Just Do It—Shaping the New Financial System

By José Viñals

Fearful financial markets, an uncertain growth outlook, fiscal anxieties, long unemployment lines….no other financial crisis since the Great Depression has led to such widespread dislocation in financial markets, with such abrupt consequences for growth, trade, and employment.

The crisis exposed fundamental weaknesses in many areas of the world economy, the most obvious being dramatic deficiencies in the regulation and supervision―nationally and internationally―of financial institutions and markets.

On the bright side, the crisis has provided the impetus for a major overhaul of the financial regulatory system. So, are we making the most of this opportunity to fix the system?

Three years into this crisis, the good news is that policymakers have made important progress in some areas, and the work underway is moving in the right direction.

The bad news is that we are barely half way there and the hardest part may lie ahead. In a new Staff Position Note, Shaping the New Financial System, we examine just how far we’ve come and, more importantly, how much further we have to go. Indeed, unless we—the collective “we”—make concrete progress over the next 12 months in a few key areas, we may well sow the seeds of the next financial crisis.

What are the guiding principles of this urgent work? The first is to build a financial system that provides a solid foundation for strong and sustainable economic growth; one that satisfies, first and foremost, the needs of households and firms. The second is to address the risks posed by the entire financial system, not just banks.

The recent proposals of the Basel Committee on Banking Supervision represent a substantial improvement in the quality and quantity of bank capital, but these apply only to a subset of the financial system, and they don’t yet include macroprudential considerations, that is, systemic issues and the impact of the business cycle on how financial institutions function.

Real progress is therefore needed over the next year in several key areas―areas where much has been said, but less accomplished. The financial sector remains the Achilles’ Heel of the global recovery. Prompt action is essential to alleviate regulatory uncertainty, which is acting as a drag on credit and economic growth, and to reduce the likelihood of another crisis.

Policymakers need to make progress in the following five areas:

  • Ensuring a level playing field in regulation. Global coordination is needed to foster competition and minimize the scope for regulatory arbitrage.
  • Improving the effectiveness of supervision. Better supervision is necessary to prevent a new cycle of leveraging and excessive risk taking. Supervision needs to be intensive, intrusive, and more focused on cross-border exposures.
  • Developing coherent resolution mechanisms. At the national level, the IMF has proposed a “financial stability contribution” to pay for the fiscal cost of any future government support. At the international level, we have proposed a “pragmatic” cross-border coordination framework. As a first step, we suggest making this pragmatic approach operational among a subset of countries that are home to most cross-border financial institutions. This is critical for addressing the problem of “too important to fail.”
  • Establishing a comprehensive macroprudential framework. Microprudential regulations, which aim to improve the resilience of individual institutions, must be accompanied by macroprudential regulations that strengthen the resilience of the system as a whole. This means identifying, monitoring, and addressing procyclicality and systemic risks generated by the individual and collective behavior of firms.
  • Casting a wide net. Regulation and supervision must capture the entire financial system, not just the banks. Absent a broader perspective, riskier activities and products will surely migrate to the less (or un-) regulated segments of the system.

More than just focusing on the right issues with sufficient vigor, the official sector needs ‘buy in’ from the private sector for these new rules. This will require rules that encourage the industry to reduce their collective risk taking, through better risk measurement and risk management, and with boards of directors that are empowered to rein in excessive risk taking, and be held accountable for it.

Finally, since the issues are complex and involve many conflicting interests, we need political commitment at the highest levels. To borrow from the success of the Nike spirit in the corporate world, policymakers need to “just do it”.

2 Responses

  1. I have recently started to suspect that when the Basel Committee calculated the risk-weights by which they adjust the capital requirements of banks they did not consider at all the fact that those perceived as risky pay much higher interest, precisely because they are perceived as more risky, and that these risk premiums go directly into the equity of banks, when paid of course.

    It would be like if the insurance regulators asked the insurance companies to post higher capital when insuring the health of persons who represent higher health-risks, without accounting for the fact that these persons will be obliged, precisely therefore, to pay much higher insurance premiums.

    If this is so, I cannot but qualify it all as gross negligence.

  2. Jose Viñals writes “The recent proposals of the Basel Committee on Banking Supervision represent a substantial improvement in the quality and quantity of bank capital”

    I agree, but unfortunately the shoddy quality or the 8 percent quantity of the bank capital was not what produced this crisis. This crisis resulted from the arbitrary regressive and utterly minuscule risk-weights that were applied… especially the 20% for anything in the private sector related to a triple-A rating… (and the 0% for anything related to a triple-A rated sovereign).

    That, which allowed the banks to leverage their equity in those operations 62.5 to 1, increased so dramatically the expected profitability for the banks when pursuing these investments that they went berserk and invested too much in these “risk-free” operations.

    Basel III, with their still untouched risk-weights, albeit on a much more solid 7 percent capital, is now authorizing a 71.4 to 1 leverage for precisely the same instruments that created the crisis… If this is not a sheer madness and evidence that the Basel Committee experts need to be put in a straightjacket, what is?

    Just think of the public bad the Basel Committee experts have been able to do with a global regulatory body that was supposed to be a public good. We need good global institutions but, as such, these need also to be the most accountable institutions of them all.

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