The Role of Law in Preserving Financial Stability

By Sean Hagan and Ross Leckow

Since the 2008 global financial crisis, the international community has made a great deal of progress in strengthening legal frameworks governing the financial sector, but a great deal more needs to be done to implement international standards and develop appropriate approaches to emerging challenges.

This is the main takeaway from the high-level seminar on “Law and Financial Stability” held on May 16-18 in Washington, D.C., organized by the IMF’s Legal Department to mark its 70th Anniversary, and which brought together more than 120 senior lawyers and policymakers from over 80 countries.

The discussions highlighted the great progress many countries have made in strengthening their legal frameworks in a number of important areas. These include:

  • Bank resolution through international standards: Many resolution authorities now have the mandate and powers needed to resolve a troubled financial institution in an orderly manner. At the international level, national authorities from key jurisdictions have established Crisis Management Groups (CMGs), and have made great progress in implementing resolution planning across borders.
  • Central Clearing Counterparties (CCPs) and resolution: After the Pittsburgh summit in September 2009, the G-20 leaders agreed that all standardized over-the-counter derivatives contracts should be, where appropriate, cleared through CCPs. Reforms to implement this mandate have advanced, although resolving a CCP involves complex legal and regulatory challenges that deserve further reflection.
  • Macroprudential policy: The global financial crisis has highlighted the costs of systemic instability at both the national and global level, as well as the need for dedicated macro-prudential policies to achieve financial stability. Central banks, in addition to their “classic” mandate of defining and implementing monetary policy in order to pursue price stability, are also being given macro-prudential tasks, often accompanied by the microprudential supervision of banks or resolution. Still, national authorities need to put in place effective legal frameworks to support those policies.
  • Corporate debt restructuring and economic recovery: IMF member countries directly or indirectly affected by the global financial crisis have experienced the negative consequences of an overleveraged corporate sector. These countries need to develop comprehensive resolution strategies for non-performing loans, which include both robust insolvency regimes, as well as speedy and cost effective out of court debt restructuring mechanisms.
  • Islamic finance: The activities of institutions providing Shari’ah-compliant banking services have grown rapidly over the years, and are becoming an increasingly important component of the global financial system. Significant progress has been achieved in developing international standards for Islamic banking that complement more general international norms. The role of the Islamic Financial Standards Board (IFSB) and other standard setters in the Islamic banking space has been key.

Further work remains

Despite this progress, participants acknowledged the work that still remains. Many countries still do not yet have effective resolution regimes in place. They also face challenges in in designing effective frameworks for cross-border cooperation that, in particular, will ensure that resolution actions in one jurisdiction can be given effect in the laws of another jurisdiction. As noted above, legal frameworks still need to be strengthened in the areas of CCP resolution, macro-prudential frameworks, and corporate debt restructuring.

Further, prevailing international standards enforcing bank resolution as well as anti-money laundering and combating the financing of terrorism (AML/CFT) may need to be modified to accommodate the specific features of Islamic financial institutions.

The international community also confronts new and emerging issues, including:

First, a reduction in correspondent banking relationships. Several countries have reported a reduction in correspondent banking relationships (CBRs) by global banks in recent years. Pressure on CBRs has been associated with restricted access to financial services by certain categories of customers, business lines, jurisdictions or regions. The IMF staff has been supporting member countries experiencing issues in this regard by analyzing risks and policy responses in its surveillance and Financial Sector Assessment Program; assessing compliance with international standards including those on AML/CFT; building capacity that can help strengthen regulatory and supervisory frameworks; and facilitating international dialogue, working with other international organizations and stakeholders.

 Second, the expansion of the shadow banking system. This has been one of the key areas of recent attention by policy makers, as it is estimated to account for approximately 25% of total assets of the financial sector. Interaction between banks and shadow banks should be strengthened, and securitization should be made safer. Further work is necessary to decide whether institution-based or activity-based regulation is the right approach to deal with shadow banking.

Third, rising misconduct risks. At the international level, work continues on reducing misconduct risks. It focuses on exchanging best practices on governance frameworks, developing supervisory toolkits, and examining the effectiveness of post crisis reforms to compensation. It also involves sharing experiences on bank regulators’ enforcement powers to address instances of market abuse by professional market parties. However, it is doubtful that this problem can only be addressed through regulation. More fundamental changes involving a shift in the ethical climate within the financial sector may be necessary.

Finally, financial inclusion in emerging economies. Broadening access into formal financial networks is instrumental not only to empower individuals and families to take advantage of economic opportunities, but also to generate strong and inclusive growth. The growing use of financial technology, supported by robust legal and regulatory frameworks, may play an important role in this respect.

The road ahead

  • The international community needs to continue to develop international standards and best practices to guide the design of legislation at the national level and frameworks for cross-border cooperation.
  • And countries need to continue to put existing international standards and best practices into effect by enacting national legislation, and strengthening countries’ institutional capacity to implement them.
  • The law, however, cannot solve all of the problems arising in the financial sector. A change in culture may also be necessary to improve the ethical standards of financial market participants and public authorities.

The IMF remains deeply committed to advancing the legal reform agenda in all areas.

 

 

 

 

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