Systemic Challenges for Global Finance and Priorities for ReformRemarks by John Lipsky, First Deputy Managing Director, International Monetary Fund1
At the seminar, Reshaping the Global Financial Landscape: Implications for Asia
May 18, 2010
1. Good afternoon. It is my great pleasure to participate in this seminar co-hosted by the Japanese Ministry of Finance and the IMF Regional Office for Asia and the Pacific. I would like to express my thanks to Vice Minister Tamaki and Deputy Chief Executive Arthur Yuen who have made time from busy schedules to share their valuable insights with us.
2. As we gather here today, events in Europe loom large, so I will begin with some very brief remarks about the IMF’s perspective on the evolving situation. The IMF strongly welcomes the far-reaching package of measures adopted by the European Union in creating the European Stabilization Mechanism (ESM) and the supporting actions announced and implemented by the European Central Bank. These measures will strengthen economic and financial stability in the eurozone, improve market functioning and, in turn, boost market confidence. Together with strong implementation by Euro area countries—notably through actions to put public finances on a sustainable path—they will help sustain the global recovery. On the Fund’s part, if called upon, we stand ready to support our European members’ individual adjustment programs through the design and monitoring of economic measures, and through providing financial support alongside the new ESM, if requested.
3. Looking beyond the recent turbulence in Southern European financial markets, the IMF’s assessment is that a deep global downturn has been averted, and the world economy is staging a recovery. Notably, Asia is at the vanguard of the upturn. This turn of events in large part reflects concerted and coordinated policy actions. In general, however, the global recovery remains sluggish, uneven and still in need of policy support. Moreover, as recent events in Greece have shown, risks remain considerable. Unemployment is high across the globe, the financial sector still needs repair, public debt has risen sharply in some countries – including most of the large advanced one—and the welcome resumption of large-scale capital inflows underscores the need for emerging market countries to prepare to meet new challenges.
4. With recoveries taking shape, policymakers have turned with added focus in recent months to the pending issue of financial sector reform. This is entirely appropriate—as we all know, failures of financial regulation and supervision were a major factor behind the current crisis. At the same time, the crisis has refocused attention on guarding against disruptive capital account crises by providing countries access to a credible global financial safety net.
5. Today’s seminar is an opportunity to share Asian perspectives on these issues. With efforts to reshape the global financial architecture still very much in a discussion phase, Asia can and should be heard in the international debate. As these discussions gain momentum, the IMF will encourage its members both to consult closely with each other and to coordinate reforms. As we all know, a coherent global approachto these issues offer the best chance of limiting the risk of uncoordinated policies, distorted capital flows, and regulatory arbitrage.
6. Against this backdrop, I would like to focus my remarks on two topics: 1) key priorities for overhauling financial regulation and supervision: and 2) the future role of the IMF in strengthening the global financial safety net.
Building a More Resilient Global Financial Framework: Reform Priorities
7. Turning first to the challenges faced by the global financial system in the wake of the crisis, a consensus has formed that important reforms are needed to ensure that the financial sector can support growth through the efficient allocation of resources —but without leaving economies vulnerable to disruptive crises. There is broad agreement on the key principles of reform—widening the regulatory perimeter to include all systemically important institutions, bolstering supervision, improving the measurement and regulation of systemic risk, and strengthening crisis resolution mechanisms. In addition, there is recognition of the need to create more effective and appropriate limits on leverage and risk-taking. These objectives could be achieved through a combination of regulations and taxes designed to make financial institutions hold more and better quality capital, build buffers during good times, improve liquidity and risk management, and curb excessive leverage.
8. In this context, some important enhancements to the Basel II framework were proposed last December and will be finalized by the end of this year. At the same time, the international community has asked the IMF to collaborate with the Financial Stability Board—the FSB—and its associated international standard-setting bodies to develop stronger international regulation and supervision. In designing these new standards, the desire for greater stability will need to be balanced carefully against the risk of excessive intervention that stifles enterprise and innovation.
9. However, it should be recognized that even with strengthened regulation and supervision, it should be expected that will be failures of individual institutions. After all, regulations are intended to reduce risks to an acceptable level, not to eliminate them altogether, as financial institutions exist to take on some risks. However, the creation of effective resolution mechanisms presumably would reduce the costs of failure. Nonetheless, there will be some expected cost of failure, and it is reasonable to take a considered decision regarding who should bear such costs. Toward this end, the G-20 Leaders at their Pittsburgh Summit asked the IMF to review how the financial sector could make “a fair and substantial” contribution to paying for government interventions to repair the banking system. This is a complex and contentious issue, but some form of levy, charge or tax on financial institutions potentially could serve as a complement to enhanced regulation and supervision—and in support of a resolution mechanism.
10. We presented our initial analysis to the G20 Finance Ministers and Central Bank Governors at their recent Washington, DC meetings. In our interim report, we considered two potential taxes that could be relatively easy to set up and coordinate across borders. First, a Financial Stability Contribution could be levied on risk-adjusted balance sheet variables and used to pay for the fiscal cost of resolving failing institutions, including those currently deemed “too-big-to-fail”. In addition, governments might decide to go further—for example, to seek to compensate for an undertaxation of financial institutions resulting from their expemtion from a VAT. In this case, a Financial Activities Tax levied on profits and remuneration effectively would provide a means of taxing the resulting excess profits or rents.
11. I should stress that these proposals are preliminary and simply designed to frame the debate. As we undertake more analysis to refine them for the G-20 summit in June, we will rely critically on feedback from our membership, including Asian members. We already benefited from some input during last month’s Spring Meetings of our International Monetary and Financial Committee (IMFC). Ultimately, we shouldn’t lose sight of the overarching motivation driving global reform efforts—reducing the risk, and costliness, of future financial failures. In particular, we are stressing two themes. First, that initiatives regarding regulation, supervision, resolution mechanisms and possible charges or taxes must be set in a comprehensive and coherent fashion. And second, that we should be very careful not to repress the legitimate and beneficial functions of the financial sector by imposing too heavy burdens, thus stifling the innovation that is vital for economic growth.
Implications for Asia
12. What could these reform efforts imply for Japan and the rest of Asia?
13. First, it is gratifying to note the remarkable resilience of the region’s financial systems during the current crisis. This strong performance owes much to significant structural improvements that were introduced following the Asian crisis. The latest results demonstrate once again that traditional virtues—maintaining adequate capital, avoiding excessive reliance on short-term funding, ensuring proper underwriting standards, and following sound risk management—remain as critical as always. Looking forward, these principles are sure to figure prominently in the reforms that will be enacted globally.
14. Just as they were less effected by the crisis, Asia’s banking systems generally will be less affected by reforms than those in the United States and Europe, for example. For the most part, Asian banks already operate under tight liquidity and capital rules, with regulators having adopted a conservative approach in the implementation of Basel II capital requirements. In fact, Japan was one of the first countries to adopt Basel-II, in 2007. In addition, the need to curb risky behavior is less pressing, given that Asian banks typically have a different business model—one that relies on more stable sources of funding and revenue, namely deposits and interest income, respectively. This clearly is the case in Japan.
15. That said, the reform effort will have some regional impact. For instance, reforms regarding the quality of capital will carry implications for some Japanese and Malaysian banks that hold deferred tax assets or hybrid instruments. In addition, new liquidity standards could affect banks in Australia, Korea, and New Zealand that have a relatively high reliance on short-term wholesale funding. Also, if leverage limits include government securities on the asset side, banks in Japan and India could be affected.
16. Of course, reform priorities differ between countries, reflecting their widely differing experiences in the recent crisis. However, no country is immune from the risk of a future—and inevitably global—financial crisis. Indeed, banks and regulators in Asia already have grasped the benefits of introducing some reforms that likely will be adopted internationally —Japanese banks have bolstered their capital positions through share issuances over the last year, New Zealand has introduced a core funding ratio, and Korean regulators are encouraging banks to move to longer-term funding maturities.
17. Some worry that moving too quickly on reforms could stifle still-fragile economic recoveries or that a rigid approach would unfairly burden banks with less risky business models. These are legitimate concerns, and they are being heard by officials. For instance, the Basel reform proposals are not likely to come into effect before end-2012 and are set to be phased in, based on country circumstances. However, early agreement on reforms would alleviate uncertainty about the future shape of the financial system, even as phased implementation ensures that financial systems are not unduly burdened at a time when many need to build up capital. In addition, the relevant officials are cognizant that new regulations and charges should be incentive-compatible and better differentiated, including by linking financial taxes and capital buffers to the riskiness of bank balance sheets. Such refinements demonstrate the benefits that come from all countries carefully considering and contributing to the discourse on reform. Effective cooperation does not require full uniformity, but broad agreement on principles. In the absence of such a dialogue, unilateral actions could be undermined by regulatory arbitrage and would do little to safeguard the stability of the global system as a whole. My IMF colleagues consider it one of our responsibilities to help promote a broad dialogue on these issues.
18. Despite our best efforts, realism counsels that new risks will continue to emerge both within and across borders. As a result, a strong supervisory regime is essential for future success. There are important themes for future improvements in this area. These include building up risk assessment capabilities and incorporating a macro-prudential factors.
19. It is encouraging that so far emerging markets appear to have drawn the right lesson from the crisis—namely, that financial development can bring great benefits if managed adequately, and crises that are not inevitable. With capital flows likely to grow in coming years, achieving new progress in the development of Asia’s financial markets will become even more important. Not only will stronger domestic financial systems help to effectively direct the likely strengthening of capital flows, but they also will help make the best use of the region’s significant savings.
A Multilayered Global Financial Safety Net: An IMF for the 21st Century
20. Another key lesson from the crisis on which there is broad consensus is the need to further strengthen the global financial safety net. The reforms that I have outlined so far should help lower the risk of a future financial crisis. But risks will not be extinguished altogether. Moreover, history tells us that the next crisis, if and when it comes, is unlikely to exactly mirror recent events, but rather it will be rooted in new vulnerabilities and transmitted through new channels. We should be thinking now how to limit the potential dangers when new risks arise.
21. Looking ahead, the world needs a multilayered global financial safety net that can provide adequate measures of crisis prevention, in addition to stronger means of crisis resolution. Inevitably, IMF lending facilities will be at the core, working in concert with other financing vehicles such as regional financing arrangements and central bank swap lines. I see each of these vehicles as a strand, which if woven together, would build a stronger and more complete net. Each has its unique role.
22. Increasingly the role of the IMF should emcompass providing crisis resolution insurance-like facilities that offer contingent funding, where appropriate, that could be available on very short notice. In addition, the Fund should continue to develop its more traditional countercyclical lending, that is based on the Fund’s large liquid resources, and its ability to catalyze private lending through agreed policy frameworks. Central banks have a natural advantage in alleviating specific short-term liquidity pressures, especially among the major markets. The Fed’s recent reactivation of its dollar swap line demonstrated how this can be useful in creating confidence in the availability of adequate dollar liquidity in key markets. At the same time, by pooling risks, regional financing arrangements help address idiosyncratic shocks that hit an individual economy.
23. By providing critical financing to a broad array of countries over the last two years, the Fund has played its part as a central pillar in the global financial safety net. But the crisis has shown that to serve as a truly dependable global lender of last resort, the Fund will need adequate resources. Over the past year, our resources have been tripled to over $850 billion. However, our envelope is still smaller as a share of global GDP than it was when the Fund was created. And it is clear that providing insurance-like, crisis prevention facilities in a world of extensive cross-border finance implies the need for adequate contingent liabilities in order to back up the potential creation of significant contingent assets. Recognizing this, during the Annual Meetings last year, members asked us to assess the appropriate size and composition of the Fund’s financial base. This topic will be addressed by our membership in the coming months.
24. Of course it is not just the amount of resources that matters, but also how they are deployed. Over the last year, we have overhauled our general lending framework to make it better suited to country needs. We have introduced the Flexible Credit Line—or FCL—through which the IMF now offers a pre-emptive insurance facility, without ex-post conditionality, for members with strong policies. Mexico, Columbia and Poland have used the FCL successfully to help stabilize their financial markets during the crisis. And in our traditional crisis resolution financing, we have streamlined conditionality so that it focuses on the measures that are essential for a particular country to regain macroeconomic stability.
25. Looking ahead, we will examine further reforms of our lending facilities in order to boost the availability of precautionary and crisis financing for our membership. For instance, we could make FCL qualification more predictable, while extending its duration and scope. For those members that do not qualify, alternative contingent instruments that have an element of predictability and automaticity could be designed. At the same time, the Fund is considering how it might be able to offer a short-term contingent facility that would provide adequate liquidity in a timely way in response to future market strains.
26. We are also exploring how we could increase our collaboration with regional reserve pools. Here in Asia, the Chiang Mai Initiative—with $120 billion in pledged reserves—plays an important role in providing financial insurance at the regional level. Potentially the Fund could work cooperatively with the CMI to make our combined resources more effective. As can be seen in the latest developments in Europe, we do not view such regional funds as “competitors.” Indeed, they can be a positive and stabilizing force.
27. At its most ambitious, Fund resources could serve as a backstop to regional pools. This has been demonstrated already during the current crisis by the European Union lending in parallel with Fund programs, including in Hungary, Latvia, Romania and most recently, Greece. Such collaboration has clarified that the IMF has a crucial role in dealing with the policy challenges—and potential financial needs—of the eurozone. It also shows that the IMF has an integral role to play in sustaining economic and financial stability in advanced as well as emerging economies.
28. For the IMF to play an effective role in providing global insurance, we will need to ensure that we have the confidence—and the trust—of our member countries. Without these, it will be impossible to succeed in our efforts to strengthen the international monetary system. One way I see of accomplishing this in Asia is for the Fund to collaborate very closely with regional groupings like APEC and ASEAN + 3.
29. Another critical priority is to make new progress in improving our governance. Already we have taken several important steps, including through the quota reforms agreed in 2008. Under these reforms, underrepresented Asian countries stand to gain nearly 3 percentage points in quota share, raising the region’s overall IMF quota to about 19 percent. Looking ahead, Asia is expected to gain even more under the Pittsburgh G-20 Summit agreement to shift at least a further 5 percentage points of quota from over-represented to under-represented countries by early 2011. This shift will benefit dynamic emerging markets and developing countries in the region.
Closing Thoughts: Japan and Asia Lead the Way Forward
30. In concluding, I think you will all agree that the crisis presents us with an historic opportunity – in fact, the obligation—to redefine the global financial order to make it stronger, more resilient, and better able to promote growth and prosperity for all. Asia, of course, was not at the epicenter of this crisis and its financial systems have remained sound, offering important lessons for the rest of the world. However, the reforms being discussed on the international stage will have consequences for the region: the changes put in place today will shape the future financial system and its role in the global economy over the next several decades.
31. Just as Asia is leading the world recovery, its voice in these debates will be vital. Asia’s important and growing role in international institutions like the IMF provides the region with a key platform. It is also strongly represented in the new, major institutions – the G-20 Leaders process and the FSB. More than at any time in modern history, the region as a whole has the ability to influence global policy making. Moreover, it is in its own interest to do so. Unprecedented global coordination has been the hallmark of this crisis. Now, we together can deliver the financial reforms needed to sustain growth in the post-crisis years. Japan has already shown the way: it was the first country to provide extra resources to the IMF through its generous $100 billion loan, catalyzing the agreement to boost our anti-crisis funding at last year’s London G-20 Summit.
32. As it powers the global economy in coming decades, the region will need a resilient financial system that can support growth through sound intermediation, efficient capital allocation, and facilitating innovation. At the same time, putting in place a comprehensive global financial safety net would help the region’s vast savings to be invested more effectively, including a shift within Asia from mature economies to less developed ones with rapid growth opportunities. In turn, this could promote regional integration, consistent with Prime Minister Hatoyama’s vision for an East Asia Community. The IMF is also playing its part in the region, through active partnerships with our Asian members and regional organizations. This July, we are co-hosting a high-level international conference in Korea, which will bring together leading figures from around the world to showcase Asia’s economic dynamism and its evolving role in international policy-making.
33. We are confident that our engagement with the region will strengthen in the years ahead. Thank you very much for your attention, and I look forward to our discussion this afternoon.
1 At the IMF Regional Office for Asia and the Pacific (OAP) and the Japanese Ministry of Finance Seminar on Reshaping the Global Financial Landscape: Implications for Asia Tokyo, Japan: May 18, 2010