Challenges and Opportunities for the Financial Sector and for Savings Banks, speech by Rodrigo de Rato, Managing Director of the International Monetary Fund at the Meeting of the Spanish Confederation of Savings Banks

March 2, 2007

Palma de Mallorca, Spain, March 2, 2007

As Prepared for Delivery

1. It is a great pleasure for me to be with you on this beautiful island. I would like to thank President Matas for his words and the CECA for inviting me to this meeting. The links between the International Monetary Fund and savings banks have always been close. Some of you may remember that my predecessor as Managing Director of the Fund, Horst Köhler, was once head of the German savings banks association. Horst is now, of course, President of Germany.

2. I would like to talk to you today about some of the opportunities and challenges that the financial sector is facing today, and about the role that savings banks can play in financial sector development, including in developing countries. But I would like to preface this with a brief overview of the global economy.

3. At the moment, the world economy is in a strong position. We have already seen several years of strong growth, and we expect that global growth will once again be close to 5 percent in 2007. This would be the fifth year of strong growth—indeed the strongest five-year span for the global economy since the late 1960s. In the United States, the speed of the expansion has eased—largely reflecting the slowdown in the housing market. But growth prospects have improved in Japan, while China and India continue to be engines of growth, and many other emerging market and developing countries are enjoying a continuation of the rapid growth of recent years. The momentum of the expansion in Europe also seems strong, with both consumption and employment growth picking up. To some extent this reflects improvements in the structural competitiveness of European product and labor markets, although more work remains to be done in both of these areas.

4. Financial conditions have been unusually benign. Even though central banks in the major economies have steadily increased policy interest rates over the past year, long-term bond rates remain low by historical standards, and markets do not seem concerned about a possible increase in inflation. This may be because central banks have done much to enhance their credibility in fighting inflation. Equity markets around the world have been hitting new highs, and risk spreads on corporate and emerging market debt have fallen to new lows.

5. This is not to say that all is well with the world. The movements of financial markets this week should be a reminder to investors that they need to focus on credit quality and be aware of risks from volatility in currency markets. Investors should not expect governments to bail them out if they run into trouble. This would create great problems of moral hazard. There are also economic risks. We are still waiting to see the full effects of the downturn in the U.S. housing market, though so far the effects on the real economy seem to be largely confined to residential investment, the effects on financial markets seem to be confined to the most creative parts of the mortgage lending market, and the spillover to other countries has also been limited. Oil prices remain vulnerable to political developments. In part because of uncertainties about oil prices, and in part because of the maturing economic cycle, central banks need to remain vigilant about inflation, and markets should not ignore the possibility that further increases in interest rates will be needed. The risk of a disorderly unwinding of global economic imbalances remains: the risk may be low, but were it to materialize it, would be costly. Finally, citizens should be concerned about the rise in protectionist sentiment around the world, which could threaten global prosperity over the long term.

6. Nevertheless, the general picture that emerges is a bright one, and it is especially bright in the financial sector, which is at the center of a tremendous period of change as part of globalization. Over the past decade we have seen an extraordinary increase in cross-border lending by banks. A great deal of this increase has stemmed from EU-based financial institutions. We have also seen greatly increased integration of emerging market countries into the global economy, and growing sophistication of financial markets and risk management. All of these developments present industrial and developing country governments and private financial institutions with great opportunities—and new challenges.

7. Some of the most exciting opportunities are in Europe, where the European Union is undertaking a pioneering regional financial integration process, spanning 27 countries and 490 million people. Financial integration promises higher economic growth and a better allocation of risks. Countries' financial sectors are a major factor in determining their growth performance. Indeed, about half of the economy-wide lower productivity growth in the euro area relative to the United States during 1996-2003 is estimated to arise from lower productivity growth in financial intermediation. Countries in the EU that have particularly dynamic financial markets have also tended to do particularly well in terms of economic growth since the mid-1990s. So it is encouraging that changes are taking place in the financial sector. Financial integration is also contributing to higher capital flows from richer countries to the New Member States. Fund research suggests that these inflows are associated with significant acceleration of income convergence.

8. Of course, financial integration also entails new risks. Integrated financial markets allow shocks to spread across borders much more rapidly than in the past. Furthermore, the integration process itself involves a number of transition risks, which are particularly relevant for some of the New Member States. Integration may also introduce risks that are not yet known, as cross-border operations increase the complexity of financial institutions' organizations and the difficulty of monitoring their activities.

9. Policymakers and regulators in the EU are responding to these changing risks. There has already been notable progress in adjusting regulation and supervision to the blurring boundaries between banking, insurance, and securities. However, more work is needed in the area of crisis prevention and management. There are still no EU-wide standards for remedial action against banks facing problems or a potential crisis, and in their absence, countries cannot be confident about what actions other countries will take. Convergence in this area is important, because both member countries and financial institutions need to be sure that the cost of a potential crisis will be limited as much as possible through timely intervention based on clear criteria. There also needs to be more convergence and cooperation in supervision of large cross-border banking groups. More routine and centralized sharing of information between national supervisors is an essential first step in this. Finally, integration of equity market infrastructures, such as clearing and settlement systems, remains incomplete. A combination of market-based and public policy initiatives is needed to encourage capital market development.

10. Let me touch briefly on another area where the financial sector is undergoing rapid changes, in Europe and beyond. This is the extraordinary increase in the activities of hedge funds. Assets managed by hedge funds have grown tremendously—from US$25 billion in 1990 to over US$1.3 trillion today—while the number of hedge funds has multiplied more than tenfold over the same period. Hedge funds provide obvious benefits. They have added to market liquidity, and they have helped to transfer risk to a much wider variety of willing investors. In that sense, they have contributed to stability. They have also helped reduce market inefficiencies.

11. However, hedge funds also pose new challenges. Certainly, the limited amount of timely information available about hedge fund investments complicates the monitoring of their activities and calls for hedge fund investors and counterparties to exert rigorous market discipline and seek more transparency. In a perceptive speech delivered last year in Hong Kong, Tim Geithner, President of the New York Fed, urged that the focus for supervisors should be on making the supervision of hedge funds' regulated counterparties more effective. But he also noted that as the structure of markets changes, supervisors may need to adapt the framework of supervision to maintain protection against systemic risk. With this in mind, we in the Fund also believe that it would be useful to monitor developments in the global hedge fund industry from an international and multilateral perspective.

12. At the IMF we are very interested in the performance of financial systems. The close cross-border interlinkages between financial sectors make it especially important that all of them function well. Together with the World Bank, we work closely with our member countries to preserve the stability of financial systems and promote their development. For instance, the Financial Sector Assessment Program, the FSAP, was conceived to provide an impartial analysis of the strengths and vulnerabilities of our members' financial systems. The recent financial sector assessment that the Fund conducted with Spain is an interesting case on point. The FSAP found Spain's financial sector to be highly dynamic and competitive, operating under strong prudential supervision. It also made recommendations designed to strengthen the financial sector further, and stressed the need to exercise vigilance with respect to fast credit growth and developments in the mortgage market.

13. Let me now turn to the more general issue of the role of savings banks. While there are great differences between savings banks in different countries, savings banks are an important part of financial systems around the world.

14. Savings banks can play a central role in facilitating access to financial services. As you know, they are deeply rooted in the communities and regions where they operate. They usually have a retail and regional focus. Often, savings banks have a clear commitment to offer universal access to financial services in their founding statutes. All of this is particularly important in developing countries. If you look at bank accounts of small savers in transition and developing countries, you find that three quarters of the estimated 1.4 billion accounts are managed by savings banks.

15. In many countries, savings banks can also play an important role in fostering competition in the financial sector. One of the results of the financial liberalization and regulatory reform in most countries is a commensurate increase in competition and financial innovation. Savings banks must be part of this process, searching for synergies and operational improvements, and stepping-up joint operations and mergers within a region or across regions.

16. Another area where savings banks can take an active role is in facilitating the international flow of remittances. For many developing countries, remittances represent a significant part of their international capital flows and a major source of foreign exchange. In some cases they exceed export revenues, foreign direct investment, and aid. A recent report by the World Bank noted that recorded remittances in 2005 were over US$ 230 billion. This is an increase of 40 percent over the levels of 2002.

17. Remittances have become an important point of entry for emigrants into financial sector services in industrial countries. In this way, remittances can serve as a stepping stone for expanding access to other financial services, both in the originating and receiving countries. Savings banks here in Spain are a good example of what can be achieved. I understand that the Spanish Confederation of Savings Bank has negotiated 16 bilateral agreements with savings banks in 12 different countries to distribute remittances at around half the normal cots of traditional channels, and that already this covers three-quarters of the foreign nationals who live in Spain.

18. Savings banks, and especially those in developing countries, can also play an important part in microfinance. Savings banks already have large distribution networks, accessibility of services, products and services tailored to the needs of low-income households, and a social commitment to provide financial services to those who need them. Many savings banks also already embrace the culture of microfinance institutions by distributing profits back to the local economy. Indeed, close links to local communities are a part of the identity of savings banks that many societies value highly.

19. I would like to refer to another aspect of particular significance for savings banks: the importance of having adequate governance structures conducive to both sound risk management practices and good market orientation. An adequate governance structure with appropriate built-in incentives helps ensure the efficient operation of savings banks. The retail and regional focus of the savings banks should not be an obstacle to adopt the most modern practices in corporate governance. Likewise, from the regulatory perspective, prudential supervisory and regulatory frameworks should create the incentives to foster healthy governance structures. The overlaps between supervisory responsibilities of different agencies often create regulatory gray areas, which call for better frameworks for monitoring and oversight.

20. Our experience in different countries, including Spain, shows that efficient operation of savings banks requires that they operate in the same way regardless of the diversity of ownership forms, and that savings banks compete on a level playing field with other financial institutions, including commercial banks. For all savings banks, the governance structure should provide appropriate incentives for portfolio management and risk management decisions. Special care is also needed in governance structures to avoid potential political interference in the commercial management decisions of savings banks. For example, policies which aim to direct credit to specific industries have often ended up just benefiting narrow interest groups. Savings banks have a commitment to provide broad access to their services. But subject to this commitment, business decisions should be made on a commercial basis.

21. Before concluding, I would like to refer to another aspect in which the role of savings banks could be especially important in the current context of financial markets: consumer education. We are witnessing important structural changes with regard to risk transfer. Today, credit risk is transferred from lenders to stock exchange markets and, through them, to investors (who become the ultimate holders of risk). This evolution, which is broadly positive for financial stability, requires better "financial education" on the part of consumers. Governments and regulatory authorities are partly responsible for creating this awareness and providing education. Financial institutions also have an important role to play. Educating the client, understanding the client's financial needs, and verifying that recommendations regarding assets and liabilities are adapted according to the client's payment capacity and ability to assume risk, are important contributions that the financial sector can make. For their part, savings banks have a privileged position to contribute to consumer education, given their access to a broad base of small investors.

22. Finally, I want to commend the role of savings banks' associations and federations. Many associations have become a source of knowledge and technology diffusion across their members. In some countries, they have also helped to enhance access to international capital markets. And of course cooperation among savings banks can supplement national authorities' efforts to build capacity, share resources, and disseminate sound practice.

23. I said earlier that this is a time of great opportunities in the financial sector and in the global economy. If governments and the private sector can take the opportunities offered, meet the challenges, and manage the risks, the prospects for continued global prosperity are excellent. I am sure that savings banks will play their part in this process. And I thank you again for inviting me to speak to you.

24. Thank you very much.


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