Don’t Forget Financial Sector Reform
IMF Blog, January 7, 2010
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Bibliographic details
- Authors: John Lipsky
- Published: January 7, 2010
Major conclusions and context
- There is a broad consensus that "Fundamental changes are needed in the global financial sector."
- Publication and author: John Lipsky, January 7, 2010.
- Reform urgency arises from the turmoil of the past few years; needed changes are both technical (risk management, capital) and institutional (regulation, supervision, resolution regimes).
- Political hurdles and tradeoffs: restoring economic growth requires renewed credit flows, while some reforms "may limit the ability of financial institutions to meet this need, at least in the near term."
Clear reform priorities
- Risk management of many financial firms needs strengthening.
- Compensation schemes need to be re-evaluated.
- Capital standards need to be bolstered.
- Regulation needs fundamental reform.
- Supervision needs to be improved.
- Financial institutions’ balance sheets need to be freed of the burden of impaired assets.
Risks to reform momentum
- Risk of slippage: reforming financial regulation "will slip down the list of priorities" as growth and financial conditions improve.
- Political difficulty: reform is politically difficult and could complicate efforts to get credit flowing again.
- Public anger: "there is still a lot of anger directed against those institutions viewed as responsible for the crisis," especially where taxpayer funding was used.
- One-off measures: some countries are enacting one-off taxes on financial sector bonuses, but these are not substitutes for fundamental reforms.
Key principles for reform
- Widen the perimeter of regulation to encompass all systemically important institutions.
- Add macro-prudential elements to existing regulation that currently focuses "almost exclusively on individual instruments and institutions."
- Strengthen regulatory standards on capital and liquidity to better reflect firm risk exposures and risk profiles; "Almost certainly, this will imply increased capital buffers and new limits on risk-taking."
- Establish a robust resolution regime for large, complex financial institutions that operate in multiple jurisdictions.
- Institutional roles:
- The Financial Stability Board (FSB) will take the leading role in coordinating development of new global standards for regulation and supervision.
- These standards "subsequently will be adopted and implemented at the national level."
- The IMF’s unique role is "to conduct independent monitoring of the implementation of the agreed standards."
Strengthened supervision
- Bolstering supervision is critical in addition to enhancing regulation.
- Notable risk management deficiencies persist in many important financial institutions.
- Improving supervisory performance requires:
- Increasing the resources devoted to supervision.
- Providing the backing needed to ensure supervisory recommendations are taken seriously.
- Bank boards need sharper oversight in setting and monitoring risk management standards.
- Compensation design is relevant; the FSB has promulgated standards to help reduce concerns that compensation schemes promote excessive risk-taking.
Burden sharing and fiscal questions
- Core question: "Who should bear the cost of crisis mitigation?"
- The G-20 Leaders in their Pittsburgh Summit Communiqué asked the IMF to investigate how the financial sector could make "a fair and substantial" contribution to paying for government interventions; an options paper is anticipated "at their June Summit."
- Observations:
- The issue of burden sharing is "complex and contentious."
- Despite widespread practice of paying for deposit insurance through a banking levy, systematic attention to broader burden sharing has been limited.
- Debates have not focused enough on tradeoffs involved in designing a sound regulatory system.
- Policy tradeoff: balancing "more constraining regulation that limits the cost of future crises" against "the need to promote effective financial intermediation."
- Consideration of taxes:
- Taxes applied to more risky financial activities—either directly or indirectly—could be designed to reinforce or possibly substitute, to some extent, for stricter regulation.
- The public debate is divided about the purpose of a new financial sector charge or tax: recouping costs of net support already provided versus creating a mechanism to cope with potential future costs. Both need independent analysis.
- Financial transactions tax discussion: sometimes referred to as a "Tobin tax," noting Tobin’s original proposal was restricted to foreign exchange transactions and intended to suppress transactions, not raise revenue. Current supporters have differing intentions; some view it as a source of earmarked revenues.
IMF analysis scope and upcoming work
- The IMF’s analysis will cover issues and options broadly, including—but not limited to—a financial transactions tax.
- Evaluation criteria: potential to reduce distortions and improve systemic efficiency and effectiveness.
- Analysis will address pros and cons of creating a fund in advance of future crises.
- Technical issues to be evaluated include:
- Definition of systemically important institutions.
- The perimeter for the supervised financial sector.
- Implementation of any regulatory changes needed to support financial stability.
- Reference to related content: "See also my interview with IMF Survey online."
Implementation outlook and governance
- The reform effort "won’t be either quick or easy," but potential payoff is significant for underpinning long-term growth and enhancing systemic stability.
- Actual implementation will require sustained cooperation and focus.
- Improved global governance—including of the IMF—will aid the reform effort; this will be addressed in the next piece in the series.
IMF blog post: Don’t Forget Financial Sector Reform — John Lipsky, January 7, 2010.