Building a More Resilient Financial Sector : Reforms in the Wake of the Global Crisis

Aditya Narain, Inci Ötker, and Ceyla Pazarbasioglu

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2012
• eBook ISBN: 9781616352295

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Contents

Foreword

Acknowledgments

Abbreviations

Contributors

Chapters

1 From Crisis to a New Financial Architecture: Taking Stock and Looking Forward

İnci Ötker-Robe

2 Shaping the New Financial System

José Viñals, Jonathan Fiechter, Ceyla Pazarbasioglu, Laura Kodres, Aditya Narain, and Marina Moretti

3 Impact of Regulatory Reforms on Large and Complex Financial Institutions

İnci Ötker-Robe and Ceyla Pazarbasioglu

4 The Perimeter of Financial Regulation

Ana Carvajal, Randall Dodd, Michael Moore, Erlend Nier, Ian Tower, and Luisa Zanforlin

5 The Making of Good Supervision: Learning to Say “No”

José Viñals, Jonathan Fiechter, Aditya Narain, Jennifer Elliott, Ian Tower, Pierluigi Bologna, and Michael Hsu

6 Resolution of Cross-Border Banks: A Proposed Framework for Enhanced Coordination

Ross Leckow and Ceyla Pazarbasioglu

7 The Too-Important-to-Fail Conundrum: Impossible to Ignore and Difficult to Resolve

İnci Ötker-Robe, Aditya Narain, Anna Ilyina, and Jay Surti

8 Contingent Capital: Economic Rationale and Design Features

Ceyla Pazarbasioglu, Jianping Zhou, Vanessa Le Leslé, and Michael Moore

9 Recovery and Resolution Plans (Living Wills): A Solution to the TITF Problem?

Katherine Seal

10 Making Banks Safer: Can Volcker and Vickers Do It?

Julian T.S. Chow and Jay Surti

11 Subsidiaries or Branches: Does One Size Fit All?

Jonathan Fiechter, İnci Ötker-Robe, Anna Ilyina, Michael Hsu, André Santos, and Jay Surti

12 Redesigning the Contours of the Future Financial System

Laura Kodres and Aditya Narain

References

Index

CHAPTER 1: From Crisis to a New Financial Architecture: Taking Stock and Looking Forward

İNCI ÖTKER-ROBE

“Space: the final frontier. These are the voyages of the starship Enterprise. Its five-year mission: to explore strange new worlds, to seek out new life and new civilizations, to boldly go where no man has gone before.“

——Star Trek: The Original Series

Imagine a financial system where financial institutions help create growth and prosperity for the countries they operate in and for the individuals populating them. Only a financial system that is well managed and resilient to shocks would provide a solid foundation for strong and sustainable economic growth and the prosperity brought by such growth. The journey of policymakers through Basel II to Basel III, and the initiatives of the Group of Twenty (G-20), the Financial Stability Board (FSB), and national authorities have been no less exciting or challenging than the voyages of the starship Enterprise—to identify the contours of a new financial architecture and to seek out policies and practices that can create a stable and resilient financial system capable of achieving its important mission.

This is the financial system policymakers strive to achieve: a better-governed and more competitive financial system with transparent corporate structures and instruments and markets that allow for easy entry and exit; financial intermediation that delivers products better geared to satisfy the needs of households and firms; banks endowed with higher, better quality, and globally consistent capital and liquidity buffers that adequately weigh systemic risk and discourage procyclical lending behavior; and institutions—even systemically important ones—that can be resolved in timely fashion with minimum or no cost to taxpayers.

The ongoing global financial crisis—which has been assigned the “honor” of being the worst crisis since the Great Depression—has taken us miles away from such a vision. It led to an unprecedented dislocation in financial markets, with abrupt consequences for growth and unemployment, and prompted a rapid and sizable internationally coordinated public sector response. Behind this response was the acknowledgment that these costs have been imposed partly due to systemic weaknesses, or cracks, in the regulatory architecture and partly due to the failure of supervisors to rein in excessive private sector risk taking.

The global crisis has made these cracks in the financial architecture very visible. Incentives at both macro and micro levels (through low interest rates, abundant liquidity, a favorable macroeconomic environment, and compensation schemes) encouraged financial institutions to take greater risks than they could manage in an attempt to extract higher returns. When combined with inadequate regulation and supervision, insufficiently wide regulatory perimeters, poor disclosure, and poor risk management practices, these incentives resulted in a highly complex and opaque financial system, with overleveraged institutions dependent on short-term wholesale funding to finance risky investments, including the rapid growth of credit of dubious quality. In many cases, institutions moved away from their traditional banking model to become large and complex financial institutions (LCFIs) heavily interconnected within and across borders, making them, in turn, too important to fail (TITF).

A new architecture is urgently needed to take policymakers back to their envisioned world. This requires, first and foremost, addressing the market failures that planted the seeds of the crisis: the principle-agent problem fed by information asymmetries, externalities that individual institutions imposed on others, and irrational exuberance that amplified the impact of economic cycles. It calls for

• tighter regulation to internalize the negative externalities caused by the risks individual firms take;
• better supervision to effectively implement that regulation;
• greater transparency and disclosure both to address the information gaps and, together with more “skin in the game” (e.g., through compensation practices and the sharing of losses in the event of a failure), to strengthen market discipline and limit incentives for risk taking;
• better macroprudential policies and effective safety nets to dampen the impact of swings and failures on the rest of the financial system so that no institution is viewed as TITF; and
• reforms to establish an infrastructure that could cope with large, complex, and interconnected institutions so that the financial system can still perform its essential functions when some of its parts are troubled.

Significant reforms are in the making along these lines internationally and domestically (Figure 1.1), and the IMF has been participating in the deliberations. The reforms have focused on microprudential measures that aim at reducing the probability or the cost of failure by making individual financial institutions more resilient and/or allowing them to fail in an orderly fashion in the event of severe stress. They have also focused on policies aimed at strengthening the resilience of the overall financial system by mitigating risks caused by systemically important financial institutions (SIFIs) and procyclicality. The chapters in this volume describe work undertaken at the IMF on the various reform proposals to address some of the key issues.

Figure 1.1 Financial Reform Proposals in the Aftermath of the Global Crisis

SHAPING THE NEW FINANCIAL SYSTEM

The overarching objective of the ongoing reforms is to create a financial system that provides a solid foundation for strong and sustainable economic growth. Chapter 2 provides a broad overview of the financial reform agenda and lays out a vision for a better future global financial system capable of delivering this objective. It acknowledges that the current reforms are moving in the right direction, including through the proposals of the Basel Committee on Banking Supervision (BCBS) to strengthen the quality and quantity of bank capital and liquidity, but many urgent and challenging policy choices lie ahead, nationally and internationally.

In dealing with the obstacles along the way and carrying out the reform agenda, policymakers need to focus on five key tasks: (1) ensure effective and globally consistent regulation, (2) improve the effectiveness of supervision, (3) develop coherent resolution mechanisms at national and international levels, (4) establish a comprehensive macroprudential framework, and (5) cast a wide net to cover risks in the entire financial system.

Private sector ownership of the reforms will be key to a successful implementation of the new rules. In particular, business models and practices will need to be aligned with the new financial structure, governance and risk measurement/management will need to be improved to rein in excessive risk taking, and market discipline will need to be restored along the lines discussed above by correcting misaligned incentives and enhancing transparency.

HOW WILL THE REFORMS AFFECT THE INSTITUTIONS? SURVIVAL OF THE MOST ADAPTABLE!

Financial institutions will adjust their business strategies as they try to meet the tighter requirements and mitigate their effects on the profitability of their business; in fact, they have already started doing so. Chapter 3 explores the likely effects of the ongoing regulatory reforms on a sample of LCFIs with a range of business models. It notes that the gradual phase-in period for higher and better quality capital and liquidity rules under Basel III would allow most banks to meet the requirements through earnings retention, assuming a modest economic and earnings outlook. Should banks generate strong earnings in the coming years and distribute lower dividends, they could in fact rebuild the required capital faster than under the current phase-in periods.

The new capital standards will have a greater effect on banks with significant investment-banking activities, compared with those that focus on traditional commercial banking. The former derive earnings primarily from trading, advisory, and asset management income and are therefore more affected by the higher risk weights for securitization and trading activities that came into effect in late 2011. In contrast, traditional banking institutions have a simpler business focus and are subject to a gradual phase-in period. Investment banking activities will also be impacted by a host of other regulatory initiatives, including those that limit the scope of their activities. Yet, because LCFIs with an investment banking focus have more flexible business models, they also can adjust more easily to mitigate the effects of the regulations. A key challenge, then, is to ensure that tighter bank regulations achieve material reductions in systemic risk while avoiding an unintended shift of risks to the shadows of less regulated sectors and locations. Chapter 3 discusses some safeguards (e.g., widening the regulatory perimeter, strengthening supervision, and coordinating policies) to mitigate these and other unintended consequences.

EXPANDING THE PERIMETER, BUT WHERE AND HOW, AND AT WHAT COST?

With the crisis showing how significant credit risks, often highly concentr...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Foreword
• Acknowledgments
• Abbreviations
• Contributors
• Chapters
• Footnotes