“Failure would be disastrous”

The IMF’s Capital Market Director on the dramatic U.S. budget negotiations
Interview with Jose Viñals, Director, Monetary and Capital Markets Department, International Monetary Fund

Published in Die Welt, December 27, 2012

Die Welt: Mr. Viñals, Europe's crisis countries have recently been paying significantly lower interest rates on new debt. Is this, as so often in this crisis, only a temporary improvement?

Jose Viñals: Financial markets have recently calmed down mainly for three reasons. In September, the European Central Bank (ECB) unveiled its program to allow for potentially unlimited purchases in secondary sovereign bond markets (Outright Monetary Transactions). This is the most important factor. In addition, government leaders reached a new agreement on Greece and took important steps toward banking union. Now it comes down to the credible implementation of these important decisions. Otherwise tensions could quickly return.

So far, the ECB did not have to buy any securities. Do you think that the markets will eventually provoke the ECB?

Jose Viñals: That cannot be ruled out. It is important that, if a country were to participate in the OMT program, the ECB honor its commitments. If markets decide to test that commitment and if the ECB shows its force, they may not be willing to do it a second time.

The Bundesbank is adamantly against this decision of the ECB and fears for its independence. How independent can a central bank be that finances countries by printing money?

Jose Viñals: The ECB has taken a number of extraordinary policy actions in the past 12 months. I think these steps are justified. The program of potentially unlimited purchases in secondary sovereign bond markets was introduced because the traditional monetary policy tools were no longer effective in some euro area countries. Moreover, countries seeking that support will need to fulfill strict conditions. That was a very wise decision.

But doesn’t that make the central bank clearly a political actor?

Jose Viñals: I do believe that the ECB is completely independent because it can decide whether it wants to provide support or not. Like everything in life, the ECB’s decision is not without risks. But these risks are mitigated by the fact that countries seeking support must fulfill strict conditions. This means that the ECB has a constructive influence on the policies of these countries. And this will also help their economies recover.

Even if you're right, the ECB already supports countries indirectly on a massive scale—through support for the banks. And that will be difficult to get out of.

Jose Viñals: The ECB’s liquidity support for banks has been and remains essential. But it is not sufficient to offset the forces of financial and economic fragmentation that have widened the gap between core euro area countries and the periphery. This fragmentation has been driven by large private capital flows from the periphery to the core, which has driven up funding costs for governments, companies, households, and banks in the periphery. These banks are now very dependent on the ECB and the emergency liquidity assistance of the national central banks. It is a reflection of a wider problem that requires a number of policy measures to resolve this crisis. But it is also clear that banks must play their part. They must comply with the new capital rules, and weak banks have to be restructured or resolved. We should only have banks that are viable and strong enough to support economic growth.

The ECB will now also supervise banks. Will this overwhelm the central bank?

Jose Viñals: I don’t think so. I welcome the decision. But it will require huge work to put in place the adequate supervisory infrastructure and guarantee its top quality. And it is essential that national authorities also do a good job in supervising smaller banks, because major problems can arise from these institutions. Prominent examples include the Spanish Cajas and Northern Rock of the U.K.

Should Europe also implement a common fund for bank liquidations and a common deposit guarantee fund?

Jose Viñals: We welcome Europe’s recent steps toward a banking union, because a completed banking union will complement the monetary union and anchor confidence in its viability. It should include a pan-European deposit insurance guarantee scheme and a bank resolution mechanism with common backstops.

Starting January 1, stricter capital rules (Basel III) are supposed to make the banks more resilient worldwide. The U.S. wants to delay the introduction, but Europe is pushing for quick implementation. Subsequently, the U.S. has threatened Europe to regulate European banks more stringently. Will this lead to a regulatory war?

Jose Viñals: The discussion on stricter capital rules has to be put into the right context. Many commentators completely disregard the fact that the 19 largest U.S. banks have already been asked by their supervisors to comply—de facto—with the Basel III criteria from January 1, 2013, even though the law has not yet entered into force.

Should the U.S. set a firm date for the introduction of Basel III?

Jose Viñals: It is important to increase confidence in the markets. Therefore, while there is going to be some delay in implementing Basel III, it should be a small one.

In the U.S., the Volker rule to prohibit the risky practice of proprietary trading by banks, has also been delayed. Will it ever be adopted?

Jose Viñals: Details still need to be worked out. But I am confident that—after some adjustments—this new rule will be implemented in the U.S.

After the financial crisis, the U.S. banks have grown even bigger. Critics say too big.

Jose Viñals: The problem here is the complexity of these banks, not just their size. There has been some progress in addressing this issue in the U.S. and elsewhere. For example, there is now a list of the world’s 28 most systemically important banks, which are subject to stricter regulation. There has also been a recent move by the U.S. and U.K. authorities to coordinate their contingency plans for winding down large cross-border banks when they fail. We strongly encourage other financial centers to follow this example to protect taxpayers and preserve global financial stability.

But how thoroughly can these banks really be supervised?

Jose Viñals: As much as possible! But the current discussions about structural reform initiatives—including the Volker rule, the U.K.’s Vickers proposals, and the European Union’s Liikanen report—indicate that supervisors continue to feel that banking risks are hard to assess. These initiatives may help create safer business models for banks, but this has yet to be proved.

This could result in the separation of banks into retail and investment banking. Does the IMF support such a two-tier banking system?

Jose Viñals: We are currently analyzing the implications of the various initiatives. But the recent proliferation of such initiatives at the national and regional levels may have unintended consequences. If these initiatives become law, greater international consistency of rules will be needed to discourage banks from moving their business to the least regulated jurisdictions.

In the U.S., Democrats and Republicans must settle their budget dispute by the end of the year. Otherwise tax increases and spending cuts will come into force which could push the U.S. economy into recession. What would happen in financial markets?

Jose Viñals: If the United States were to fall off the fiscal cliff, that would have very serious consequences not only for the U.S., but for the world economy and global financial markets, where uncertainty would likely increase again. What is interesting is that financial markets do not currently expect the negotiations to fail. So far, they have not considered this scenario in their investment decisions. Therefore, it is important that the politicians do not disappoint the markets.

In a recent paper, the IMF said that capital controls can be useful. Does the IMF no longer promote the idea of free markets?

Jose Viñals: The IMF recently formulated an institutional view on policies affecting capital flows. It represents our current thinking, and we expect that it will continue to evolve. To be clear, capital flows offer countries huge potential benefits. But their size and volatility can also create huge policy challenges. These risks can be magnified by gaps in countries’ financial and institutional infrastructure. That is why (capital account) liberalization needs to be well planned, well timed, and appropriately sequenced to ensure that its benefits outweigh its costs. And in certain circumstances, capital flow management measures can be useful. However, they should not be used as a substitute for necessary macroeconomic adjustment.


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