Speech

Opportunities and Challenges for Banks and Supervisors in an Internationalized Financial System, Remarks by Agustín Carstens, Deputy Managing Director, IMF

October 4, 2006

As prepared for delivery

Ladies and Gentlemen,

Although I am not one of the organizers of this conference, allow me the liberty and pleasure of welcoming you all to my home country, and in particular to this beautiful city of Merida, on the historic Yucatan peninsula. Let me also thank the organizers for inviting me to address this distinguished audience of leaders of the international supervisory community. That we are present at already the fourteenth bi-annual International Conference of Bank Supervisors testifies to the vitality of this community.

The financial services industry continues to become more global in its reach. This demands the development of innovative supervisory and cooperative arrangements. Let me, therefore, take this opportunity to speak to you on some of the aspects of your increasingly internationalized responsibilities, and raise some of the difficult questions this "globalization of supervision" poses to all of us.

Over the past decade we have seen enormous changes in the way the world conducts financial business and how we supervise financial institutions. Trends toward development of new products and globalization are strongly market driven. I consider this fundamentally a good thing, because it shows that the providers of finance are flexible and innovative, and capable of adapting to the rapid and far reaching developments in the world economy and financial markets. Flexibility and innovation are only good, however, if they are built on stability. In this context, we need to ask ourselves some tough questions. Is what we are doing effective? And what more can we do to maintain financial stability in changing markets and a changing financial world?

I believe there is much to be done to ensure that financial innovation and flexibility continue to provide finance to a changing world economy on a basis of stability. So, while factors of change in financial services are becoming rapidly visible, we need to balance this with stabilizing factors of reliable infrastructure and effective oversight.

While you can change the form and distribution of risk, move it around and slice and dice it into very small pieces, you cannot make it disappear. Therefore, one of the key challenges to financial supervisors today is to understand the changing forms and distribution of risk. It is important to investigate the functioning of transfer mechanisms, to track where risk is being held, and to assess its potential for causing or exacerbating instability. Traditionally, financial risk was primarily located in banks, where it could be measured and managed relatively easily. Today, however, much risk is being offloaded by banks to other investors, who are frequently unregulated, and possibly less capable of assessing and pricing risk. Thus, the risks become less visible to the supervisor and more difficult to contain. And despite the distribution and fragmentation of risk, on a cumulative basis the negative wealth effects of materialization of these risks remain fundamentally unchanged. We can therefore not exclude the emergence of quasi-fiscal liabilities in cases where pension funds or insurance companies purchase such risk, which subsequently goes bad, and for which governments may need to take responsibility.

Once we have succeeded in tracing the risk to its ultimate holders, we need to ask ourselves: what role should supervisors play to help the institutions under their supervision contain these risks, so they do not cause unacceptable levels of instability? As supervisors, we need to develop the tools to keep track of these risks.

Stability starts with sound and stable macro economic policies, but also requires elements such as market and public infrastructure, sound legal underpinnings of property rights and security interests, reliable systems for transfer of ownership, effective foreclosure and bankruptcy procedures, and reliable accounting and auditing.

Our FSAPs have shown that there still is work to be done in this area: well designed capital adequacy rules, realistic and effective credit risk assessment, adequate provisions, a consolidated overview of capital and risks, effective internal risk management systems, effective internal controls and reliable accounting. All these areas need to be reinforced in many countries. This is all the more so, since the revised Basel Core Principles on the agenda of these meetings for approval, raise the bar further, while many countries have not yet jumped over the first bar. We consider Basel II an important contribution to potentially greater financial stability, and a powerful incentive to improved supervision. However, we must also recognize that implementation poses significant additional challenges, also for countries not implementing the advanced approaches.

For Latin American countries, the FSAPs have highlighted a number of key issues that need to be resolved before the banks can reap the full benefits from the connection to the global financial system. Two preconditions must be met: first, continued improvement in macro policies, in particular controlling inflation and following sustainable fiscal policies. These are necessary to build the foundation for continued economic growth, which increases the demand for credit, and provides a stable background for banking business. The second precondition is a continuation of structural reforms aimed at improving market structure, which will contribute to the resilience of the financial sector. These reforms should ensure clear and strong creditor rights, an effective judicial system, high standards for market conduct, transparency of financial information, and good accounting and auditing. Aside from these preconditions, it is also necessary that banks improve risk management, and that supervision be improved.

In particular, the FSAPs have identified six key areas in which Latin American supervisory systems need to be strengthened. First: in many of the countries assessed, supervisors are not able to effectively exercise banking supervision on a consolidated basis. Second, in many countries capital adequacy rules do not meet international standards, due to inappropriate risk weights or capital components, or the lack of consolidated supervision. Third, in many cases, credit, market, liquidity, operational or country risk are not properly regulated or supervised. Fourth, independent internal control and audit are often not present. Fifth, supervisors often do not have an adequate set of remedial actions at their disposal, or are unduly hindered in their application.

Finally, another key issue which needs to be addressed with some urgency is the reinforcement of the independence, legal protection and adequate resources of the supervisors. This is necessary in the Latin American region, but our assessments have found this to be a serious issue in other parts of the world as well. Given the challenges we face, now is the time to ensure that supervisors can do their jobs without undue constraints and interference. The IMF is preparing a study on the issue of supervisory governance, and will shortly conduct a cross-country survey, of which supervisory independence will be an important part. The Fund is consulting closely with the Basel Committee on this study.

It is clear that supervision needs to be brought to a higher level, but not only in Latin America. For all its complexity, and the effort required for its implementation, Basel II creates enormous incentives for a more astute and sophisticated supervisory profession. More and more countries are subscribing to the new international financial reporting standards. All these developments will force the quality of supervision upward. They will encourage better implementation of the BCP, and will prompt supervisors to conduct a professional dialogue with banks and colleagues across borders, in particular between home and host supervisors of international banks operating under the advanced capital adequacy variants.

Furthermore, supervisors need to understand the changing forms of financial business, not only in banking but also in insurance, pensions, and securities markets. All these added supervisory responsibilities and the need to qualitatively upgrade supervision imply the need for more and better staff. Are supervisors being adequately funded to attract such staff? We have found that in many countries this is probably not the case.

Let us now take a look at the cross border dimension of financial supervision. As if the increasing complexity of financial institutions and products, supervisory techniques and sophisticated risk management were not enough of a challenge, we shall also be required to apply our new-found insights across borders. We shall need to work together with countries with different financial markets, different legal and accounting systems, and different levels of supervisory development.

What are some of the challenges to effective cross border supervisory cooperation? We need to develop and use channels for the exchange of information. Frequently this involves confidential information requiring specific procedures and a robust legal foundation. We also need more convergence of supervisory standards and practices, as a basis for more effective action with regard to international financial institutions that encounter problems.

We are also seeing that internationalization of financial markets and the impact of macro policies and market developments on financial institutions implies that supervisors need to become more aware of the international and domestic macro economic factors that impact financial risk. At the IMF we are very actively seeking ways to better integrate our macro economic analysis and advice with market intelligence, and with our financial sector stability analysis and advice. Supervisors and financial sector specialists need to become more aware of the macro economic backdrop to much of their activities, as well as the impacts of market developments. We need to explore better the linkages between, for instance, exchange rate and interest rate policies and banks' balance sheets and market developments. We should examine more, the impact of banking sector weakness on fiscal projections, the impact of global commodity prices on the real sector in countries, and on their banks' balance sheets. And we should examine the speed and volume of financial flows in and out of a country. All these issues can play out differently in different countries.

We shall be pleased to share the results of our own analysis at the IMF, and to discuss these issues with the supervisory community. We do not have the answers to all these questions, but we are keen and interested in working toward answers together with you.

A number of threads in this nexus of risks and opportunities are already woven into the agenda of this conference. We therefore congratulate our hosts and the Basel Committee with their initiative and thank them again for bringing us all together at this delightful location. I wish you every success at this conference and the IMF looks forward to continued cooperation with you toward a modern, efficient and stable international financial system.