Lessons Learned from Regulatory and Supervisory Responses to the CrisisRemarks by Mr. José Viñals, Financial Counselor and Director, International Monetary Fund
At the G-20 Reform Initiatives: Implications for the Future of Financial Regulation
Seoul, Korea: November 11, 2009
As Prepared for Delivery
Good morning, Ladies and Gentlemen. I am delighted to be here with you today to share what we believe have been some of the key lessons for regulation and supervision from the crisis.
The crisis has generated a number of regulatory and supervisory responses. Countries directly affected by the crisis have had to take a number of immediate actions to support their institutions and financial markets. At the same time, the international community of regulators and supervisors are focusing on enhancements to regulatory policies to reduce the likelihood of future crises.
For some, there is a strong sense of déjà vu. Just over ten years ago, similar discussions took place in the context of the crisis that affected countries in this region including Korea. A host of measures were taken back then at both the national and international level in an effort to strengthen the international architecture. The IMF and World Bank introduced the Financial Sector Assessment Program to improve our capacity to identify risks and vulnerabilities in member countries’ financial sector infrastructure. Subsequently, the Global Financial Stability Report was introduced by the IMF as a key instrument of multilateral financial sector surveillance. The G-7 established the Financial Stability Forum (now the Financial Stability Board) to enhance cooperation among the various national and international supervisory bodies and international financial institutions so as to promote stability in the international financial system.
While these different initiatives have made valuable contributions to a better understanding of the trends and risks in the global financial sector, they have obviously not prevented crises. What we are learning is that each crisis has its own unique set of characteristics –that it is important as we develop regulatory responses that we not take a rear view mirror approach and end up fighting the last war. For as we have learned at the Fund over a number of years, often the next crisis will emerge from an a sector or a region where we least expected it.
Nonetheless, there are a number of lessons from our analysis of past crises that are relevant today. Korea, too, has drawn from its experience a decade ago and worked to strengthen the crisis response and management framework in the country. I am pleased to note that economic activity in Korea has gathered strength over 2009. As our Regional Economic Outlook has observed, Asia is now rebounding fast after being hit hard by the crisis. Authorities in the region have moved quickly to deploy macroeconomic stimulus packages and other measures to stabilize their financial systems on the back of strong initial conditions in country economies and bank balance sheets. Asia is projected to grow by 5¾ percent in 2010, which is much higher than that predicted for the G-7 economies but short of that recorded in the region over the past decade. Given the region’s heavy dependence on exports, continued weak global demand would have a considerable impact on Asia’s future growth.
II. Taking stock of global policy responses
Let me now look back at how other G-20 countries have responded over the past year and half. Overall, G-20 governments have made extraordinary efforts to strengthen programs designed to address the fragility of banking systems in their countries. Since October 2008, those G-20 governments directly affected by the crisis have publicly announced a series of actions to restore creditor confidence, stabilize markets, and restructure the banking system. Even some of those G-20 countries not directly affected by the crisis have been reviewing their existing frameworks to ensure that they are sufficiently robust.
In our view, policy actions during a financial crisis should be tied to three interrelated objectives. The first objective is containment –to halt any runs on banks by depositors and other creditors; the second objective is to identify and address weak and nonviable financial institutions through a process of restructuring and resolution. This requires loss identification, a diagnosis of banks’ viability, the operational restructuring of weak but viable banks, and resolving of nonviable banks. The third objective is to address any overhang of problem assets that are too voluminous or complex to be left in the banks. The process of managing distressed assets, sometimes through standalone asset management companies, is a critical component of resolving the banks. Underlying these policy actions is the expectation of a framework of cooperation and coordination between the different agencies involved, as well as effective public communication of the policy objectives.
Now, let me briefly summarize the actions countries have done to meet these three objectives. A number of policy measures were taken to address crisis containment and facilitate aggressive bank recapitalization. Twelve of the G-20 which were affected by the crisis responded with some form of containment measures, including enhanced depositor protection plans and debt guarantee programs. At the same time, close to US $400 billion ($384 billion) was injected into the banking sector between September 2008 and February 2009.
Since then, public sector outlays for bank recapitalization have been less frequent as many banks have successfully raised private equity in the capital markets. Nonetheless, many banking systems remain under capital pressure due to the continued deterioration in credit quality and the general agreement among bank supervisors of the need to raise both the quality and quantity of bank capital in the coming years.
As the immediate crisis waned, governments turned to the second phase of crisis management—bank restructuring. A key element of this stage is an evaluation of the health of the banking system. The use of supervisory stress tests to determine adequacy of bank capital has been a distinguishing feature of the national responses to this crisis. In early 2009, both the United Kingdom and the United States announced they had conducted stress tests for key banks. In mid-2009, the Committee of European Banking Supervisors (CEBS), together with the ECB and the EC announced a coordinated, system-wide stress test. In addition, a number of individual G-20 countries have been undertaking stress tests of key domestic and global private financial institutions. Governments are now confronting the issue of how to deal with banks who are unable to meet the required capital.
The third related objective of addressing the underlying problems in the banks—nonperforming and toxic assets, has proven more difficult. A few governments have moved to establish programs for managing impaired assets either thorough asset guarantees or shifting the assets out of the banks but progress in this area has been more limited.
Finally, with respect to communications and cooperation, there is a continued need for ensuring good communications of policies among countries and a sensitivity to the consequences of actions in one country on other countries. The benefits are recognized, but domestic constraints have, at times, overshadowed efforts of such cooperation. The G20 leaders forum has emerged as an important vehicle for coordinating policy, and the actions taken by the G-20 have helped to underpin confidence and support financial institutions. Yet the crisis management frameworks remain incomplete: formal policy cooperation remains at an early stage and has largely been through low-key and existing channels, which has had only a limited impact on public perceptions of the consistency of reform programs across countries.
III. Looking ahead—the financial sector reform agendaWe share the view that inadequacies in regulatory policies contributed to the causes and propagation of this crisis. But the problems extended well beyond regulations. We believe that the reform agenda must be broadened to focus on all four key pillars of financial system stability –(i) sound regulation, (iii) effective supervision, (iii) good governance and risk management in financial institutions; and (iv) appropriate resolution frameworks.
RegulationOn the international front, the G-20 has been leading the global coordination of regulatory reform to mitigate the likelihood and impact of future financial crises. In both domestic and international fora, wide-ranging debates and initiatives are proceeding to address the appropriate boundary and structure of regulation, raise capital and liquidity buffers, and reform standards for accounting and disclosure, credit ratings, executive remuneration, and asset securitization. Much of the recent attention has been on regulatory reform. A distinguishing feature of this crisis has been the policy focus on introducing a macroprudential perspective to financial regulation. While sound regulation of individual financial institutions continues to be essential for systemic stability, there is now widespread recognition that regulation should look across both time and space in its quest for financial stability. In short, the focus of financial regulation should not only be the trees, but also include the forest—and, it should not only focus on the outcome today but take into account the effects through the economic cycle. Striking the right balance between making the financial systems safer and less risky while at the same time efficient and dynamic and able to meet the needs of all sectors of the economy, will continue to be a challenge. In our examination of the lessons from the crisis for regulation, we have identified the following priorities:
• The first one is clear—the need for banks to hold more high quality capital, reduce leverage, and put more of a focus on adequate liquidity. It is clear that simply monitoring liquidity risk is no longer sufficient: banks do need to hold sufficient liquid assets to provide insurance against funding shocks.
• The second is expanding the perimeter of financial sector oversight and regulation to get a complete picture of activities and risks being assumed by less regulated institutions and markets and the exposure of regulated institutions to these institutions.
• The third is addressing procyclicality in the financial system. This is an area where a number of ideas are being considered, some of which are difficult and controversial. We support the introduction of ‘through the cycle’ regimes for capital and provisioning, but recognize that the operational and methodological aspects involved are not trivial. On balance, we would argue in favor of options that are simple even if at the cost of precision. Solutions need to be understandable by markets and they must be able to be implemented globally with ease.
• Promoting more effective disclosure is the fourth area for reform. More and better disclosure is needed. Here I must stress that “better” is certainly more important than “more”. Disclosure is important for market discipline, but we also need to ensure that disclosed information is both accurate and informative to all stakeholders involved. Requiring financial institutions to provide vast amounts of information can be just as ineffective as having too little information, if it is not presented in a useable format. The development of a common database of comparable financial statistics for all globally active banks would also be a substantial benefit to strengthening market discipline.
• Finally—last but definitely not the least—there is a need for more effective collaboration in addressing the challenges posed by cross-border financial institutions. It is perhaps one of the most difficult areas to advance on, as it will require actions on two fronts—coordinating prevention and having countries agree on crisis management arrangements. In addition, the matter is further complicated because such frameworks are core parts of national regulatory and legal traditions. Nonetheless, we need concrete action in this field.
I should add that many of these issues are already in their final stages of discussion in the standard setting bodies. I compliment these bodies for having responded swiftly to the demands of the international community. It will be important to have a broad-ranging impact study of the conjunction of all proposed regulatory measures before these measures are implemented, so that any unintended effects of the combined application of the merging regulations is identified and addressed in time.But we must realize that no state-of-the-art set of rules will prevent a future financial crisis from happening. We have learned from this crisis that even when the banking system is heavily regulated, it may still be vulnerable.
The virulent spread of the crisis across the globe raises an important question—why did some countries with similar financial and regulatory systems not fare as badly as others ? While there is certainly more than one factor at play here, an important factor may simply be the quality of supervision. And this is an important policy take away as we deliberate enhancements to the prudential framework.
We cannot rely on rules alone. Regulation has to be accompanied by a strong supervisory regime, the second pillar. Supervisors must ensure that institutions comply with the underlying objectives as well as the letter of the various regulations. Management must be fully aware of the risks and exposures that the institutions are taking on. Weaknesses in banks’ systems must be identified and addressed appropriately and promptly to discourage weaknesses in one bank from becoming endemic. Broadly, a regime of effective supervision has to have the following components:
• The supervisors need to have clear objectives and mandates, operational independence and adequate resources. Our work has shown us that a significant share of our membership has fallen short in meeting the minimum expectations laid out in the Basel Core Principles. Regulatory agencies may have explicit or implicit conflicting mandates in addition to the role as a prudential supervisor, for example, promoting financial access, allocating credit, and managing competition. This can lead to a confused approach towards taking timely supervisory action. Similarly, supervisors may lack access to sufficient resources and flexibility regarding compensation to hire, train and retain skilled supervisors. They may also lack protection from nuisance legal actions by supervised institutions. This can affect the operational independence of the supervisors and make them subject to industry or political pressure and make them less willing to take appropriate supervisory actions.
• An appropriate mix of supervisory approaches and techniques, including on and off-site work focusing on identifying emerging risks at the firm level and system-wide. While most countries have the appropriate supervisory tools, these were focused on individual institutions and failed to be alert to the build up of related risks in less regulated affiliates and off shore entities that then had to be brought back on to the balance sheet as a result of the crisis. Going forward, supervision will have to reorient itself to allow for the macro dimension to be more thoroughly integrated into ongoing supervisory efforts.
• A wide range of remedial actions that can be taken if regulated firms do not play by the rules. What we have seen here is that while countries generally have been given the appropriate legal authority for such sanctions, in practice these are not always taken in a timely manner. Having in place an approach which combines rules-based actions with supervisory judgment, as available in some jurisdictions, will give greater comfort in the ability of supervisors to take timely and appropriate action, and also enhance their accountability.Risk Management and Governance The third pillar that I mentioned is governance and risk management within financial institutions, which are closely interrelated. Institutions need robust internal risk management systems accompanied by a culture of strong corporate governance in the individual institutions. We must not allow the incipient recovery in some capital and financial markets to lead to a “this time it’s different” environment where business goes back to normal and there are no longer incentives for risk managers to effectively rein in the build-up of risky exposures. In the run up to the crisis, it is clear that some bank boards appear to have abandoned their oversight role. Board oversight of risk management policies and processes is the foundation of the bank’s internal defense mechanism. The board is expected to determine the risk appetite of the firm, nurture the appropriate risk culture in the light of the firm’s risk profile, and assure that the bank does not take on excessive risk. As the recently released report by the Senior Supervisor Group has shown, even one year after the crisis much remains to be done in this regard. There is a need to hold board members more accountable for the performance of the firms they oversee.
The fourth pillar is having appropriate resolution mechanisms for failing institutions, particularly to deal with systemically important firms. While there is broad agreement on the undesirable moral hazard issues that very large systemic institutions pose, there is less agreement on how they should be dealt with both in preventing crises and in their resolution. There are many suggestions being made on this issue: regulators could find ways to “discourage” institutions from becoming “too important to fail” by either imposing additional capital requirements based on their contribution to systemic risk, or by applying a leverage ratio on a group wide basis and heightened supervisory oversight.
The issue becomes more complex because where systemic institutions have stability implications across borders, both supervision and resolution challenges are further complicated by national interests. The problem has become even bigger because the process of addressing the crisis in some countries has resulted in the creation of some very large institutions through assisted mergers and acquisitions. One of the suggestions under discussion is that systemic institutions should be required to maintain a plan for their orderly breakup—approved by supervisors—so that group structures can be dismantled and penalties for failure are credible.
IV. Emerging markets’ concerns
It is also clear to us, at the Fund, that the appropriate combination of measures will vary by country or region. There is always a trade-off that needs to be assessed for each policy mix.
Having learned from past experiences of international integration and fast contagion, many emerging countries including in the Asian region, already make careful evaluation of financial innovation and its impact on financial stability. Some emerging markets are now concerned that their institutions could face a surge of perhaps overly conservative regulatory action, even though their institutions did not take part in the frenzy which led to the collapse of many lending firms in developed countries. We are aware that there is a concern that the medication not kill the patient. Thus, care should be taken to integrate crisis-generated concerns into international recommendations so as not to impose a costly and unneeded effort for emerging countries, sometimes with unwanted effects on the development of still incipient financial markets. An example is securitization—some emerging countries were in the process of a careful and cautious progression to developing their securitization markets, which has been derailed by the broad brush tainting of this financial activity in developed markets.
In some emerging market countries branches of major banks may be viewed as systemically important to the local financial system but they are not significant to the overall parent firm. Were the parent bank to get into trouble, the home country supervisor may not always keep the host supervisor informed regarding developments and measures being taken regarding the parent. The same is true of the obligation of host countries to keep the supervisors of the home country informed of problems. This highlights the need for greater communication and cooperation among home and host authorities.
It is important for emerging market countries to monitor domestic and international market events on a continuous basis, to make timely interventions and adopt necessary regulatory enhancements as needed and as international recommendations evolve—using available national discretion to implement international recommendations in such a manner as to reflect domestic market conditions. The challenge is to combine this with a non-protectionist approach that can sustain the level of international cooperation achieved with the G-20 initiatives during the crisis.
V. Concluding remarks
At the Fund, we are deeply involved with the ongoing global efforts to enhance the regulatory, supervisory and crisis management frameworks. We have worked with the Financial Stability Board in developing guidance on a framework for assessing the systemic importance of financial institutions, markets and instruments; and continue to partner with them in conducting a periodic Early Warning Exercise. We are also collaborating with the Basel Committee and the World Bank to develop a framework for the cross-border resolution of insolvent financial institutions; and with the IADI to elaborate on the core principles for deposit insurance and to develop a methodology for assessing compliance with them.
The G20 has also tasked us with expanding the FSAP and other surveillance tools to encompass the evolving regulatory frameworks. Accordingly, we are introducing a more nimble and modular version of the FSAP, and also developing a risk based approach to financial standards assessments. At the same time, we recognize the need to provide strong capacity building and technical assistance, and will continue to devote proportionate resources to work with our member countries. We will continue to support the essential need to strengthen supervision—while recommending caution in the urge to write new, complex regulations to ensure that the right balance is maintained between ease of implementation and risk sensitive design.
I would like to conclude today’s talk by sharing with you the Fund’s broader work agenda for the coming period. Our policy steering group, the IMFC, has asked us to address four major reform areas, which we call the Istanbul decisions, named after the historic city in which the recently concluded Annual Meetings were held. These decisions will shape our work in the coming period and comprise the following:
• A review of the mandate of the IMF, to encompass the whole range of macroeconomic and financial sector policies that affect global stability.
• An assessment of whether the Fund’s enhanced financing instruments, such as the Flexible Credit Line, could help address the question of global imbalances by reducing the need for countries to self-insure against crisis by building up large foreign exchange reserves.
• An endorsement of the G20 proposal to help with their mutual assessment of the consistency of national policies, which represents a new kind of multilateral surveillance, so as to deliver strong, stable and sustained global growth.
• An endorsement of the proposed governance reform agreed by the G-20 which will shift quota shares toward dynamic emerging markets and developing countries by at least 5 percent from over-represented to under-represented countries, by January 2011.
In the context of the ongoing discussions on governance reform, it is a matter of great comfort to us that major emerging markets have now been given their rightful place in the international policy making and standard setting bodies like the FSB and the Basel Committee. This will allow the new members to provide valuable inputs, based on their experiences, to the ongoing policy considerations. This is an important time for Korea to have taken on the presidency of the G20 and we look forward to its stewardship as we emerge from this financial crisis.