Speech

The Changing Landscape of Financial Intermediation, Speech by Christine Lagarde, Managing Director, IMF

June 4, 2015

Christine Lagarde
Managing Director, IMF
Fifteenth Annual International Conference on Policy Challenges for the Financial Sector
June 4, 2015

As prepared for delivery

Introduction

Good afternoon everyone! And welcome to our fifteenth Annual IMF/World Bank/Federal Reserve seminar for senior supervisors. We always look forward to this annual event and very much appreciate our partnership with the World Bank and the Federal Reserve.

It is my particular pleasure to talk to you as supervisors and custodians of financial integrity and stability. Over the past few years, the Fund has been actively engaged as a forum for global conversation among policymakers on key issues related to the financial reform agenda.

For example, during our recent Spring Meetings, we hosted a high-level event on macro-prudential policies, bringing together policymakers and supervisors from advanced and emerging economies to compare notes on policy implementation and spillovers. So this conference is another important milestone in our collective effort to secure the stability of our financial systems through well-designed regulation and appropriate supervision.

In the words of one of my predecessors as Managing Director of the IMF, Jacques de Larosière: “It is not just more regulation that is needed; it is better regulation.”

For sure, there has been important progress on the regulatory front in many places, including in the United States, as Chair Yellen outlined in her remarks yesterday. The financial system today is more resilient than in the wake of the crisis.

Even so, financial stability is still not well-entrenched in advanced countries and risks are rising in emerging economies. And in many advanced countries, the financial system is not doing its part to support a revival of economic activity. So the agenda for regulators and supervisors is far from finished.

With this in mind, I would like to share my perspectives on three issues:

(i) First, our assessment of the key issues and risks for the global economy and financial stability;

(ii) Second, policy priorities to address these risks; and

(iii) Third, the role of supervisors and regulators in promoting financial stability.

1. Global Outlook—Modest Recovery, Rising Financial Stability Risks

Let me begin with the outlook for the global economy and financial stability.

Overall, as discussed in our latest World Economic Outlook, the global recovery remains modest and uneven. Global growth is projected at 3.5 percent this year—roughly the same pace as last year. At this pace, growth is just not good enough—certainly not for the 200 million currently unemployed around the world.

At the same time, our latest Global Financial Stability Report finds that risks to financial stability are rising and rotating—from areas that we know more about, to areas where they are harder to assess and address. Risks are migrating from banks to non-banks, from solvency to market liquidity risks, and from advanced to emerging economies.

More specifically, financial systems in many emerging market economies are potentially vulnerable to rising U.S. interest rates. In several of these countries, businesses may find themselves wedged between a strong U.S. dollar, lower commodity prices, and higher borrowing rates. So the key for policymakers is to address domestic vulnerabilities and strengthen their macroeconomic frameworks to enhance resilience to heightened volatility.

This is not to say that risks in advanced economies have completely disappeared. For one, there can be some undesirable side effects from the divergent stances of monetary policies in the major economies.

For example, there are signs that liquidity risks may be underpriced by markets. This has the potential for becoming a more systemic problem when policies are reversed. The persistent low, and even negative, interest rate environment could also put pressure on the balance sheets of life insurers, especially in Europe.
There has certainly been progress on improving financial sector resilience, with a very successful international agenda to improve the regulatory framework for banks.

But there is more to be done. International standards on the nonbank side remain patchy, and there needs to be strong attention to implementation and supervision.

Yet staying strong on regulatory matters can be tough, especially when good growth is hard to find; growth that is job-rich and inclusive.

In several ways, the disconnect between financial exuberance and economic weakness is still with us today. Think for instance of the deterioration of underwriting standards in America, where covenant-light loans now account for two-thirds of new issuance of leveraged loans. Even though the leveraged loan market is still a relatively small part of the U.S. credit market and does not pose immediate systemic threat, the sector is growing rapidly and weak underwriting could pose problems down the road.

For this, we do not just need more regulation; we need “smart” regulation.

2. Smart Regulation for Financial Stability and Inclusion

Which brings me to my second topic—how smart regulation can be good for financial stability and inclusion.

We have just published a study on how financial development in emerging economies can better serve the needs of the economy and society at large. Let me highlight two key findings.

First finding: there is such a thing as “too much finance.” The gains for growth and stability from financial deepening are large but there are limits on size and speed.

When financial sector development outpaces the strength of the supervisory framework, there is excessive risk taking and instability. In other words, there is a “tipping point” – although that point will depend on country specifics, such as its income level and regulatory and supervisory quality.

Bottom line: there is a tradeoff between financial deepening and financial stability. So the question now becomes: have emerging economies entered this zone of “too much finance”? The answer is “No” and let me give you some numbers.

As of end-2013, in advanced economies, private credit stood at 130 percent of GDP and stock market capitalization at 70 percent of GDP. Think of countries such as Japan, Ireland, and the United States. In these countries, the financial sector has increased as a fraction of GDP to the point where the marginal returns to growth from further expansion in finance are diminishing.

However, in emerging economies, these two numbers—private credit and market capitalization—were 50 percent and 15 percent of GDP, respectively. So most emerging markets, such as Morocco and Ecuador, are still in a relatively safe zone, where financial development increases economic growth.

Second, our study finds that regulatory reforms can increase the benefits from financial development while reducing the risks.

Financial systems around the world are quite sizable. Yet, some 2 billion adults remain “unbanked”—that is, without access to basic financial services or a bank account.

Why does it matter? It matters because financial inclusion is a key pillar for inclusive growth. Yet, if not well managed, financial inclusion—and credit expansion—can undermine financial stability, and in turn, growth. Extending credit to unproductive projects or unfit clients can expose lenders to higher risks; it can also expose ill-informed borrowers to increased risk of debt distress.

So how can we guard against this risk? Our study found that out of the many regulatory principles that we examine in our Financial Sector Assessment Programs, a subset of 23 principles are critical for both financial development and stability.

In other words, in terms of regulatory principles, there is very little tradeoff between financial development and financial stability and a sound regulatory framework goes hand in hand with financial development. This finding is particularly important since a priority for policymakers in many countries is to expand financial inclusion as part of financial development and to make the financial sector “work” for everyone in society.

3. Financial Stability and Inclusive Growth—What Role for Regulators?

Milton Friedman once said: “The existence of a free market does not eliminate the need for government. On the contrary, government is essential both as a forum for determining the "rules of the game" and as an umpire to interpret and enforce the rules decided on.”

So let me now turn to my final topic—how regulators and supervisors can promote both financial stability and inclusive growth. I can see two main areas.

The first area is by ensuring that “smart” regulation is in place. Remember, a key finding of our study is that strong regulation and supervision is not a luxury—it is a necessity for the financial system to develop in a healthy and stable manner. This means that there are concrete actions on the regulatory front that can be taken to promote financial development and stability simultaneously.

For example, we saw stronger systems where regulators were able to set and demand adjustments on capital and loan loss provisioning when risks were rising. Financial systems were also stronger if regulators were able to set compensation rules and require transparent reporting and disclosure. These were the kind of systems capable of supporting both financial development and stability.

The second area where supervisors can play an important role is by ensuring the regulation is enforced. Only through strong supervision can regulation be effective in curtailing excessive risk taking and protecting the system from crisis.

Without a doubt, a financial crisis takes a huge toll on the economy and the broader society—particularly on those who can least afford it. We are all still living with the memory of the Great Recession. And while regulation cannot substitute for individual ethics, there are a few aspects where regulation can help align financial incentives with societal objectives.

Our in-depth analysis in the October 2014 Global Financial Stability Report suggests that changes to compensation and governance structures can help reduce risk-taking and promote interest in the longer-term performance and soundness of banks.

Even so, rules and regulation can only go so far in promoting “responsible” and ethical risk-taking behavior. Ultimately, individual integrity must also step up to the task.

4. Conclusion

To conclude, the financial landscape that is emerging in the aftermath of the crisis is just as complex—perhaps even more complex—than pre-crisis. We know that financial development is good, up to a point, and for most emerging markets that point has yet to be reached. To support financial stability and inclusive growth, regulatory and supervisory frameworks will need to match that greater complexity and better understand the shifting sources of risks.

The task ahead of supervisors is challenging, but not insurmountable. You are not alone—the Fund is by your side, ready to help.