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Time For A Spring Cleaning: The Global Economy Will Thank You

Jose Vinals

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It is still winter in the northern hemisphere, but there is never a bad time for spring cleaning. I suggest that policymakers de-clutter their to-do lists by focusing on three priorities.

These policies will help economies grow and will significantly improve financial and monetary stability in 2013 and beyond.

Strong banks

We need strong banks that can support economic growth. Financial institutions in advanced economies look healthier today. But policymakers have yet to complete the cleanup of the banking sector. This is a particularly pressing issue in Europe, where weak banks have become a drag on growth.

Non-performing loan ratios continue to rise in several countries in the euro area periphery and emerging economies in Europe amid high unemployment and anemic growth. Some banks may need extra capital cushions to offset this deterioration in the quality of their loans. And in some cases, direct recapitalization of weak euro area banks through the European Stability Mechanism should be a viable option.

Other banks, however, may prove to be beyond repair and must be restructured, or wound down, to prevent the emergence of “zombie” banks. These financial institutions have little or no capacity to provide fresh loans to companies and households. They also tend to avoid writing down bad loans. This masks inevitable losses and creates “zombie” companies that are unviable in the longer term.

Weak banks in Europe should complete their spring cleaning this year to get the real economy back on track. But they cannot do it alone. This work requires a joint commitment by all financial industry stakeholders, including management, investors, regulators, and political leaders.

Strong regulation

We need strong financial regulation and supervision that encourage a shift towards lower-risk business models. This would support financial stability and growth and restore confidence in some of the world’s biggest banks.

Much has been done, but the job has yet to be completed. The new international banking rules known as Basel III need to be implemented, and further work is needed on the too-big-to-fail problem, over-the-counter derivatives reform, and shadow banking regulation.

National authorities must make further progress in the next few months in implementing the Basel III capital and liquidity requirements. Worryingly, there are still significant differences across countries in banks’ calculations of basic Basel III metrics such as risk-weighted assets. Policymakers must therefore encourage a steady, and internationally consistent, buildup of the new capital and liquidity buffers to minimize the risk of banks seeking out jurisdictions with the most lenient rules. IMF research shows that larger, shock-absorbing capital and liquidity buffers contribute to lower financial stress and higher and more stable economic growth. This is particularly true in cases where these buffers consist of high-quality capital and more liquid assets.

I also believe the reform of the market for derivatives must shift into high gear. The wider use of derivatives clearing houses, known as central counterparties, will increase transparency in the over-the-counter derivatives market and will help make the financial system as a whole less risky. But national authorities have not met recent deadlines to implement these reforms, reflecting the legal complexities of this opaque industry. Recent scandals involving complex derivatives suggest that banks’ internal risk controls are all too often inadequate, leaving investors, regulators, and banking executives in the dark.

Because of their size, complexity, and interconnectedness, some banks are still considered “too-important-to-fail”. Policymakers must remove this unacceptable moral hazard. For example, the Financial Stability Board is promoting the establishment of effective resolution regimes that allow unviable banks to die safely. And the IMF encourages financial centers in particular to swiftly adopt resolution regimes. The United States and the United Kingdom have recently become trail-blazers in this area. They have agreed to coordinate their contingency plans for winding down failing cross-border banks.

But creating stronger rules is not enough.

We also need stronger supervisors who can enforce the new rules in a fair and effective manner. One of their biggest challenges is the need to address risks to the financial system as a whole. Policymakers largely ignored these systemic risks in the run-up to the recent global financial crisis.

This year, many national authorities will need to press ahead with the implementation of new macroprudential policies to identify and mitigate risks to the financial system as whole. This requires national decisions on the institutional and operational aspects of these policies. The IMF has been heavily involved in the development of the new macroprudential frameworks and policies. And we will support their implementation by integrating the new concepts into our surveillance and technical assistance work.

Strong central banks

We need strong central banks that are independent and continue to deliver on price stability. More than five years after the onset of the financial crisis, central bankers continue to face a daunting challenge—how to respond to the changing demands placed on them, while preserving credibility and confidence that were built up over a long period.

This balancing act is at the center of an increasingly lively public debate about the effectiveness of monetary policy in a world of ultra-low interest rates, anemic growth, and high unemployment. It is a healthy discussion because it compels central bankers to reinforce their commitment to price stability and independence that have served us well.

I believe the focus on price stability—avoiding both inflation and deflation—remains the most appropriate goal of monetary policy. It may be tempting to think that countries can use increased inflation to address high public debt ratios, which continue to weigh on growth and financial stability in many advanced economies.

Yet countries cannot use inflation to substantially reduce the real value of public debt unless inflation shocks are large and unanticipated, and uncertainty may actually push up real interest rates. The cost of such policy action would be unacceptable: numerous historical examples­ underscore the devastating impact of high inflation on economic growth and social stability.

I therefore believe that we need to preserve independent central banks with a mandate and tools to maintain price stability. Empirical evidence strongly suggests that central bank independence is associated with lower inflation. We must preserve these achievements, even while we need to modify the traditional monetary policy toolkit.

Some commentators have recently argued that extraordinary monetary policy actions, such as quantitative easing, may have already undermined central bank independence. But there is little evidence to support this claim.

Granted, many central banks have taken actions that would have been inconceivable in normal times. But they have done so in the context of their mandates and have steered clear of political pressures. Strong central banks that are independent and continue to deliver on price stability will be well equipped to navigate this new world.

Perfecting the plan is a must

I believe these priorities—strong banks, strong regulation, and strong central banks—should be at the top of the policy to-do lists. They are “must-haves”, rather than “nice-to-haves.” They will support growth and significantly improve financial and monetary stability in the medium term. I also believe that policymakers can muster the necessary resolve to stick to these priorities.