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Finish the Job on Financial Regulation

Brisbane and Basel may be 10,000 miles apart, but when it comes to financial regulation the two cities will be standing cheek by jowl.

At the next summit of the Group of Twenty advanced and emerging economies, to be held in Brisbane in November, political leaders will take the pulse of the global financial regulatory reform agenda, launched five years ago. The explicit goal of the Australian G-20 presidency is to finally complete these essential reforms. As Prime Minister Tony Abbott said today in Davos, “Financial regulation is always a work-in-progress, but these reforms now need to be finalized in ways that promote confidence without eliminating risk.”

I strongly support this extra push to create a safer financial system that can better support the needs of the real economy, and better protect taxpayers. For far too long, critics have been able to portray the G-20 reform agenda as a regulatory supertanker stuck in the shallow waters of technical complexity, financial industry pushback, and diverging national views. This image is increasingly off the mark.

I believe the reform process has gradually moved the global financial system to a better place. It is now safer than before the crisis—but not yet safe enough. This is why I believe policymakers should particularly focus on one of the key unfinished reforms—the too-important-to-fail problem.

Too-important-to-fail taking too long to fix

The prime example of  progress in reforming the global financial system are the Basel III regulations  that make banks more resilient by requiring them to maintain higher and better capital and liquidity. The design of these rules is largely complete, and the focus is now shifting to the nitty-gritty of their implementation by countries.

Other key planks of the G-20 agenda may be less advanced, but are also moving in the right direction. They include reforms to resolve the too-important-to-fail problem, address risks in shadow banking, and make derivatives markets safer. The notable laggard is accounting standards reform, which has been stuck in low gear for too long.

I believe the success of this ambitious reform package will depend in large part on its ability to address too-important-to-fail. By removing this Damoclean sword hanging over the modern financial system, policymakers could score an epic financial stability victory.

As Ben Bernanke, the outgoing chairman of the U.S. Federal Reserve, put it: “Too-big-to-fail was a major part of the source of the crisis. And we will not have successfully responded to the crisis if we don’t address that problem successfully.”

At the heart of this issue lies the expectation that governments will stand behind systemically important financial institutions in times of trouble. These institutions can reap the benefits of this implicit public subsidy through artificially lower funding costs, excessive risk taking, and taxpayer-funded bailouts.

Policymakers have sought to shrink this implicit public subsidy by reducing the likelihood and cost of bank distress or failure. For example:

  • Global systemically important banks are now subject to intensified supervision and additional capital requirements, on top of Basel III levels.
  • In key economies, including the United States, the European Union, and Japan, rules require systemically important institutions  to prepare “living wills” to facilitate their resolution if they fail, and minimize taxpayer involvement in this process.
  • Several advanced economies want to reduce the size and complexity of banks through measures that directly impose limits on the scope of banks’ businesses, including the Volcker rule in the United States, the Vickers reform in the United Kingdom, and the forthcoming European Union regulation based on the Liikanen proposals.

Despite these efforts, implicit subsidies to these systemically important financial institutions remain too large. We are working on new analysis of the implicit subsidies provided to these institutions that we will publish in April, so stay tuned.

Focus on bank resolution

I believe policymakers should focus on one of the key unfinished elements of the too-important-to-fail reforms—bank resolution, especially across borders. It is astonishing that officials in countries are still largely ill-equipped to deal with a Lehman Brothers-style bankruptcy, where assets and liabilities are scattered across multiple jurisdictions and entities.

Over the past year or so, we have seen some progress in this area, including agreements on the European Union’s bank recovery and resolution directive, and the planned European single resolution mechanism. We have also seen the continuing implementation of the United States’ Dodd-Frank legislation and the agreement in principle by officials in the United States and the United Kingdom to address cross-border resolution. The latter initiative is particularly relevant for the biggest U.S. banks, which hold almost 70 percent of their on and off-balance sheet foreign assets in the United Kingdom. The “London whale” incident was a reminder that the U.K.-based derivatives activities of U.S. banks remain significant.

But policymakers have yet to do much of the heavy lifting. For example, they need to remove legal obstacles to cross-border resolution in areas such as derivatives and national insolvency regimes. They also need to reach agreement on the amount, nature, and location of “bail-in-able” bank debt that should be available to absorb losses.

More broadly, cross-border resolution requires an unprecedented level of trust among officials in different countries. Building this mutual trust—through strong cooperation and uncompromising implementation of agreed reforms—would go a long way toward ending too-important-to-fail. It would also help avoid the risk of a gradual balkanization of global finance, because officials would be less likely to ring-fence the operations of global systemically important banks within national borders.

Supertanker still in refit

In the coming months, policymakers should heed the call to action by the Australian G-20 presidency. By completing the reform agenda, they will make a major contribution to the global public good of financial stability, which underpins economic growth. But this regulatory supertanker is not yet ready to hit the high seas.

The G-20 leaders should continue to fully support efforts by the Financial Stability Board to complete the reform agenda, and they should have the political will to implement it. The International Monetary Fund, in turn, will continue to contribute its resources and expertise to help address the remaining challenges, in collaboration with the Financial Stability Board and international standard setters. The IMF will also help its members implement the new rules in the coming years through surveillance and technical assistance.

In the short term, however, all eyes will be on the G-20 summit. What was developed and nurtured in the meeting rooms of Basel should come to fruition in Brisbane.