Time Waits for No Man: How to Secure Financial Stability in 2011

By José Viñals

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This morning, I presented our latest views on global financial stability in Johannesburg, South Africa.

So, where does the global financial system stand at the moment? Yes, we have witnessed improvements recently, but we are also observing a dichotomy between the economy and the financial system. While the global economic recovery has been continuing, financial stability is still at risk, because of a persistent lack of investor confidence in some advanced country sovereigns and their banking systems.

At this cross-roads, we see three key messages.

  • First, more than three years after the onset of the financial crisis, global financial stability is still not assured.
  • Second, policymakers need to step up their efforts to tackle pressing policy challenges, such as sovereign risk, banking system vulnerabilities, and increased global capital flows.
  • Third, we need to press ahead with structural solutions to longstanding financial problems.

Financial stability challenges

I would like to elaborate further on the key challenges that keep global financial stability at risk.

First, in light of high public debt levels, market concerns about sovereign risk have persisted and have spilled over to a greater number of countries, mostly in the euro area. At the same time, we have seen an increasingly negative interaction—an adverse feedback—between banking and sovereign credit risks in some euro area countries. In other words, the fate of some banks is now increasingly intertwined with that of their sovereign—and vice versa.

Second, fragilities remain in key parts of several banking systems.

  • Markets are questioning the quality of many bank assets, reflecting concerns about banks’ exposure to countries facing sovereign pressures, and concerns about exposure to real estate loans.
  • Banks also face significant funding needs over the next two years. During that period, sovereigns will also need to refinance their debt, creating competition for limited funding resources.
  • Many banks still need to raise their capital levels. They also need to improve the quality of their capital to reassure investors and to meet the more stringent Basel III standards. The challenges facing banks—if left unresolved—would hinder the provision of credit to companies and households and would hurt the global economic recovery.

And third, there is the challenge of coping with the rapid rebound in capital inflows into emerging market economies. While capital flows are generally beneficial for recipient countries, rapid and strong inflows can fuel asset price bubbles and strain the absorptive capacity of local financial systems. Although we appear to be at the early stages of such a cycle, policymakers need to be vigilant about these risks.

Policy priorities

So, what policies should be put in place to meet these challenges?

In advanced countries, we need to deal with the legacy of the crisis by resolving financial fragilities—once and for all!

In Europe, policymakers need to break the adverse feedback loop between sovereigns and banks.

  • Sovereign risk should be contained through credible, medium-term fiscal consolidation strategies.
  • In addition, the financial system should be repaired through a comprehensive plan to reduce uncertainty about banks and help restore investor confidence. This plan should include the following elements: improved bank transparency; greater firepower for the European Financial Stability Facility (EFSF); a decisive pursuit of recapitalization and restructuring of banks; and better economic governance for the European Union.

In the United States,

  • Policymakers must put in place a credible strategy for medium-term fiscal consolidation to avoid a potential, sharp rise in long-term interest rates.
  • Increased efforts are also needed to address the effects of the still-damaged real estate markets on banks.

In emerging markets, policymakers must act now to avoid future crises. It is important to maintain the appropriate mix of macroeconomic and prudential financial policies to deal with the challenges posed by capital inflows. In addition, local capital markets will need to become deeper and more resilient, for example through improved market infrastructures.

There is also a need to ensure continued progress on the global financial policy agenda. Financial systems everywhere need to adapt to cope with regulatory reform. New regulations need to be adopted consistently across the world, including on systemically important financial institutions and the so-called “shadow” banking sector. Supervision and bank resolution regimes need to work more effectively within— and across—national borders to safeguard financial stability.

Time is of the essence in addressing immediate policy challenges—particularly in the euro area—and finding a better balance between macroeconomic and structural financial policies. Without these timely policy responses, global financial stability and sustainable growth will remain elusive.

2 Responses

  1. “New regulations need to be adopted consistently across the world, including on systemically important financial institutions and the so-called “shadow” banking sector. Supervision and bank resolution regimes need to work more effectively within— and across—national borders to safeguard financial stability.”

    Yes, these are all crucial needs. What I sense the IMF and G-20 Financial Stability committees worldwide appear to be overlooking, however, is the potential of a SMART financial transaction tax (FTT) to round out what the IMF’s report to the G-20 in the Fall of 2010 says about the links between financial stability and various forms of possible taxation of the financial sector.

    IMF Visiting Professor Stephan Schulmeister made a strong, empirically supported, case in early November that a small plain vanilla FTT would inhibit formation of asset bubbles in the shadow (think derivatives). Where is that now featuring in the IMF’s presentation of its work to help Sarkozy’s and Lagarde’s leadership this year of the G-20 process?

    I hope the IMF is not ignoring it. Could it be that the IMF is beginning to think beyond a plain vanilla FTT? While a plain vanilla FTT is better than nothing, a SMART FTT would be much better. Moreover I sense the IMF has, with the idea of a SMART FTT, an opportunity, to join enthusiasm in Europe, Japan, and South America for an FTT with traditional skepticism in North America for any kind financial transaction taxes into a smart FTT proposal. And currently I can’t see why China, India, or Russia would want to oppose a SMART FTT.

    Should anyone not yet know what a smart FTT might look like, and why it makes sense worldwide, there’s a primer now available at:

    http://www.authentixcoaches.com/ACdsFCF-1.html

    Currently the primer there is a draft one directed mainly toward audiences in Canada which, as we all know. appears a paragon to the rest of us in financial regulation; but in time the draft will factor in perspectives from other quarters.

  2. It is perfectly normal that bankers believe they can master risks. Who would want to deal with a banker who does not believe so? But, for regulators, what is more prudent, to believe that the real risks are those than can be perceived by all or that the real bad risks are those that are not perceived? Let me give you a clue… what has best chance of turning into a systemic risk?

    Though the banks and the regulators observed exactly the same credit ratings, the regulators decided to completely ignore how the banks reacted to those ratings; and to completely ignore that most of the differences in the credit ratings were already considered by means of the different risk premiums charged in the market; and took upon themselves to be the world´s risk managers, by using capital requirements for banks based on risk. I ask was this prudent or was it, as I am convinced it was, the mother of all regulatory hubris?

    I am truly amazed that in a post on “How To Secure Financial Stability” in the world, you do not mention the need of getting rid of a totally unworkable bank regulatory paradigm by which, while trying to escape from risks, the regulators pushed the banks excessively into the waters where risks were perceived as low carrying minimal life-saving capital, where they drowned or had to be rescued by taxpayers, when once again it was discovered, for the umpteenth time in history, that there are actually such thing as risks that are not perceived ex-ante.

    And also over the years, how many productive loans were not given to small businesses or entrepreneurs because of this regulatory adverseness to risk?

    I have (figuratively of course) often slapped the members of the Basel Committee on their faces (even on this blog) in order to challenge them to answer some basic questions, but they have preferred to ignore it… maybe you would dare to pick up the glove and have a go at answering it? http://subprimeregulations.blogspot.com/2010/10/members-of-basel-committee-consider.html

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