derivative contracts, whereas the Robin Hood tax scarcely addresses that problem. A dsFTT does NOT tax responsible trading in derivatives nor other innoccuous financial transactions. I therefore believe that, by refraining from doing so, proposals for a dsFTT would demonstrate an insight into the issues of traders and managers/sponsors of traders that recognizes their genuine contributions to the real economy. Such insight would be reassuring to politicians, many of whom, like Scott Brown (until recently?), are more inclined to believe the experts, i.e. senior bankers and central bank gurus, than to do the really hard cognitive work of thinking originally and fundamentally. And of course, it would be more appealing to the more responsible leaders of the trader-banking-hedgefund community, of which there are, of course, some

      3. Implementation of a dsFTT obviates the delays and costs of frustrating legislative and legal work. Legal processes continue, even with the descent of bankers to the position of society’s most hated professionals, to be the object of much frustration and anger by the public at large — because, once a matter becomes legally controversial, progress tends to be slow, animosity is evoked, and the trauma of a lose/win result is always experienced. In other words, a dsFTT is friendly to the philosophy of free markets

      4. A dsFTT is eminently calibrateable to changing conditions. For more on the dsFTT idea, and in particular for a practical sense of how, organizationally, it might be calibrated to reflect the interests both of the trading-banking community and of real-economy executives, as well as of people at large, please take a look at the paper entitled “Regulating Derivatives to Meet Real Needs: The Toronto G20 Summit”. This paper is accessible at:

      http://www.authentixcoaches.com/DerivativeRegulation.html

      5. Lastly, a dsFTT would minimize, and perhaps obviate entirely, the additions of capital proposed in some quarters — presumably people who think that capital is the answer to all evils. Because a dsFTT would directly attack the main problem, namely grossly imprudent speculation, rather than merely protect against it by insulating bank shareholders against the irresponsible behaviour that a dsFTT would inhibit, it’s a much more economic solution than the smug Canadian proposal for contingent embedded capital.

      Angus Cunningham
      Executive Coach

      Angus operates an executive coaching practice is Toronto, Ontario, Canada, and includes a trader amongst his clients. Angus’ firm delivered to a Toronto-Montreal bond trading firm in the 80s the world’s first electronic trading system builted from open-system hardware and software components.

  4. The G20 final Toronto final statement: “We are building a more resilient financial system that serves the needs of our economies, reduces moral hazard, limits the buildup of systemic risk, and supports strong and stable economic growth.”

    But nowhere does it mention the problem of regulatory interference, by means of assigning lower capital requirements to what is perceived by credit rating agencies as having a lower risk of default; and which has absolutely nothing to do with serving the needs of the economy; and which in fact was precisely the arbitrary risk discrimination that induced the buildup of excessive risky levels in what was supposed to be risk free which naturally caused the crisis… as crisis never ever thrives where the risks are perceived as high but always blooms where the risks are perceived as low.

    Also, in that same statement, we find, with respect to financial regulatory reform, the Basel Committee on Banking Supervision is mentioned 11 times, and the Financial Stability Board (FSB) 27 times.

    But, in the 2,319 pages of the Financial Regulatory Reform approved by the House of Representatives in the U.S. Congress those entities are not mentioned once… And that is a disconnect we do not understand and that does not bode well for the future.

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