Speech

Dealing with Downturn -- Lessons and Opportunities, Keynote Remarks by Jaime Caruana, Counselor and Director, Monetary and Capital Markets Department, IMF

June 5, 2008

Introduction

Good morning, ladies and gentlemen. I am delighted to have the opportunity to talk to you as you begin the second day of this seminar. The Fund has collaborated with our colleagues at the World Bank and the Federal Reserve for eight years on this forum and I would like to thank them again for hosting this seminar. This event, which brings together Deputy Governors, heads of supervision and senior supervisors from around the world, is a wonderful opportunity for all of us to share views and exchange ideas on the challenges we all confront.

You have already had a day of presentations and discussions on the causes of turbulence in the markets. Later today, speakers will discuss the lessons being drawn by supervisors, central banks and market participants. I do not intend to pre-empt any of these discussions, which no doubt will be very engaging. Instead, I will focus my remarks around three basic themes associated with these events that we have been discussing in the Fund and mostly related to the word downturn.

I will address the following three issues : (i) regulating bank capital in downturns (ii) managing procyclical effects of accounting and (iii) strengthening the supervisory structures, meaning the interaction between supervisors and central banks. But first, to put matters in perspective, let me begin with a few words about the potential impact of a downturn.

The direct financial losses associated with the present financial crisis, both incurred and projected, are not trivial. While estimates may vary, in the recent Global Financial Stability Report, taking together subprime and Alt-a loans plus their structured securities at market prices, IMF staff have estimated the aggregate potential write downs and losses to be above $500 billion. Banks account roughly for half of that.

But we also tried to have a rough estimate of the losses associated with the downturn in the US economy. The linkages between the financial sector and the real sector are being revealed in full bloom in the US and other mature markets as the deceleration in credit is projected to contribute to the slowdown in output growth. WEO estimates for global growth projections for 2008 have been moderated to 3.7%, one and a quarter percent lower than the previous year.

The downturn will also contribute to a wider credit deterioration, affecting a wider range of assets. In the next two years, we estimate that the cumulative writedowns could be as high as $400 billion for US prime residential loans, commercial real estate, corporates and consumer loans. As you can see the potential challenges to the banks coming from the downturn are significant.

These losses and write downs have led to the lowering of bank capital adequacy ratios of between 150 and 250 basis points in the US and Europe, and many banks have had to scramble to raise capital to meet either regulatory or internal capital adequacy targets. By now, banks have already raised capital of USD 240 billion, which is significant. This is one of the short term priorities and most likely more will be needed.

Capital in downturns

This need to source capital on a large scale in the midst of turbulent financial markets brings me to my first theme, an old one but that requires some thinking: The importance of holding adequate capital. Of course, capital matters, but any measure of capital is meaningful only if at least three conditions are met: first, the quality of the assets is well understood and assessed, if as it has happened in some structured products, assets that where supposed to be AAA turned out to be CCC, capital ratios can do very little. Second, the perimeter of the consolidation must be wide enough to take into account all significant risks. Let me say here that the figure of $5 trillion that is being mentioned as the amount that banks may need to take in their balance sheets, is staggering. Let me remind you that the assets of the bank balance sheet in USA and Europe is $ 30 trillion. I just will add that the role of the supervisors in controlling off-balance sheet vehicles and proper consolidation is hugely important. And third the potential evolution of risks through the cycle must be taken into account.

I think that Basel II represent a significant improvement of the capital framework in these three fronts. The Basel Committee is now reviewing Basel II to strengthen capital requirements for complex structured products and the risks associated from the return of securitization products to the balance sheet. We welcome these efforts to make Basel II more robust.

Questions have been raised on whether the Basel II framework, which is being implemented (or is planned to be implemented) in more than a hundred countries around the world, will exacerbate procyclicality and also whether Basel II could have prevented the chain of events in this crisis. Of course, as we all know, the Basel II framework was either not implemented or still in the transition period in many of the affected countries at the time the current events began unfolding, and as such did not have any causal role in contributing to the losses. Nonetheless the question of whether implementation of Basel II would have limited the damage and what might be done to strengthen Basel II in light of lessons learned are very important.

Let me emphasize that the Fund strongly supports the full implementation of the Basel II framework, which is a distinct improvement over the previous framework. It provides a framework for enhanced risk sensitivity, stronger incentives for better risk management, sounder supervision and the use of market incentives as additional discipline on bank behavior by requiring greater transparency in their operations.

In the context of recent events, it seems to me that the incentive structure in the three pillars of Basel II could have mitigated some of the problems we have seen. An obvious example is the treatment of securitization, the risks of which were simply not captured in Basel I. Had Basel II been in place and requiring banks to hold capital against the risks associated with securitization exposures, whether as originators, sponsors, investors or liquidity providers, it is likely that the loss exposures would have been at least contained. Further, it also provides stiff disincentives for inappropriate behavior linked to securitization. For example, in cases of provision of implicit or non-contractual support which undermines the clean break criteria and signals to the market that the risk has in effect not been transferred, supervisors are required to take strong action which could include denial of capital relief in the case of originated assets or an increase in capital required against acquired securitizations.

However, I should emphasize two points. First Basel II is a regulatory capital framework—not an overall guide to how banks should run their businesses. Capital requirements can, and should, create the right incentives for risk takers and support good risk management generally. But capital requirements cannot prevent banks from making mistakes—or substitute for banks' own responsibilities for assessing risk and managing it appropriately. Second, the current problems in the market in any event clearly go beyond the objectives of a capital adequacy framework. The issues range from loose underwriting standards, opacity in complex financial products, lax investor due-diligence to inadequacies in liquidity management Basel II is not the panacea for all the financial market troubles, but is part of the remedy. In particular it is not a liquidity standard, and as you may know,

As far as the procyclicality issue, one cause of procyclical behavior is low capitalization and weak risk management. Undercapitalized banks will be forced to make abrupt decisions to cut lending when there is evidence of a slowdown, and banks that have not assessed risks properly may also be forced to react abruptly. Increased risk sensitivity under Basel II may help to dampen some of these procyclical effects by increasing risk awareness and early detection of emerging vulnerabilities. It also encourages banks to build capital levels as exposures increase even before actual problems are detected and to be more sensitive to the economic cycle. Of course, any risk-sensitive capital framework will cause capital requirements to fluctuate as a borrower's creditworthiness strengthens or weakens.

It was for this reason that the framework has several elements built into both the minimum capital requirements of Pillar I and the supervisory review process of Pillar 2 that are specifically geared to get both banks and supervisors to focus on holding capital which is adequate through the business cycle. All of these elements will ensure that bank managers are conscious of how risk drivers can change through the cycle and in stress conditions, and that they incorporate these elements into their decision-making processes and capital strategies.

The challenges of implementing Basel II are heightened in turbulent financial markets, and this transition must be managed carefully to mitigate any unintended effects. Banks and their supervisors should make full use of provisions to mitigate procyclicality, and let me remind you of a few of these provisions in pillar I and II. Ratings must represent the bank's assessment of the borrower's ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events; risk parameters should be estimated as a long-run average(PD) or to reflect downturns (LGD), moreover, in order to avoid over-optimism, banks must add to its estimates a margin of conservatism that is related to the likely range of errors. Where methods and data are less satisfactory and the likely range of errors is larger, the margin of conservatism must be larger. Supervisors are expected to encourage banks to take more account of uncertainty over the full economic cycle promoting the use of rating systems that take into account business cycle effects; and developing a robust and credible Pillar 2 process to ensure that capital buffers are appropriate for bank risk profiles; In addition to these supervisors should be prepared to extend bank floors in transition, if warranted by impact studies.

Accounting rules and procyclicality

I now turn to the second theme of my remarks.

Accounting rules also have a procyclical propensity and deserve to be included in any discussion on the subject. In a downturn, the reliability and verifiability of fair values cannot be counted on in the absence of active markets and uniform valuation techniques, and can potentially put certain assets in a downward price spiral and introduce volatility in capital. However this is only part of the story and the analysis should be more symmetric. In the good times optimistic valuation of assets can exacerbate risk taking, pushing valuations further. Let me clarify that fair value is in my view the direction to go, and this is not the moment to change the rules. Instead, we should be taking full advantage of the flexibility offered under the present rules. This is also clearly an issue that merits further analysis.

A related issue is in my view the tendency to under-provision in good times, and the accounting standards do not help matters in this regard. I think this episode of crisis supports the need of a more forward looking method of loan provisioning. Changes are required to make accounting more consistent with sound provisioning and best risk management practices, but I am also of the belief that the challenges posed by the accounting standards in this regard arise from a very narrow interpretation, in valuation and provisioning the existent room for maneuver should be use to get sounder practices. I would advise supervisors not to blame the accountants for their own lack of will in dealing with the important issues of ensuring that banks are well provisioned in all times. I think it is possible to satisfy the accounting regime while continuing to require them to hold forward looking provisions in keeping with regulatory prescriptions. This is an area where there is great need for more sharing of experience between supervisors and I hope that you will take the opportunity of events such as this to discuss among yourselves how this balance between accounting and regulation can be best achieved.

The role of Central Banks in banking supervision

I would now like to turn to the third theme of my remarks. This is a different but equally important issue which is being discussed by us. What should be the role of central banks in the supervision of banks and what should be their relationship with supervisory agencies ? This question has arisen in the context of the tremendous demand placed on central banks by the turmoil to find non-traditional approaches to the provision of liquidity, when markets dried up and some banks found themselves facing heightened rollover risks which threatened their solvency. Recently, even market participants outside the banking system have been forced to come to the central banks. These events have placed the traditionally anonymous central banks center stage in efforts to manage the fall-out from the crisis—even where they did not have any role in the supervision of financial institutions or their resolution.

I will not enter the discussion whether there is a universal optimal supervisory arrangement that fits all countries and financial systems. But I think another lesson of this episode is that whatever is the arrangement, central banks need to have access to supervisory information on the financial condition of individual banks. Liquidity crises can build up without much warning and the provider of liquidity in such volatile conditions has to have access to what the supervisors know about their banks.

My own view is that if central banks are not in charge of prudential supervision, they should at least have an important role in this process. I know that supervisory agencies may be hesitant to share supervisory data, often for reasons of banking confidentiality, but this is something which can be addressed. This engagement should exist in both normal and crisis times, and of course, this ability should be accompanied by the responsibility to take timely action and accountability in case of a failure to do so.

A Final Word

Returning to the theme of procyclicality, not only is regulation procyclical but so are, or potentially can be, regulators—regulatory responses tend to follow the cycle as well. A delicate balance is required not to over react to the events and swing from one extreme to the other.

Banks are ahead in innovation, regulation takes time to catch up. It is but natural that some regulatory changes will, and must, occur in the aftermath of any major stress event, but I would caution that these be implemented carefully with a close eye on any unintended effects. More than regulation, I would argue, it is the practice of supervision that needs to be strengthened. I share the view that supervisors had most of the regulatory tools that they needed in order to address the fault lines, but appear to have been overwhelmed by the external environment.

At the same time, there is no doubt in my mind that supervisors face an increasingly difficult task in the coming years. Our work has shown that key preconditions for effective supervision such as operational independence, capacity and resources continue to be under strain in many jurisdictions around the world even as the practice of supervision becomes more complex as it mirrors developments in the financial markets.

Supervisors are always surrounded by a plethora of red flags—and the challenge lies in telling the red from the pink; prioritizing responses to these flags and allocating scarce resources accordingly. While advances in risk identification and measurement will help; there will be no substitute for expert judgment built upon years of experience in hands-on supervision of institutions and markets. Developing these capacities is, and will remain, the greatest challenge for supervisors worldwide.

In conclusion, I would like to summarize my observations on the three themes that I have discussed. Simply put, capital, accounting and valuation, and central banks all matter greatly for our understanding of lessons and opportunities arising from the turmoil. I am sure that you will hear more on these three broad themes from other speakers in the sessions that follow. I am confident that you are well poised to respond to these issues and identify solutions for your jurisdictions and we stand ready to work with you as you face these challenges.

Thank you.