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Safer Global Financial System Still Under Construction, Says IMF

Reform of regulation of derivative markets aims to make them more transparent (photo: Von Brauchitschi/Newscom)

Financial sector reform

Safer Global Financial System Still Under Construction, Says IMF

IMF Survey online

September 25, 2012

  • Five years after start of crisis, global financial system still not well
  • More to do to implement reform agenda, make sector more transparent, less complex
  • Yet to tackle "shadow banks" and "too important to fail" institutions

A host of regulatory reforms are under way around the world to make the financial system safer, but a study by the International Monetary Fund (IMF) shows that there is still a lot of work to do by regulators, supervisors, and the private sector to put the system on a firmer footing.

Five years after the start of the global financial crisis, the IMF says that the reforms—although aiming in the right direction—have yet to create a safer set of financial structures and that there are still some difficult issues left to tackle.

“Although the intentions of policymakers are clear and positive, the reforms have yet to effect a safer set of financial structures, in part because, in some economies and regions, the intervention measures needed to deal with the prolonged crisis are delaying a ‘reboot’ of the system onto a safer path,” said the IMF in an analytical chapter of its Global Financial Stability Report.

The global financial crisis, which started in the subprime mortgage market in the United States and later spread around the world, triggered the worst global downturn since the Great Depression, throwing millions out of work and forcing public bailouts of a number of prominent financial institutions.

Aiming in right direction

The analysis, titled “An Interim Report on Progress Toward a Safer Financial System,” says reforms are aimed in the right direction, “to make markets and institutions more transparent, less complex, and less leveraged.”

But it argues that reforms in some areas still need to be further refined, far more work needs to be done to implement them, and that the system, in many cases, remains vulnerable, overly complex, and activities are too concentrated in large institutions. Reliance on non-deposit funding is very high, linkages across domestic financial institutions are very strong and complex financial products are taking on new forms.

“The good news is that there do not appear to have been serious setbacks to financial globalization (despite reversals from some crisis-hit economies); however, this also means that in the absence of appropriate policies, highly integrated economies are still susceptible to harmful cross-border spillovers,” the report said.

Focus on banking reform

The report said that so far most reforms have been in the banking sector, with the aim of imposing higher costs on certain risky activities.

Higher capital and liquidity buffers under Basel III requirements should enable institutions to better withstand distress. Reform of regulation of derivative markets aims to make them more transparent, could improve the pricing of derivatives, and mitigate some of the counterparty risks.

The report said that banks will likely adjust to the new costs in various ways, some of which may not have been intended. Innovative products are already being developed to circumvent some new regulations, it pointed out. The new banking standards may encourage certain activities to move to the nonbank financial sector, where those standards do not apply.

Alternatively, big banking groups with advantages of scale may be better able to absorb the costs of the regulations; as a result, they may become even more prominent in certain markets, making these markets more concentrated.

The low interest rate environment is crucial for now; however, it may also be creating new vulnerabilities in the future. And this is the time to alert regulators and supervisors about the possible side-effects of these crisis-related measures so that they do not wake up to new risks down the road,” said Laura Kodres, chief of global stability analysis in the IMF’s Monetary and Capital Markets Department, at a Washington press conference to launch the study.

“We do not yet see the impact of the reforms; they have long implementation lags and the crisis is ongoing. Yet, we provide a framework that can be used to assess the effect of reforms on the structure of intermediation in the future, when the dust has settled” Kodres added.

Much more to do

Despite much progress on the reform agenda, reforms in some areas still need to be further refined by policymakers, the report noted. Areas included:

• the need for a global-level discussion on the pros and cons for direct restrictions on certain business activities for banks, rather than just requiring them to hold more capital for these activities;

• monitoring, and a set of prudential standards if needed, for nonbank financial institutions posing systemic risks within the so-called shadow banking sector;

• careful thought on how to encourage the use of simpler products and simpler organizational structures;

• further progress on sorting out large institutions that get into financial trouble, including cross-border resolution to help secure the benefits of financial globalization.

In addition, the report says that the success of the current and prospective reforms depends on enhanced supervision, incentives for the private sector to adhere to the reforms, the political will to implement regulations, and the resources necessary for the task of making the financial system simpler and safer.