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98/22

Spanish

Financial Sector Soundness and International Financial Reform

Address by Michel Camdessus
Managing Director of the International Monetary Fund
to the Federation of Latin American Banks
Panama, November 18, 1998

I am very pleased to have this opportunity to participate in this opening session of the Federation of Latin American Banks and to discuss financial matters and policies intended to respond to the global economic crisis that has affected so much of the world this year. But there are more immediate concerns on our minds also. It is distressing that this occasion takes place against the backdrop of the devastation brought about by the deadly storm that hit the region, especially Honduras and Nicaragua. Our thoughts are with the millions of people affected by this disaster, through loss of life, loss of home, and loss of livelihood, and, more particularly, with the severely injured whom I visited recently near Managua. Naturally, the IMF is already deeply involved in the enormous task of recovery that these countries now face. Indeed, the IMF expects to extend immediate emergency support to Honduras and Nicaragua, and we are evaluating possible support for other countries, in particular El Salvador and Guatemala.

However, although it is difficult to escape natural disasters of such a magnitude, we must at least ask ourselves how we can better protect the world from the sort of upheavals in international financial markets that have spread across the world in the past year and a half.

Soon after the Mexican crisis broke, in 1995, I was asked where the next such event might occur. I could not name a place or a time, but I did say—as many of you will recall—that I had a strong sense that it would originate in or would dramatically affect the financial sector. I cannot claim to be clairvoyant, because it was an obvious call, but I must acknowledge that I did not anticipate that it could be so severe or could spread so quickly.

For over fifty years the world has benefited from the progressive liberalization of trade and the expansion of international financial flows. During the last quarter-century the process has deepened as capital flows have become globalized, bringing higher investment, more rapid growth, and rising living standards to many countries and many people around the world. Latin America has been among the leading beneficiaries, especially since the return to more normal conditions after the debt crisis of the 1980s. Net private inflows to emerging markets in 1996, before the onset of the Asian crisis, were over $200 billion, 15 times themid-1980s level. Latin America, which in the mid-1980s registered net outflows, received about 30 percent of total private flows to emerging markets (almost 5 percent of its GDP), with a high concentration, of course, in the major economies.

Recent developments have revealed two flaws in the system. First, although the markets are attaining a high degree of technical sophistication, the large volume of funds has made the markets prone to volatile movements of capital because of many shortcomings including: weak banking institutions; lack of transparency in capital movements, and an environment in which the regulation, supervision, and monitoring of financial institutions around the world has just not kept up with markets’ evolution. This, in turn, has made the recipient emerging market countries more vulnerable to periodic crisis and contagion. Second, as far as their development is concerned, too few countries can yet benefit sufficiently—or at all—from the enormous potential that globalization offers. A solution to the first problem, improving the predictability of capital flows in a more integrated global economy, would increase the opportunities for sustainable development in the world; it will of course not be enough. This illustrates the importance of reform of the international financial system and, indeed, one specific aspect of it, the soundness of the financial sector.

The sound international financial system that we all desire must include sound and resilient national financial systems throughout the world, regulated and supervised according to a set of internationally consistent, transparent standards and codes of good practice. Establishing an environment for sustainable capital flows will also require that countries wishing to attract these flows maintain the confidence of investors through establishing sound, well-run economies based on transparent policymaking.

Let us reflect on these two perspectives on this question of sound financial systems: first, looking at the experience of the emerging market economies, then turning to a more general perspective on some issues that each country must face in establishing financial sector soundness.

The national perspective: the emerging market economies

The experience of successful market economies, no matter their state of development, points to the need for a policy strategy based on three elements: first, sound macroeconomic policies; second, robust financial institutions set within a strong regulatory framework supported by prudent and efficient supervision; third, a system of governance that relies on transparency and an economic culture that keeps the roles of the state, corporations, and the financial system as independent from each other as possible. Where there have been clear departures from one or more of these three elements, then the country has become vulnerable. Some major events of the current turmoil confirm this. For instance,

  • In East Asia, the cumulative effects of deficiencies in at least two of these areas, financial sector soundness and governance, explain the changes in market sentiment and sudden capital outflows; and,

  • Russia faced problems on all three fronts: a persistent central macroeconomic imbalance—the budget; a troubled financial sector still in its infancy; and endemic problems of poor governance.

These countries, and indeed the international community as a whole, while seeking to benefit from potentially large flows, had not paid sufficient attention to the lessons of the Mexican crisis. This made them especially prone to contagion.

There are a number of good reasons to suppose that the countries of Latin America are better placed to withstand the pressures of contagion. For over a decade, in the wake of the debt crisis, many of its countries had been strengthening their economies. Their determination has redoubled in the wake of the Mexican crisis. Strong macroeconomic policies have borne results. A region once familiar with triple-digit inflation or higher is now becoming used to figures in the single-digit range. Prior to the onset of the present crisis, economies were growing strongly, and international reserves had strengthened.

As you are well aware, Latin America has certainly experienced deficiencies in its banking sector over the years, but many countries have been taking determined measures to strengthen their financial systems. For a variety of reasons, throughout the region, countries as diverse as Argentina, Brazil, Chile, Jamaica, Mexico, Venezuela, and others have confronted banking sector crises since the 1980s. No one should be surprised by the number of crises: indeed, three-quarters of the countries of the world—including several industrial countries—have experienced serious financial sector stress during the past two decades. My point is that many countries of this region had already begun addressing these problems well before the present global turmoil developed, in some cases several years ago. Responses have varied from country to country, but they have generally consisted of strong actions to restore bank soundness and improve bank management. These have included restructuring bank assets; establishing higher capital requirements; privatizing banks and opening them to foreign participation; and adopting better risk assessment procedures, disclosure systems and accounting standards. Also, the supervisory institutions often have been strengthened, and the legal framework reformed accordingly. On occasion, the authorities have not shied away from closing insolvent banks, nor from using public funds. In several cases the fiscal expenditure has been quite high: as much as 20–30 percent of GDP. In brief, some countries in this region have already progressed some distance along the road that countries in Asia, including Japan, are just beginning. However, progress has been uneven—many countries still have much to do, including in the legal framework and even the enforcement tools of supervisory institutions.

This being so, can Latin America withstand contagion?

While continued vigilance is essential, there is some basis for confidence about the efforts of authorities. One factor is the progress made in strengthening the financial sector. A second is the determined macroeconomic policy stance adopted promptly by a number of countries in the region. And a third factor reflects our experience that policies work best where the authorities are fully committed, or as we say, take full ownership of the policies. It is a privilege to be able to attest here to the unwavering determination and commitment of the authorities of countries in this region.

Here I must make special mention of Brazil’s courageous efforts to forestall the severe external crisis suffered in other regions. These efforts have led to its successfully completing negotiations with the IMF a few days ago. The courageous three-year program of economic and financial reform includes substantial up-front adjustment. This augurs well for its ability to withstand the current market turbulence and to strengthen its prospects for future growth. Our response is an exceptional package of financial support totaling $41 billion, three-fourths of which will be ready for disbursement in the next twelve months. To this must be added a universal commitment from domestic and international banks. With this agreement, the outlook for this region and for emerging markets everywhere has brightened considerably. To those glib commentators, those prophets of doom who chronicle the imminent collapse of the Brazilian and Latin American financial system, I would say what I have said all along: the Latin American domino will not fall. But, I repeat, what this requires is the total commitment of your banks to your countries, to the region where they prospered. I appeal to your sense of responsibility, and to your experience, which amply demonstrates that success is not founded on a short-term perspective. I urge you to take a long view! Let us all work together so that it can be said that in Brazil and Latin America, the crisis in the international financial system was brought under control.

Policies from a global perspective

It is precisely because I wish to ensure that we build on this success that I would like to take a few minutes to ask: What are the flaws in the international system, especially in the financial sector, that have contributed to the current turmoil? This is how I see it: capital markets have been developing very rapidly. New institutions have sprung up and existing ones have diversified, sophisticated new instruments have been developed, and new markets have emerged. Many countries benefited from the available flows but saw a disorderly liberalization in which flows at the short, riskier end in practice became paradoxically more open than flows at the longer end. For the future, they will need to ensure that their banking systems are sufficiently robust and their macroeconomic policies sound enough to withstand volatility. As for the advanced financial centers from which much of the capital originates, they have long applied effective standards of regulation and prudential supervision to onshore activities and for protecting smaller-scale investors. But recent developments suggest that practices and standards of regulatory oversight may also need to be reviewed in other areas of activity, such as the operations of financial institutions in offshore centers and those which have highly leveraged operations.

These risks, these disturbances, have given rise recently to many varied and detailed proposals for reform. The Interim Committee of the IMF, our ministerial level policy-advisory body, has devised an extensive agenda of action for the IMF with respect to many aspects of the reform. Subsequently, in a welcome endorsement and consolidation of these principles, the leaders of the largest industrial countries, the G-7, unambiguously declared their support for sustained reform of the international monetary and financial system. These sentiments are also reflected in the proposals of the G-22, a grouping of both industrial and emerging market economies whose work is specifically devoted to proposals on international monetary reform.

But what are the possible basic components of international financial reform? Let me suggest five that would aim to strengthen an integrated financial system:

  • internationally accepted and consistent standards and codes of good practice, based on the most successful experiences;

  • transparent behavior by all market participants;

  • strengthened national financial systems;

  • orderly opening of capital accounts; and

  • a private sector that accepts the risks as well as the rewards of the emerging markets and is involved in preventing and resolving crises.

It must bring together the roles, rights, and responsibilities of the different constituents of the global economy: governments, citizens, private corporations—especially financial institutions—and international organizations. Obviously, it is not a task that we in the IMF can perform alone: we shall be working with national governments, the World Bank, the OECD, the BIS, and other specialized agencies. We must all adapt in some way, and I can tell you that we are now looking carefully at our own role, adapting the IMF to the needs and new realities of the global economy.

But let us take a moment to consider the implication of these five components for the financial sector.

The best functioning economies and financial markets operate on the basis of a framework of transparent standards and codes of good practice that have been developed and adapted over many years. These rely on compliance that is voluntary or market-based, but is reinforced by a strong institutional framework of regulation and supervision. These, together with well-defined legal and judicial systems, form a structure that helps markets operate efficiently and generally promotes good governance. Much of the work of reforming the international monetary system will consist of extending to the global level the same principles and similar rules and codes of conduct that have long existed within the best developed financial systems at the national level.

Let us reflect on the system for regulation and supervision of financial institutions at present. At the heart of the system are the efforts of national authorities. Increasingly over the years, these authorities have recognized the need for international coordination of standards and activities, and a large number of international supervisory groups, mostly of a regional nature, have emerged. The best known group, the Basle Committee on Banking Supervision, over the years has coordinated standards for the ten largest industrial nations. In a major extension of its work, in 1997, in part precipitated by the Mexican crisis, the Basle Committee devised a set of Core Principles for Effective Banking Supervision, a set of 25 principles that were sufficiently flexible that they could be applied to the banking systems in both developing and transition economies. It is significant that these principles were developed in close consultation with the national authorities from the wider group of countries, including Brazil, Chile, and Mexico, and were strongly supported by the Association of Banking Supervision Authorities of Latin America and the Caribbean. This is precisely the type of consultative and cooperative effort that should form an integral part of the process of international financial reform.

The Mexican crisis made the international community much more aware of the need for financial sector soundness. Recognizing that the IMF, with its nearly universal membership, can play an important role in disseminating standards, and monitoring their implementation, we have been called upon to enhance our dialogue with member countries. Through our surveillance mechanism, supported by our extensive technical assistance and training capabilities, we are well placed to identify potential problems, and to help the authorities devise responses. To this end, early this year, we published a study "Toward a Framework for Financial Stability," a kind of road map for this work, which, together with the Basle Core Principles, provides a sound reference point for our continuing work with the national authorities.

I would like to emphasize some of the principles outlined in that study. Four key principles emerge that I would like to draw to the attention of this congress in particular. These include:

  • Fostering banks that are intrinsically sound. This means seeking to build high-quality assets by establishing clear criteria for entry and exit through a competent, professional management with a high degree of integrity, and a proper relationship between the bank and its owners that avoids conflicts of interest.

  • Increasing the transparency of banking: a key aspect is to ensure that bank assets are valued realistically—reporting bad loans accurately and avoiding the temptation to overvalue assets—and to expect from banks high standards of public disclosure and prudential reporting. All of these should be underpinned by internationally consistent accounting and auditing systems.

  • Limiting the distortions imposed by public sector policies: it is in everyone’s interest to take the view that troubled banks will not be supported. Even when bank failures are the result of public policy—such as directed lending or administered interest rates—market-based solutions should be sought before governments step in with public resources. I realize, of course, that for some time the desire to avoid systemic effects can lead the authorities to intervene—sometimes with great urgency—to avoid further damage. It is imperative in such extreme cases that guarantees be limited, granted in a wholly transparent manner, with full awareness of their cost to the budget, and within the framework of current monetary policy. Operations of this sort must not generate quasi-fiscal losses for central banks, and shareholders must of course bear full responsibility for their own capital losses.

  • Controlling risk through prudential regulation and supervision: risk cannot be eliminated, nor can the failure of poorly run banks. The authorities should concentrate on the soundness of the system as a whole through sound regulation and supervisory agencies that have adequate autonomy, authority, and capacity. The prudential regulations that they will need for this task should define clearly the scope of financial activities, strengthen internal governance, and reinforce market discipline.

Of course, sound banking requires a strong legal and judicial framework. Of course, sound financial market infrastructure is essential, including an efficient payments system and robust money, foreign exchange, and capital markets. But rules and regulations are not enough. Ultimately, efficient banking requires a "credit culture"—an environment in which credit contracts are customarily honored and can be enforced, and one in which weak corporations, including financial institutions, are subject to "market discipline," and ultimately face the sanction of bankruptcy. In sum, sound banking must be supported by strong governance in both the public sector and the corporate sector—including the financial institutions.

Next, let us turn to the national authorities and the particular responsibility they bear for transparency in policymaking. The international community, through the Interim Committee, has already asked the IMF to prepare a code of good practices on fiscal transparency; this code was released in mid-1998. It has subsequently called for a code ofgood practices for monetary and financial policies, and the IMF is currently undertaking this critical work. Although this is still work in progress, I can mention a few key principles that seem fundamental to a functional code of this type.

The case for transparency in this domain—previously one of the areas of policymaking in which most countries tolerated or encouraged complete obfuscation—is twofold. First, transparency fosters accountability and imposes discipline on policymakers. This is an essential precondition for good governance, especially if—as is desirable—considerable autonomy is given to the central bank and other official agencies in charge of regulation and supervision. Second, transparency can enhance policymakers’ credibility. This enhances the effectiveness of policymaking by making the private sector better able to anticipate policymakers’ intentions and likely responses to new developments.

The code will not take a stance on specific monetary and financial policies, but it will be based on the presumption that an overriding policy goal is to promote and deepen money and capital markets, and to develop the use of market-based instruments in the implementation of monetary policy. Therefore, promoting transparency rests on four key principles:

  • The roles, responsibilities and objectives of the key official institutions in the financial sector should be clearly defined, giving them as much autonomy as possible; I am of course referring to the central bank and other official financial regulatory and supervisory agencies.

  • These agencies should be held to high standards of accountability and integrity.

  • Policymaking should take place in an open and predictable fashion. For instance some central banks have begun to make public, with a short lag, the minutes of their policy meetings.

  • Information is the lubricant of the market economy, and official agencies should make available monetary and financial statistics and information for policy decisions routinely, regularly, and promptly.

These four virtues—autonomy, accountability, information dissemination, and transparent policymaking—should be engraved in marble in every Cabinet meeting room and—I venture to say—in central bank boardrooms around the world!

What then of the regulation and supervision of institutions engaged in international capital flows? At this time, the onus of supervising the activities of offshore or highly leveraged operations falls to existing national authorities, especially those in the countries where the major financial centers are found. As we approach this task, several areas will haveto be opened up, each one of which—I must admit—raises difficult questions for implementation.

  • First, regulatory and supervisory functions for banking institutions may have to be extended to a wider range of activity, specifically to cover cross-border activities in a more thorough way than previously, explicitly recognizing not only the interests of domestic investors, but also the goal of preserving international stability.

  • Second, standards for regulation and supervision will have to be coordinated and harmonized more extensively across nations.

  • Third, standards for activities outside the purely banking sector will be needed; this means extending the philosophy of the Basle Core Principles to a wider range of markets, institutions, and transactions. Already, the International Organization of Securities Commissions (IOSCO) has prepared a document, "Principles and Recommendations for the Regulation and Supervision of Securities Markets," which sets out the basis for promoting high standards of regulation in order to maintain just, efficient, and sound securities markets.

* * * * *

In sum, as we look to the changes that will be needed in financial systems, we can see a role—and responsibilities—for each major component of the system. From change will come progress. We can expect clear benefits for the global economy to emerge as the international system begins to operate more efficiently within a more complete legal and regulatory framework.

The national authorities’ priorities will include maintaining sound macroeconomic policies that promote high-quality, sustainable, and equitable growth as the prerequisite for a stable banking system, as well as making sure that the institutions, laws, regulations, standards, and codes of practice are in place to support an efficient system prudential regulation and supervision. National regulators and supervisors of the larger markets and institutions will need to take ever stronger account of the systemic implications of certain types of operations.

Banks and financial institutions should persevere at what they do best: seeking opportunity based on sound management and exacting risk assessment. In so doing, they will appreciate that promoting the orderly expansion—and indeed liberalization—of the global economy, may well involve extending to the international arena practices of regulation and supervision that are already accepted as the norm in most advanced financial markets.

The IMF, in cooperation with other institutions and as part of its adaptation to the demands of the global economy, will be deepening its surveillance, in particular by a further increase in the coverage of financial sector issues in our surveillance. We will participate in the development of new standards, and contribute to disseminating them and monitoring their implementation.

This is without a doubt an ambitious agenda, one which will keep us active for many years. Indeed, one of the lessons to emerge from this crisis is that there is a need for constant vigilance and adaptation of policies, practices and institutions to keep pace with the ever-changing world of finance and economics. Another lesson, my final observation, is that these efforts must stress a higher level of international cooperation, which is and will more than ever be essential to maintaining stability and soundness in the global economy.


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