The Role of the Fund in Reshaping the Financial Sector Landscape

Keynote Remarks by Min Zhu, Special Advisor to the Managing Director International Monetary Fund
Tenth Annual International Seminar on Policy Challenges for the Financial Sector Towards a Brave New World: Reshaping Financial Regulation
June 3, 2010

Good afternoon distinguish guests, ladies and gentlemen. It is my pleasure to be here today and to have this opportunity to talk to you over lunch.

I would like to thank our colleagues at the World Bank and the Federal Reserve, and all of the speakers for collaborating with us and for working so hard over the past few months to make this event successful.

This forum, now in its tenth year, brings together supervisors from around the world. It is a wonderful opportunity for all of us to share views and exchange ideas with our peers and return home with the benefit of new insights from our colleagues around the world. I would like to thank you for your continued support for this event.

The issues covered in this forum focus mostly on micro prudential and regulatory areas. In my talk, I will focus more on macro issues and highlight the macro-prudential linkages.

The global financial crisis showed all of us that micro regulation and micro-supervision is not enough, and that macro considerations need to be an integral part of efforts to attain and sustain financial stability.

To be sure, micro-prudential measures and reforming these measures are critical. No system can be considered stable unless the individual institutions that comprise it are healthy. The whole is only as good as the sum of its parts. A lot has already been done in this area, but much more work is required. The ongoing discussion in this conference shows the challenges and the progress.

Nevertheless, it is also critical to develop a macro-prudential approach to managing financial stability and growth. The crisis showed us we need to evaluate and respond to not only individual institutions but also the system as a whole – nationally and globally. The crisis showed us we need to pay particular attention to linkages across sectors and across time, systematic excess leveraging, and maturity mismatches.

The crisis showed us:

• the importance of “interconnectedness” or “interdependence” between financial institutions and markets. Domestic economic stability, the stability of the international monetary system, and the robustness of financial institutions and markets are all closely tied together.
• the importance of the unregulated parts of the financial system.
• the importance of both short and long term economic and financial cycles in assessing risks.

While we are recovering from the global financial crisis, we are faced with macroeconomic developments that bring additional challenges:

1. Excess liquidity. The global liquidity cycle started in 2003 and accelerated from the second half of 2007 when country authorities began to undertake unprecedented liquidity-easing measures to mitigate the effects of the crisis. In advanced economies, during 2000-09, M2 doubled from $4.5 trillion to more than $9 trillion and reserve money tripled from $600 billion to more than $1.8 trillion. While helping stabilize the financial system and support the return to growth, current easy global liquidity conditions and the accompanying surge in capital flows pose policy challenges to a number of countries where the crisis did not originate.

2. Strong capital flows into EMEs, which are set to continue for some time. Some emerging market economies have experienced a resurgence of capital flows. These inflows are driven by the multi-speed recovery, different fiscal positions of some developed economies and emerging economies, and interest rate differentials. A significant portion of these inflows are portfolio inflows. While the resumption of capital flows is welcome, in some cases this has led to concerns about the potential for inflationary pressures and asset price bubbles, which could compromise monetary and financial stability.

3. Private debt being transferred onto the balance sheets of the governments. The onset of the crisis led to governments in crisis countries providing fiscal support to weak financial institutions and markets. With the global economy improving, risks to financial stability have subsided. However, the deterioration of fiscal balances and the rapid accumulation of public debt have altered the global risk profile.

4. Sovereign debt levels in some developed economies are high and rising. Vulnerabilities now increasingly emanate from concerns over the sustainability of governments’ balance sheets. In some cases, the longer-run solvency concerns could translate into short-term strains in funding markets as investors require higher yields to compensate for potential future risks. Such strains can intensify the short- term funding challenges facing advanced country banks and may have negative implications for a recovery of private credit.

These developments are creating a new set of macroeconomic challenges to financial stability: Once again we see risks of systemically high leverage and maturity mismatch. We also see risks spread across sectors and across time. All these require macro-prudential management frameworks to be urgently in place to deal with these challenges.

We at the Fund pay particular attention to these new challenges, and are promoting a number of initiatives:

1. Improving liquidity and capital conditions. We support reform proposals that focus on improving liquidity and capital conditions primarily by raising the minimum standards for liquidity and capital. We believe it is important that these measures are finalized on schedule so as to reduce uncertainty in the markets, to provide credibility to the reform process and to ensure that we are not still discussing proposals if the crisis manifests itself in some yet new shape or form. We also underscore the need to get this effort right through proper and comprehensive calibration and to implement these measures in a manner that does not adversely affect the nascent economic recovery. We are participating actively in the discussions of the standard setters, including the BCBS and the FSB, as they work towards finalizing these proposals.

2. Strengthening resolution frameworks. We support efforts to make national resolution frameworks be more compatible to facilitate cross border resolution situations. At the request of the G20, Fund staff are working on developing proposals in this area, examining existing legal and other barriers and proposing a framework for allocation of responsibilities. Additionally the Fund has reviewed proposals for funding mechanisms for credible resolution schemes to address troubled systemic, bank, or non-bank institutions, also at the request of the G20.

3. Expanding surveillance of the financial sector.
- We have been working with the FSB on an early warning exercise aimed at providing early indicators of emerging and tail risks.

- The Fund and Bank have worked to modernize the FSAP and develop a risk-based ROSC program to improve our assessments of the risks and vulnerabilities in the financial sector in member countries.
- At the request of the G20, we have also assisted in the mutual assessment of the consistency of member country economic and financial policies.

4. Identifying systemically important institutions and markets. The Fund has worked with other international bodies to develop a framework and is now working on addressing data and information gaps to aid in this determination.

5. Helping members strengthen their financial systems. The Fund is making every effort to help member countries through FSAPs and TAs, which highlight vulnerabilities and also help design reforms that will reduce these vulnerabilities.

6. Conducting extensive research on how to build a macro-prudential framework. For example:
- Role of the central bank. While central banks have traditionally addressed issues related to monetary stability, they are also poised to address the emerging issues that feed into financial system stability. One of the key messages that the Fund promotes relates to the changing role of the central bank and its interactions with national supervisors in ensuring the safety, soundness, and stability of financial systems. Coordinated approaches should include both central banks and supervisors, and the framework should rely heavily on information sharing among these two institutions, or, within the same institution, if that is the case. Information sharing will be critical to prevent silos from being built.
- Bank levy. The Fund has been working on options on how to have the financial sector “make a fair and substantial contribution toward paying for any burden associated with government interventions to repair the banking system.”

7. Promoting international cooperation. We recognize in a globalized world with interconnected financial systems, uneven implementation of the reform agenda across countries could lead to regulatory arbitrage and migration of risks to less regulated jurisdictions, putting the global financial system at risk. This makes international cooperation key to successful reform and permeates every initiative undertaken by the Fund and other players in the international policy arena.

It is not my intention to run down the complete list of our involvement, but to provide a flavor of our contribution to some topical issues. As I hope these remarks have shown, the Fund is working on a wide variety of fronts with the objective of assisting member countries in making their financial systems safer and sounder while keeping the goal of steady and robust growth in mind. All of you are tasked with the same goal in your countries, and we are privileged to support your work in this shared vision of a more secure global financial system in a world of more integrated national systems. As we come close to the finish line in this phase of regulatory reform, we stand ready to support you in this task.

Thank you.