Speech

Adress by José Viñals, IMF Financial Counsellor and Director, Monetary and Capital Markets Department
Berlin Conference on “Effective Financial Market Regulation after Pittsburgh—Achievements and Challenges”
Berlin, May 20, 2010

As Prepared for Delivery

Thank you. It is a pleasure to participate in this conference and to share with you my views on the key challenges in moving towards a more effective financial regulatory environment and the Fund’s role in contributing to the ongoing discussions in this area.

While it is imperative that we address the immediate challenges to financial stability resulting from increasing sovereign risks and public debt burdens, we must also continue with our efforts to build a safer financial system. This brings me to the regulatory reform agenda. To be successful in this goal, our efforts on the regulatory agenda must strike the right balance in five different dimensions:

• First, we must strike the right balance between the macro-prudential and micro-prudential dimensions. It is now widely agreed that a framework of macro-prudential regulation has to complement the micro-prudential one already in place. The former is being developed and the FSB and Basel Committee are working hard to unveil the key elements of a toolkit to deal with systemic risks reflecting interconnectedness and cyclicality. However, we must keep in mind that its successful implementation will critically depend on addressing the flaws in the micro-prudential regime. National authorities must not shrink from their responsibilities in this area. Implementing macro-prudential regulation alone will not automatically fix problems with micro-prudential regulation.

• Second, we must strike the right balance between regulation and supervision. A rule is only as good as the quality of its implementation. Implementation in turn depends on strong supervision. Unfortunately, supervision has come up short in this crisis and there are examples of supervisors not having taken effective and timely action. In some cases, regulations may not have adequately addressed the build-up of risks, but in other cases, the supervisors had the authority to step in but didn’t. There are many reasons for this – for example, the lack of operational independence, the lack of resources and competing mandates. Consequently, strengthening the will and the ability of supervisors to act must therefore be a major thrust of the international policy agenda so that it can support the regulatory reform process in delivering a safer financial system.

• Third, we must strike the right balance between banks and nonbanks. Reforms need to not only make banks safer but also the entire financial system. In the area of nonbanks and shadow banking system there is a risk of not acting soon enough. So far, policymakers have focused most of their attention on banks, and rightly so. Yet, the shadow banking sector played a significant role in the crisis – both in supporting the build-up of excessive leverage and maturity mismatches in the financial system before the crisis, and in the rapid and distressed deleveraging of the system in the early days of the crisis in 2007. More needs to be done regarding nonbank financial intermediation, at the very least to ensure that our focus on banking institutions does not simply push systemic risk further into the shadows.

• Fourth, we must strike the right balance between safety and efficiency. The proposals on the reform agenda are being carefully crafted to address the various fault lines that were exposed by the crisis. Addressing the need for appropriate levels of bank capital and liquidity is a top priority if the financial system is to be made safer and sounder. However, adopting new rules on capital and liquidity needs careful planning. We have to be fairly sure of the impact of the various proposed rules, both individually and collectively, on the financial system and the overall economy before adopting them. If we get the calibration of the steady state impact wrong, we could end up with rules that lead to a system that is either not sufficiently safe or that imposes an excessive burden on the financial sector. Getting this balance right—as well as the timing for the implementation of the new regulations—is a very challenging task, and the Fund is working with the FSB and Basel Committee to assess the impact of these proposals.

• Fifth, we must strike the right balance between the regulations being both nationally appropriate and internationally consistent. Some countries that were less affected by the crisis may not see the need for implementing some of the new reforms. In a financially globalized world, however, having uneven regulations across borders may lead to a migration of risky activities to those countries with the lowest regulatory requirements. This would put their financial systems at risk and ultimately endanger the global financial system. Certain critical minimum standards will have to be established in a uniform way across countries (Pillar I). Other standards may be dealt with at the national discretion, at least initially, to take into account local conditions (Pillar II) but with compatible processes.

Let me focus briefly on the role of the Fund in the process of regulatory reform. Under the direction of the G20 Leaders, the FSB and the standard setting bodies have done a remarkable job in putting together the agenda in record time and are now working against the clock in getting it in place by the year end. We fully support their work and have been contributing in collaboration with other international bodies on a number of projects in support of the reform agenda.

• At the request of the G20, we are developing proposals aimed at creating the requisite financial space to enable financial institutions to pay for their own resolution if the need were to arise. These are still being discussed but could, for example, take the form of a financial levy that prefunds a resolution mechanism extending beyond banks which is not in the nature of a bailout fund but aimed at supporting an orderly resolution in a credible manner. This should be seen as supporting regulatory reforms aimed at enhancing resolution. An interim report was delivered to the G20 meeting of ministers and governors during the IMF/WB Spring Meetings in Washington, DC in April; and a final report is due for the G20 Leaders’ Summit in Toronto at end–June;
• We have partnered with the FSB and the BIS to develop a framework for the practical identification of systemically important financial institutions (SIFIs) and are now extending this work to identify and address data and information gaps in this regard;
• We are developing proposals for an international framework to facilitate the cross-border resolution of insolvent financial institutions;
• We have modernized our assessment instruments including the FSAP and ROSCs to meet the increased requests from members for the in-depth health checkup of their financial systems; and are also working with the International Association of Deposit insurers (IADI) to develop a methodology to allow for a consistent assessment across systems of the newly developed Core Principles of Deposit Insurance;
• We have also looked at the workings of the over the counter (OTC) derivative markets, and our work suggests that clearing trades through central counterparties would help mitigate systemic counterparty risk present in these markets

These areas are all “work-in-progress” and discussions are still ongoing. Some observers are concerned that the agenda is not moving ahead quickly enough while there are others who suggest that there may be an overreaction and a tendency towards over-regulation, perhaps stifling market innovation and efficient intermediation.

Without doubt, we need to move promptly to adopt regulatory reform measures. There is much at stake and the time for action is now. The longer we continue with the status quo, the longer the inadequacies that brought down the financial system remain unaddressed. These could potentially surface again to set back the recovery or worse, plunge us into another crisis. Besides, delaying the finalization of the reform agenda will only perpetuate the ongoing uncertainty in the financial system regarding the rules of the game (which may restrict the willingness of banks to lend and engage in the business of banking).

We need to be mindful that these reforms when implemented will likely have implications on the functioning, structure and outlook of the future financial system: for instance, they may lead to a smaller system; may rebalance the role of non-banks versus banks; or may lead to lower sectoral earnings given higher capital and liquidity buffers. Hopefully, they will lead to a safer and more transparent financial system. And while some transitional costs may be unavoidable they do not need to sacrifice sustainable economic growth.

Let me close by saying that a lot still needs to be settled regarding the future of financial regulation but that the Fund is keen to continue contributing to this process. The Fund is uniquely positioned to make sure that the reform efforts are both sustained and coordinated across its membership, and that a redesigned global financial standards benefits all its members, not just some.

Thank you.