Just Do It—Shaping the New Financial System

IMF Blog, October 3, 2010

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Fearful financial markets, an uncertain growth outlook, fiscal anxieties, long unemployment lines: the crisis has led to widespread dislocation in financial markets with abrupt consequences for growth, trade, and employment.
The crisis exposed dramatic deficiencies in the regulation and supervision―nationally and internationally―of financial institutions and markets.
The crisis has provided the impetus for a major overhaul of the financial regulatory system.
Three years into this crisis, policymakers have made important progress in some areas, but the work is “barely half way there” and the hardest part may lie ahead.
A new Staff Position Note, Shaping the New Financial System, examines progress and warns that unless the collective “we” make concrete progress over the next 12 months in a few key areas, we may sow the seeds of the next financial crisis.

Build a financial system that provides a solid foundation for strong and sustainable economic growth and that satisfies, first and foremost, the needs of households and firms.
Address the risks posed by the entire financial system, not just banks.

The recent proposals of the Basel Committee on Banking Supervision represent a substantial improvement in the quality and quantity of bank capital.
Those Basel proposals:
- Apply only to a subset of the financial system.
- Do not yet include macroprudential considerations (systemic issues and the impact of the business cycle on how financial institutions function).
Regulatory uncertainty is acting as a drag on credit and economic growth; prompt action is essential to reduce the likelihood of another crisis.

Ensuring a level playing field in regulation.
- Global coordination is needed to foster competition and minimize the scope for regulatory arbitrage.
Improving the effectiveness of supervision.
- Supervision must be intensive, intrusive, and more focused on cross-border exposures to prevent a new cycle of leveraging and excessive risk taking.
Developing coherent resolution mechanisms.
- At the national level, the IMF has proposed a “financial stability contribution” to pay for the fiscal cost of any future government support.
- At the international level, the IMF has proposed a “pragmatic” cross-border coordination framework.
- As a first step, make this pragmatic approach operational among a subset of countries that are home to most cross-border financial institutions to address the problem of “too important to fail.”
Establishing a comprehensive macroprudential framework.
- Microprudential regulations that improve the resilience of individual institutions must be accompanied by macroprudential regulations that strengthen the resilience of the system as a whole.
- This requires identifying, monitoring, and addressing procyclicality and systemic risks generated by the individual and collective behavior of firms.
Casting a wide net.
- Regulation and supervision must capture the entire financial system, not just the banks, to prevent risk migration to less (or un-) regulated segments.

Rules must encourage the industry to reduce collective risk taking through better risk measurement and risk management.
Boards of directors must be empowered to rein in excessive risk taking and be held accountable for it.
Because issues are complex and involve many conflicting interests, political commitment at the highest levels is required.
Policymakers need to “just do it”.

José Viñals, October 3, 2010