## _spn1010

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---

### Executive Summary — Overview
- This paper explores the responses of the private and public sector to the crisis and some of the probable outcomes.
- Aside from improved supervision of individual institutions, greater emphasis needs to be put on financial regulations that reflect the systemic nature of financial risks and the role that macroeconomic policies play.
- Global consistency of regulation and financial sector taxation will be essential to mitigate systemic risks, to avoid unintended distortions, and to help ensure a level playing field.

### Executive Summary — Key aspects of the future contours likely to be
- Banks are expected to return to their more traditional function as stricter regulation will limit the risks and activities that banks can undertake.
- The nonbanking sector will likely have a greater competitive advantage—both in supplying credit and providing investors with nonbank services—and will thus grow.
- The perimeter of regulation is bound to expand to take into account the risks in the nonbank sector.
- Market infrastructure will be reinforced to protect investors and as a consequence will need to provide needed simplicity and transparency to make risks clearer and the financial system safer.
- The global financial system is likely to be smaller, and less levered, than in the recent past, and could well be less innovative and dynamic, at least for a while.

### INTRODUCTION — Overview
- The paper discusses weaknesses prevalent in the run-up to the crisis, the probable changes in the regulatory environment, how the financial system is likely to be shaped by them, and the role the IMF can play in moving toward a more robust and stable global financial system.
- A smoothly functioning financial system should match savings and investment to transform today’s resources into tomorrow’s consumption, producing stable and sustainable economic growth. In the run-up to the crisis, goals of efficiency and safety were not met, producing extreme instability and unprecedented government intervention in advanced economies.

### INTRODUCTION — Key causes and failures (What Went Wrong)
- Excessive optimism about asset prices and risk amid low nominal interest rates.
- Several trends in the five to six years prior to the crisis signaled increased vulnerability:
  - Rapid expansion of the financial sector in many countries; high levels of household borrowing for real estate tied to loosening underwriting standards.
  - Reliance on nondeposit-based funding in banking systems, linked to financing structured credit instruments held in off-balance sheet vehicles.
  - Rising trading account income and commission/fee income while net interest income was lackluster.
  - Elevated or rapidly growing banking system leverage in advanced countries (Germany, Switzerland, the United Kingdom, and the United States).
- The same trends were present, but to a lesser degree, in Brazil, China, and India; growth in financial system assets in those countries was less steep and concentrated in mutual and pension funds rather than leveraged entities.
- Shortcomings revealed:
  - Credit risk transfer often did not place risk with those best able to handle it; supervisors and banks sometimes did not understand where risks were located.
  - Nonbanks proved systemically important because of size and interconnectedness.
  - Leverage was greater and less transparent than thought; regulatory ratios inadequately incorporated some risks; procyclicality amplified upswing and downturn effects.
  - Short-term incentive structures encouraged outsized risk taking; regulators failed to offset these through accounting, transparency, governance, or risk management changes.
  - Inadequate resolution schemes and lack of information about spillovers compounded difficulties.
- The inability to supervise and efficiently resolve large, complex, cross-border institutions was a major source of moral hazard, systemic risk, and fiscal cost.

### Principal changes to the regulatory environment
- Regulation’s philosophy shifted: prudential regulation at the entity level is insufficient; systemic risks require complementary measures.
- Two broad regulatory objectives:
  - Reducing the likelihood of future crises (preventive measures).
  - Managing crises better when they occur.
- Preventive measures focus on:
  - Strengthening micro-prudential (entity level) requirements.
  - Developing a macro-prudential (system-wide) regulatory and supervisory framework.
  - Enhancing shock absorbers via increased loss and liquidity buffers, constraints on overall leverage, and extending the regulatory perimeter to systemically important institutions, markets, and instruments.

### Micro-prudential reforms (agreed or under discussion)
- Increased capital requirements for securitization products and trading book exposures.
- Improved firm-wide risk management.
- Guidance on sound compensation practices for supervisory review.
- Increased disclosure requirements.
- Higher minimum levels and better quality of bank capital; countercyclical capital requirements; more stringent funding liquidity requirements (formulated by the Basel Committee on Bank Supervision).
- Initial implementation objective was end-2012; implementation of several measures is now expected to be pushed further out to 2015 and later.

### Macroprudential approach — key features
- Dampening procyclicality to avoid regulations or market practices amplifying upswings and downturns.
- Greater attention to systemically important financial institutions judged by size, leverage, interconnectedness, or complexity.
- Areas to address procyclicality include changes to capital regimes; provisioning for losses; rules linked to accounting practices; risk management systems; and compensation schemes.

### Identification and treatment of systemically important institutions
- IMF, FSB, and BIS produced underlying principles to identify systemically important institutions, markets, and instruments.
- More information from currently unregulated entities will be needed to complete identification.
- Challenge: provide clarity about selection while maintaining discretion to avoid circumvention.

### Addressing too-big or too-important-to-fail (TBTF)
- Preventive measures under discussion include higher capital and liquidity requirements; surcharges, taxes, or levies related to contribution to systemic risk; and more intensive supervision.
- Direct limits on size and scope of banks (e.g., restrictions on proprietary trading) are proposed but not examined in detail.
- “Living wills” (advance unwinding plans) and special resolution regimes for financial institutions are advocated to assure continuity of financial services during failure.

### Cross-border resolution
- Managing cross-border resolution is difficult due to differing national legal frameworks; progress likely to be slow.
- Risk of ring-fencing increases without agreed cross-border resolution approaches.
- IMF proposed an approach focused on enhanced coordination among national authorities and “core coordination standards.”

### Products and markets reforms
- Reforms to securitization: more information from credit rating agencies about underlying loans and modeling; incentive structures rewarding longer-term decision making; originators to hold more of underlying loans.
- Over-the-counter (OTC) markets (e.g., CDS) reforms focus on transparency and reducing counterparty exposures.
- Move to central counterparties (CCPs) or additional transparency for OTC markets; careful construction of CCPs required to avoid concentration of operational risk.
- Better margining, valuation/matching facilities, and trade repositories are being developed.

### Scenarios for regulatory outcomes
- Two very different near-term scenarios:
  - First: Officials allow complacency after temporary recovery and private-sector resistance to new regulation; the difficult reform agenda languishes.
  - Second: Vigorous public action yields over-regulation, causing certain markets to disappear and blocking valuable financial innovations and products.
- Either outcome is undesirable; a balanced “Goldilocks” solution—sensible, better regulation that is neither too little nor too much—is needed.

### The future of the financial system — system-wide effects
- Safer and simpler system:
  - Higher capital charges and less leverage should reduce volatility and require institutions engaged in maturity transformation to hold more loss-bearing capital.
  - Removal or modification of procyclical policies will reduce risk build-ups and temper deleveraging effects.
  - Simpler instruments and institutional arrangements likely; higher capital charges on nonstandardized products encourage standardization.
  - Supervisors will encourage simpler institutional arrangements and better reporting and information sharing across regulators and borders.
- Impact on growth:
  - After deleveraging and attainment of steady state, a safer system should dampen amplitude around the growth path.
  - Whether the long-run growth path is higher or lower depends on whether stability encourages greater intermediation or whether regulation slows innovation.
  - Some previous growth attributed to financial intermediation may have been illusory; redeployment of resources could supplement growth.
- Banks versus nonbanks:
  - With banks constrained by higher capital and liquidity, nonbank intermediation (e.g., corporate bonds, mutual funds, life insurers) is likely to grow.
  - Risky credits may shift to the nonbank sector; regulation may need to extend to private equity, hedge funds, REITs if they exhibit bank-like risks.
  - Securitization is constrained for complex forms but should be revived on a safer footing; overly strict regulation could limit origination incentives.
  - Proprietary trading allocations in banks are being scaled back; hedge funds and private equity may shift to more specific risk-taking.
- Size of financial system:
  - In steady state, the banking system is likely to be smaller overall due to higher capital requirements and other regulatory constraints.
  - In the near term, deleveraging may overshoot, requiring public sector support to maintain intermediation.
  - The overall financial system size (value added, assets, assets as a percentage of GDP) is ambiguous: nonbank expansion could offset banking contraction, or overall shrinkage could occur if households prefer low-risk investments.
- Global financial integration:
  - Degree of cross-border financial flows is uncertain; some countries may reconsider openness and distrust mature markets.
  - Possible pull-back from cross-border relationships; risk of increased protectionism should be resisted.
  - Enhanced cross-border cooperation (e.g., stronger colleges of supervisors) could support globalization.
  - Difficult issues remain in cross-border insolvency regimes and loss-sharing; IMF and others are developing proposals for coordination without legally binding treaties.

### Banking sector: configuration and drivers
- Likely more bifurcated/tiered system:
  - Higher capital requirements and supervisory focus penalizing size/complexity could induce divestment of noncore activities; some large banks may downsize or specialize.
  - Smaller cooperative or mutual banks may thrive; they were often less exposed to the mistakes of larger private institutions.
- Forces leading to larger banks:
  - Funding advantage from being perceived as systemic or TBTF and thus government-backstopped.
  - Remuneration schemes linked to size or deal volume rather than risk-based profitability.
  - Client demand for “full service” global banks.
- Policy implications:
  - Competition authorities are ill-suited to judge systemic risk implications of mergers/acquisitions.
  - New methods are needed to assess interconnectedness and systemic importance.
  - A potential “systemic risk tax” or surcharge may cause some banks to remain large and pay to stay systemic, while others may shrink to avoid additional costs.

### Financial markets and instruments
- Markets will likely become more transparent with greater trade information and standards on information provision and best practices.
- Risk mitigation infrastructure:
  - Growth of CCPs for standardized instruments, improved margining, valuation and matching facilities, and trade repositories.
  - CCPs provide multilateral netting but concentrate operational risk, requiring impeccable structural integrity.
- Instruments:
  - Regulation will discourage instruments with high leverage, opaque pricing, or systemic destabilizing effects.
  - Standardization will be encouraged but may raise hedging costs for specialized users.
  - If global consistency of regulation is lacking, activity may migrate to less regulated jurisdictions, including offshore financial centers.

### The role of the IMF
- IMF’s comparative advantages:
  - Forum to sustain, coordinate, and promote global consistency in reform efforts.
  - Knowledge of members’ financial systems and experience in monitoring global standards and codes.
  - Ability to advise on mandates for financial stability and minimize collateral damage from uncoordinated reform.
- Surveillance and technical assistance:
  - Refining surveillance using a more global approach, including macrofinancial linkages and removing data gaps.
  - Strengthening interaction between multilateral and bilateral surveillance and providing targeted technical assistance in supervision, regulation, and crisis management.
  - Increasing focus on assessment of contingent fiscal liabilities to the financial sector and their systemic risk impact.
- Engagement with standard setters and bodies:
  - Interaction with Basel Committee, IOSCO, IASB, IADI, FSB, and BIS on regulatory reform and implementation.
  - FSAPs and ROSCs expected to be expanded to include macroprudential supervision surveillance once in place; IMF will track implementation and enforcement through FSAP and other review mechanisms.

### Concluding remarks
- Likely contours of the future financial system:
  - Simpler, safer, higher-cost system with perhaps slower but more stable growth and fewer crises, assuming effective reform.
  - Less leverage, less profit, but more bona fide intermediation between savers and investors.
  - More diversity in the nonbank sector; some banks smaller and specialized, others large but more tightly regulated.
- Preconditions for success:
  - Coordinated and consistent implementation, enforcement of better, smarter regulation and oversight.
  - Holistic regulatory frameworks that account for interconnections and systemic risks.
  - Cooperation across monetary, fiscal, and financial authorities to avoid policy cross-purposes.
  - Determined introduction of reforms despite private-sector resistance and international cooperation on the new regulatory structure.

*Source: _spn1010 - INTRODUCTION*

### Executive Summary ......................................................................................................

### Executive Summary

### Overview
- This paper explores the responses of the private and public sector to the crisis and some of the probable outcomes.
- Aside from improved supervision of individual institutions, greater emphasis needs to be put on financial regulations that reflect the systemic nature of financial risks and the role that macroeconomic policies play.
- Global consistency of regulation and financial sector taxation will be essential to mitigate systemic risks, to avoid unintended distortions, and to help ensure a level playing field.

### Key aspects of the future contours likely to be
- Banks are expected to return to their more traditional function as stricter regulation will limit the risks and activities that banks can undertake.
- The nonbanking sector will likely have a greater competitive advantage—both in supplying credit and providing investors with nonbank services—and will thus grow.
- The perimeter of regulation is bound to expand to take into account the risks in the nonbank sector.
- Market infrastructure will be reinforced to protect investors and as a consequence will need to provide needed simplicity and transparency to make risks clearer and the financial system safer.
- The global financial system is likely to be smaller, and less levered, than in the recent past, and could well be less innovative and dynamic, at least for a while.

_Executive Summary, IMF staff paper._

### INTRODUCTION

### _spn1010 - INTRODUCTION

### Overview
- The paper discusses weaknesses prevalent in the run-up to the crisis, the probable changes in the regulatory environment, how the financial system is likely to be shaped by them, and the role the IMF can play in moving toward a more robust and stable global financial system.
- A smoothly functioning financial system should match savings and investment to transform today’s resources into tomorrow’s consumption, producing stable and sustainable economic growth. In the run-up to the crisis, goals of efficiency and safety were not met, producing extreme instability and unprecedented government intervention in advanced economies.

### Key causes and failures (What Went Wrong)
- Excessive optimism about asset prices and risk amid low nominal interest rates.
- Several trends in the five to six years prior to the crisis signaled increased vulnerability:
  - Rapid expansion of the financial sector in many countries; high levels of household borrowing for real estate tied to loosening underwriting standards.
  - Reliance on nondeposit-based funding in banking systems, linked to financing structured credit instruments held in off-balance sheet vehicles.
  - Rising trading account income and commission/fee income while net interest income was lackluster.
  - Elevated or rapidly growing banking system leverage in advanced countries (Germany, Switzerland, the United Kingdom, and the United States).
- The same trends were present, but to a lesser degree, in Brazil, China, and India; growth in financial system assets in those countries was less steep and concentrated in mutual and pension funds rather than leveraged entities.
- Shortcomings revealed:
  - Credit risk transfer often did not place risk with those best able to handle it; supervisors and banks sometimes did not understand where risks were located.
  - Nonbanks proved systemically important because of size and interconnectedness.
  - Leverage was greater and less transparent than thought; regulatory ratios inadequately incorporated some risks; procyclicality amplified upswing and downturn effects.
  - Short-term incentive structures encouraged outsized risk taking; regulators failed to offset these through accounting, transparency, governance, or risk management changes.
  - Inadequate resolution schemes and lack of information about spillovers compounded difficulties.
- The inability to supervise and efficiently resolve large, complex, cross-border institutions was a major source of moral hazard, systemic risk, and fiscal cost.

### Principal changes to the regulatory environment
- Regulation’s philosophy shifted: prudential regulation at the entity level is insufficient; systemic risks require complementary measures.
- Two broad regulatory objectives:
  - Reducing the likelihood of future crises (preventive measures).
  - Managing crises better when they occur.
- Preventive measures focus on:
  - Strengthening micro-prudential (entity level) requirements.
  - Developing a macro-prudential (system-wide) regulatory and supervisory framework.
  - Enhancing shock absorbers via increased loss and liquidity buffers, constraints on overall leverage, and extending the regulatory perimeter to systemically important institutions, markets, and instruments.
- Micro-prudential reforms agreed or under discussion:
  - Increased capital requirements for securitization products and trading book exposures.
  - Improved firm-wide risk management.
  - Guidance on sound compensation practices for supervisory review.
  - Increased disclosure requirements.
  - Higher minimum levels and better quality of bank capital; countercyclical capital requirements; more stringent funding liquidity requirements (formulated by the Basel Committee on Bank Supervision).
  - Initial implementation objective was end-2012; implementation of several measures is now expected to be pushed further out to 2015 and later.
- Macroprudential approach key features:
  - Dampening procyclicality to avoid regulations or market practices amplifying upswings and downturns.
  - Greater attention to systemically important financial institutions judged by size, leverage, interconnectedness, or complexity.
  - Areas to address procyclicality include changes to capital regimes; provisioning for losses; rules linked to accounting practices; risk management systems; and compensation schemes.
- Identification and treatment of systemically important institutions:
  - IMF, FSB, and BIS produced underlying principles to identify systemically important institutions, markets, and instruments.
  - More information from currently unregulated entities will be needed to complete identification.
  - Challenge: provide clarity about selection while maintaining discretion to avoid circumvention.
- Addressing too-big or too-important-to-fail (TBTF):
  - Preventive measures under discussion include higher capital and liquidity requirements; surcharges, taxes, or levies related to contribution to systemic risk; and more intensive supervision.
  - Direct limits on size and scope of banks (e.g., restrictions on proprietary trading) are proposed but not examined in detail.
  - “Living wills” (advance unwinding plans) and special resolution regimes for financial institutions are advocated to assure continuity of financial services during failure.
- Cross-border resolution:
  - Managing cross-border resolution is difficult due to differing national legal frameworks; progress likely to be slow.
  - Risk of ring-fencing increases without agreed cross-border resolution approaches.
  - IMF proposed an approach focused on enhanced coordination among national authorities and “core coordination standards.”
- Products and markets reforms:
  - Reforms to securitization: more information from credit rating agencies about underlying loans and modeling; incentive structures rewarding longer-term decision making; originators to hold more of underlying loans.
  - Over-the-counter (OTC) markets (e.g., CDS) reforms focus on transparency and reducing counterparty exposures.
  - Move to central counterparties (CCPs) or additional transparency for OTC markets; careful construction of CCPs required to avoid concentration of operational risk.
  - Better margining, valuation/matching facilities, and trade repositories are being developed.

### Scenarios for regulatory outcomes
- Two very different near-term scenarios:
  - First: Officials allow complacency after temporary recovery and private-sector resistance to new regulation; the difficult reform agenda languishes.
  - Second: Vigorous public action yields over-regulation, causing certain markets to disappear and blocking valuable financial innovations and products.
- Either outcome is undesirable; a balanced “Goldilocks” solution—sensible, better regulation that is neither too little nor too much—is needed.

### The future of the financial system — system-wide effects
- Safer and simpler system:
  - Higher capital charges and less leverage should reduce volatility and require institutions engaged in maturity transformation to hold more loss-bearing capital.
  - Removal or modification of procyclical policies will reduce risk build-ups and temper deleveraging effects.
  - Simpler instruments and institutional arrangements likely; higher capital charges on nonstandardized products encourage standardization.
  - Supervisors will encourage simpler institutional arrangements and better reporting and information sharing across regulators and borders.
- Impact on growth:
  - After deleveraging and attainment of steady state, a safer system should dampen amplitude around the growth path.
  - Whether the long-run growth path is higher or lower depends on whether stability encourages greater intermediation or whether regulation slows innovation.
  - Some previous growth attributed to financial intermediation may have been illusory; redeployment of resources could supplement growth.
- Banks versus nonbanks:
  - With banks constrained by higher capital and liquidity, nonbank intermediation (e.g., corporate bonds, mutual funds, life insurers) is likely to grow.
  - Risky credits may shift to the nonbank sector; regulation may need to extend to private equity, hedge funds, REITs if they exhibit bank-like risks.
  - Securitization is constrained for complex forms but should be revived on a safer footing; overly strict regulation could limit origination incentives.
  - Proprietary trading allocations in banks are being scaled back; hedge funds and private equity may shift to more specific risk-taking.
- Size of financial system:
  - In steady state, the banking system is likely to be smaller overall due to higher capital requirements and other regulatory constraints.
  - In the near term, deleveraging may overshoot, requiring public sector support to maintain intermediation.
  - The overall financial system size (value added, assets, assets as a percentage of GDP) is ambiguous: nonbank expansion could offset banking contraction, or overall shrinkage could occur if households prefer low-risk investments.
- Global financial integration:
  - Degree of cross-border financial flows is uncertain; some countries may reconsider openness and distrust mature markets.
  - Possible pull-back from cross-border relationships; risk of increased protectionism should be resisted.
  - Enhanced cross-border cooperation (e.g., stronger colleges of supervisors) could support globalization.
  - Difficult issues remain in cross-border insolvency regimes and loss-sharing; IMF and others are developing proposals for coordination without legally binding treaties.

### Banking sector: configuration and drivers
- Likely more bifurcated/tiered system:
  - Higher capital requirements and supervisory focus penalizing size/complexity could induce divestment of noncore activities; some large banks may downsize or specialize.
  - Smaller cooperative or mutual banks may thrive; they were often less exposed to the mistakes of larger private institutions.
- Forces leading to larger banks:
  - Funding advantage from being perceived as systemic or TBTF and thus government-backstopped.
  - Remuneration schemes linked to size or deal volume rather than risk-based profitability.
  - Client demand for “full service” global banks.
- Policy implications:
  - Competition authorities are ill-suited to judge systemic risk implications of mergers/acquisitions.
  - New methods are needed to assess interconnectedness and systemic importance.
  - A potential “systemic risk tax” or surcharge may cause some banks to remain large and pay to stay systemic, while others may shrink to avoid additional costs.

### Financial markets and instruments
- Markets will likely become more transparent with greater trade information and standards on information provision and best practices.
- Risk mitigation infrastructure:
  - Growth of CCPs for standardized instruments, improved margining, valuation and matching facilities, and trade repositories.
  - CCPs provide multilateral netting but concentrate operational risk, requiring impeccable structural integrity.
- Instruments:
  - Regulation will discourage instruments with high leverage, opaque pricing, or systemic destabilizing effects.
  - Standardization will be encouraged but may raise hedging costs for specialized users.
  - If global consistency of regulation is lacking, activity may migrate to less regulated jurisdictions, including offshore financial centers.

### The role of the IMF
- IMF’s comparative advantages:
  - Forum to sustain, coordinate, and promote global consistency in reform efforts.
  - Knowledge of members’ financial systems and experience in monitoring global standards and codes.
  - Ability to advise on mandates for financial stability and minimize collateral damage from uncoordinated reform.
- Surveillance and technical assistance:
  - Refining surveillance using a more global approach, including macrofinancial linkages and removing data gaps.
  - Strengthening interaction between multilateral and bilateral surveillance and providing targeted technical assistance in supervision, regulation, and crisis management.
  - Increasing focus on assessment of contingent fiscal liabilities to the financial sector and their systemic risk impact.
- Engagement with standard setters and bodies:
  - Interaction with Basel Committee, IOSCO, IASB, IADI, FSB, and BIS on regulatory reform and implementation.
  - FSAPs and ROSCs expected to be expanded to include macroprudential supervision surveillance once in place; IMF will track implementation and enforcement through FSAP and other review mechanisms.

### Concluding remarks
- Likely contours of the future financial system:
  - Simpler, safer, higher-cost system with perhaps slower but more stable growth and fewer crises, assuming effective reform.
  - Less leverage, less profit, but more bona fide intermediation between savers and investors.
  - More diversity in the nonbank sector; some banks smaller and specialized, others large but more tightly regulated.
- Preconditions for success:
  - Coordinated and consistent implementation, enforcement of better, smarter regulation and oversight.
  - Holistic regulatory frameworks that account for interconnections and systemic risks.
  - Cooperation across monetary, fiscal, and financial authorities to avoid policy cross-purposes.
  - Determined introduction of reforms despite private-sector resistance and international cooperation on the new regulatory structure.

*Source: _spn1010 - INTRODUCTION*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2010/_spn1010.pdf_