Not Making the Grade: Report Card on Global Financial Reform

by Laura Kodres

Despite a host of reforms in the right direction, the financial structures that were in place before the global crisis have not actually changed that much, and they need to if the global financial system is to become a safer place.

Although the intentions of policymakers are clear and positive, the system remains precarious.

Our new study presents an interim report card on progress toward a safer financial system. Overall, there is still a long way to go.

How we measure progress

In our study, we first tried to pay attention to those features of financial systems related to the crisis—the large dominant, highly interconnected institutions, the heavy role of nonbanks, and the development of complex financial products for instance—features that need to be addressed in some way.

To do this we needed to construct measures of these features in a way that would allow us to gauge how well the reforms are working toward changing them. We looked at a lot of data, but we focus on three types of features.

  • The extent to which financial intermediation is market based—the hallmark trait of the United States, with a big nonbank financial sector, active capital markets and banks conducting activities other than borrowing and lending.
  • Features related to the size and scope of different financial activities within a country—like the size and concentration of its banking system and how connected certain parts of the financial system are, through say, interbank markets.
  • Measures about how connected the financial system is to the rest of the world through banking systems and the importance of the country in global markets

The next thing we did is try to tie the reform agenda to how it could reasonably be expected to alter these chosen financial structures.

Good effort, but requires follow through

So, are the reforms moving the structures in the right direction—to a safer financial system? Our answer so far is: “somewhat, but not enough.” We do not yet see the impact of the reforms; they have long implementation lags and the crisis is ongoing.

There are elements, such as new international banking rules known as Basel 2.5 and the market’s anticipation of the Basel III implementation that are promising: many banks hold more capital and have begun to divest themselves of activities they view as less profitable.

However, the basic financial structures that we found problematic before the crisis are still with us: financial systems are still overly complex, banking assets are highly concentrated, with strong domestic interlinkages, and the too-important-to-fail issues are unresolved.

As some activities become costly, some banks will get out of those businesses, but others with enough scale economies will stay in, making these activities even more concentrated—the fixed income, currency, and commodities trading business line is one such activity.

The good news is that globalization has not been seriously harmed, except for in crisis-hit economies in Europe. But this also means that in the absence of proper policies, bad outcomes from one country can easily affect the financial system in another.

What to do?

So why do we see so little progress and what should we do about it? We have to recognize that some regions are still in a crisis and measures to prevent deeper financial system distress, and those to bolster nascent economic growth, remain in place. The recent introduction of further central bank efforts along these lines—QE3 from the U.S. Federal Reserve, the European Central Bank’s buying of government bonds through outright monetary transactions, and similar quantitative easing from the Bank of Japan—attests to the need for ongoing crisis-fighting efforts.

While these need to be in place, this is also the time to think about their inadvertent side-effects on financial stability. Some of the cleansing of the financial system has not yet taken place, preventing a reboot to safety.

Even if the needed restructuring had taken place, financial structures tend to move slowly and the reform agenda has built in rather generous implementation schedules, in part to allow the economy to recover. So we want to emphasize that while we cannot definitively say financial systems are safer than four years ago, we want to emphasize the “somewhat” part of the answer.

By taking stock of all the regulatory reforms to date we can see some areas that still need to be addressed. These areas include:

  • More discussion on what it takes to break the “too-important-to-fail” conundrum, including a global level discussion of the pros and cons of direct restrictions on business models. We can already see that both the Volcker Rule in the United States, which aims to force banks to divest their trading businesses, and the Vickers commission proposals in the United Kingdom, which would ring fence retail banking from investment banking activities, will have effects beyond their respective jurisdictions and a global perspective is sorely needed.
  • Further progress on recovery and resolution planning for large institutions, especially cross-border resolution.
  • Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector; and
  • Careful thought about how to encourage simpler financial products and simpler organizational structures.

The success of the current and prospective reforms depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer.

Policymakers need to press ahead. We are not encouraging a sprint, but simply a brisk, purposeful walk toward the goal of a safer financial system.

11 Responses

  1. Sorry, even though the report mentions “the banks’ likely increase in their allocation to safer but low-yielding assets to accommodate regulatory requirements” it completely fails to understand the distortions that this precisely causes in the economy. In fact, the word distortion does not even appear in the report.

    And, if there is anything current regulations have done, that is to distort the efficient resource allocation so much, by favoring banks holding assets that ex-ante are perceived as “not-risky” against banks holding assets that ex-ante are perceived as “risky”.

    Basel II allowed a bank to leverage its equity 62.5 to 1 if the assets had an AAA rating but only 12.5 to 1 if it was unrated. And which means that the profitability for banks, their return on equity, when holding “not-risky” assets becomes much higher than when holding “risky” assets, like loans to small businesses and entrepreneurs. And if this is not hugely distortive, I do not know what is.

    Distortive and useless… as we know that no major bank crisis ever has resulted from banks holding excessive assets that when acquired were perceived as “risky”, these all resulted, no exceptions, from banks holding excessive assets that, when acquired,

    IMF does a lot of empirical research, but the research they have completely failed to do, is to run a regression between all the current problem assets, and the fact that these were ex-ante perceived as “not-risky” and so the banks were allowed to hold much less bank equity against these.

    And so, about five years after the beginning of the crisis, the IMF does yet not understand why a crisis that was doomed to happen because of plain dumb regulations happened.

    • Laura Kodres responds:
      Mr. Kurowski:

      Thanks for your insights on the role of regulations on the demand for safe assets and their distortionary effects. Indeed, we agree with your points, which is why we devoted an entire GFSR chapter to it last spring “Safe Assets: Financial System Cornerstone?” (April 2012 GFSR).

      In that chapter we performed some empirical analysis (more than just regressions actually) to show that assets’ risk factors changed quite dramatically from before the crisis until now–and the more so for some AAA assets (see Tables 3.1 and 3.2 for the straight up facts and Figure 3.2 for our analysis). As well we make your point that there is no such thing as an asset that is “safe” all the time and this has been most evident for sovereign bonds, where many of them maintained zero risk weights indicating they were essentially “risk free.”

      We suggest, as you allude to, that the regulatory risk weights need a complete rethink. While difficult to do this in the midst of a crisis, we advise in the chapter the start of such discussions and implementation of any changes in a slow and steady manner. As an aside, we use the word “distortions,” liberally in the chapter to describe a number of regulatory influences, not just risk weights, on safe assets—apologies for having neglected to use the word this time as it still relevant.

      • I thank you for your answer. I believe it is a first to all my many comments on this blog.

        Indeed, in the document you refer to you mention “However, factors external to asset markets—including the required use of specific assets in prudential regulations, collateral practices, and central bank operations—may preclude markets from pricing assets efficiently, distorting the price of safety.” But this only begs the question, if so important, why did you leave out that issue now.

        And, on the other hand, that document has specifically to do with “safe assets” and does not say a word about the distortions produced by pro-safety inspired regulations, in terms of the discrimination they produce against what is officially perceived as “risky”, like small businesses and entrepreneurs.

        You write “We suggest, as you allude to, that the regulatory risk weights need a complete rethink. While difficult to do this in the midst of a crisis”

        How come, if these distortions are foremost to blame for the crisis, is it not important to attack them as soon as possible?

        For instance, since there seems not to be much room in the market for dramatic increases of bank capital, why do you not half the capital requirements for banks when lending to the “risky”? Where this to happen, you would be providing the economy with important stimulus quite different from fiscal spending and QEs.

        Let me ask you: when are the citizens systemically riskier than their sovereign?

      • Laura Kodres: Allow me also to repeat here a wicked question, directed to all your Global Financial Reformers:

        When do banks most need capital: when the risky turn out risky, or when the “not-risky” turn out risky?

  2. Laura Kodres wrote:

    “However, the basic financial structures that we found problematic before the crisis are still with us: financial systems are still overly complex, banking assets are highly concentrated, with strong domestic interlinkages, and the too-important-to-fail issues are unresolved.”

    Please take this comment in the spirit in which it is offered.
    Just wondered if those working on your study have read the work of Drs. Benes and Kumhof here. IMF Working Paper 12/202

    Yes, they are IMF researchers and have provided conclusions in their working paper that finds there IS a way to reform the system so as to end not only the complexity of financialization and the threat of bigness-in-finance, but also the entire boom and bust financial cycle, while reducing debt and unemployment, and achieving near-zero inflation while expanding the economy.

    But, it is not merely the banking system nor financial systems that they propose we reform.
    It is the monetary system.
    The question of the day, again, if I may…
    When Global Financial Stability is the working group paradigm, is the IMF itself capable of sufficient soul-searching as to move these ideas forward?
    Thank you.

    Joe Bongiovanni
    Harborton, Virginia

    • Laura Kodres responds to Mr. Bongiovanni,

      As you are obviously aware, the IMF has many researchers of high caliber, including Dr. Benes and Dr. Kumhof. Our working paper series is indeed where a lot of “out of the box” thinking occurs—including on reforming the monetary system. Their paper shows how the adoption of some highly dramatic changes in the area of monetary policy, the business of banking, and government debt management could result in a safer financial system and improve economic performance. However, the changes required in their paper to obtain this better system are well beyond what the current regulatory initiatives have envisaged and their associated potential effects on financial stability. We chose to focus on such effects as a narrower, but possibly more realistic, goal for our chapter. Be assured we have a very fertile environment inside the IMF to consider all sorts of ideas, and Dr. Benes and Dr, Kumhof’s are among them

      • In reply to Ms. Kodres

        Thanks for your very clear exposition of the “workability” problem that the Benes-Kumhof paper presents. It’s not that the CPR does not itself present a workable solution. And, anything that works must be doable.
        The problem manifests as that within the present regime, no vehicle exists for consideration of what is needed to bring that which is do-able to being done.
        So we need new vehicles for consideration.

        While I admire the efforts of central bankers and the central bankers’ banker to come up with their own workable solutions to actually reform the banking and finance system so as to restore “safety” to its operations, I see nothing on the horizon that can meet anywhere near the benefits that the Benes-Kumhof paper provides.

        It is again important – in fundamental agreement with your reply – that the reforms that are proposed are only secondary-level for the banking and financial sector.
        The basic reforms are in the monetary system itself.

        I often ask this question of those with authority – again with respect for the body involved – who is working on the exit-strategy?
        How do we get from here to there?

        With the CPR publication, we seem to be at the point where the potential for providing long-term stability to the monetary underpinnings of global economics has been identified. The next task becomes to get it on the table.

        I appeal for the open-mindedness of the institution to consider whether a systemic reform to the global money system should come to the fore. And how to do that.

        Thank you.
        Joe Bongiovanni
        The Kettle Pond Institute

  3. No doubt we are in different boats but are sailing in the same sea. We have complex financial systems, different political systems and cultural and religious pressures. We need international cooperation to resolve the financial and economic issues while not forgetting that one size-fits-all is not going to work. This monster of ‘too big to fail’ needs to be thoroughly chiseled by following the international banking regulations through the courtesy of Basel 2.5 and Basel 111.

    In my personal opinion this QE mechanism followed in almost all the 2008 crisis-affected economies should have some defined limits. Liquidity should preferably be generated through taxation and maximisation of competitiveness in the labor and products markets. Plans are generally grand but implementation always has constraints.

    The global situation has been nicely explained by Laura Kodres but surprisingly nothing has been mentioned about the BRICS.

    • Mr. Mir: I’m glad you found us sailing in the same sea. I would like to suggest even in the same type of boat, though perhaps not in the same one. We agree that, while needed at the moment, the QE mechanism will not solve the problems of crisis-affected economies, which as you allude to, will take more concerted efforts on fiscal reforms as well as labor and product market reforms. These may not create funding “liquidity” for banks, per se, but would set the stage for a gradual lessening of the QE. On the BRICs, while we do not look at them as their own group, they are included in the regional aggregates and separately in various tables, India is featured in Box 3.5, and China is featured in Box 4.7.

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