Speech

National, European, or global? The future of bank regulation, Remarks by Dominique Strauss-Kahn, Managing Director, International Monetary Fund

November 24, 2009

As prepared for delivery (speech was given in French)

I am delighted to be here with you this afternoon, and share my thoughts on the future of bank regulation. As you have already spent a day and a half discussing many of the finer points of the future of banking, I will take a more “big picture” approach to some of the key issues related to regulatory reform.

I’ll begin with some thoughts on what the financial sector of the future should look like—given the objective of making it more stable and less risky. This will lead to my second topic, namely the regulatory reforms needed to foster the development of such a financial system. I’ll then focus more specifically on a few aspects of the regulatory reform agenda. And fourth, I’ll explain the contributions that the IMF can make to this effort.

So, how would we like the financial sector to evolve?

The financial sector clearly plays a critical role in enabling economic growth, by matching up savers and investors in a way that is value-enhancing.

But in the wake of the crisis, it is now widely accepted that in some countries, the financial sector has grown too large. It has gone well beyond its core function of financial intermediation, and devoted much energy to financial engineering—generating products that have been profitable for the industry, but of more doubtful value to the economy as a whole.

It seems clear that the financial system of the future needs to take on less risk and to manage this risk better, making it less prone to crisis. We need financial institutions to perform their key role of intermediation efficiently and safely. Ultimately, a smooth functioning financial system will be an important underpinning of stable and sustainable economic growth.

Probably, this means that the financial sector will account for a smaller share of output going forward, at least in many advanced economies. Of course in developing and emerging market economies, where financial development remains important for boosting economic growth, we may still see the financial sector rise as a share of GDP.

This leads me to my next topic, namely the regulatory reform agenda.

What regulatory reforms are needed to encourage the development of a safer, more stable financial system?

While we can identify many factors that contributed to the crisis, one key failing almost by definition was inadequate regulation and supervision. Even where appropriate regulation was in place, implementation and enforcement could have been much stronger. With the regulatory environment focused on risks of individual institutions or markets, the potential for a buildup of systemic risks was not sufficiently appreciated.

Supervision problems also played a role. It is fair to say that in some jurisdictions, there was an inclination towards “the private sector knows best”, which led to serious lapses in oversight. Political economy considerations also presented problems, for example where the objective of increasing home ownership was allowed to trump prudence in lending.

Policy makers around the world are working hard to devise a new regulatory framework that strikes the right balance, and in particular avoids these two risks:

• That our reforms overburden the financial system with excess regulation and unintended consequences.

• At the other extreme, that the reform agenda is too timid or is stalled, as the economy recovers and the momentum for reform loses steam.

Valuable progress has already been made on several fronts—strengthening prudential oversight, improving risk management, increasing transparency, promoting market integrity, and reinforcing international cooperation.

But the reform agenda remains significant. In particular, we need to rein in excessive risk taking and correct the procyclicality of accounting standards. Both of these were critical enabling conditions that allowed the financial crisis to occur.

The international community has highlighted a number of key reform objectives:

• Developing international rules to improve both the quantity and quality of capital and to discourage excessive leverage.

• Reforming compensation practices, so that compensation is much better aligned with long-term value creation rather than excessive risk-taking.

• Enhancing over-the-counter derivatives markets to improve transparency, mitigate systemic risks, and protect against market abuse.

• Addressing problems related to cross-border resolution issues and systemically important financial institutions.

I’d like to discuss three reform challenges in particular: first, how to deal with systemically important financial institutions; second, the possible role of financial sector taxation; and third, the importance of strengthening international coordination.

Systemically important financial institutions

There already is a lively debate on how to address the problems presented by systemically important financial institutions (SIFIs)—those considered “too big to fail”.

The support provided by governments to SIFIs over the last two years was clearly essential for saving the financial system. However, it has led to several problems. First, the risk of moral hazard has increased, to the extent that management, staff, creditors and borrowers now assume that any SIFI will get bailed out. Second, the bailouts have come at a large cost to taxpayers (though as public support is repaid, the net cost may be considerably smaller). And third, there is a problem of basic fairness, as well-run financial institutions have to compete with firms receiving government support.

A number of proposals have been put forward to deal with these problems.

Some have focused on the size and permissible activities of financial institutions. For example, Mervyn King of the Bank of England and former Fed Chairman Paul Volcker advocate a return to a narrower concept of banking. Others have focused on the role of enhanced regulation and supervision. Here, proposals include subjecting SIFIs to higher capital charges (to reflect the greater risks they pose to financial stability), and having such financial institutions prepare “living wills”.

But the fact is that in spite of our best efforts, we are unlikely to be able to prevent all future financial crises. This is why we must create a resolution regime that is flexible enough to handle the failure of a systemically important financial institution. What really matters in terms of systemic impact is not so much the size or connectedness of the failed institution, but the way the government manages the failure and resolution.

We should also develop special resolution mechanisms to handle systemically important nonbank financial institutions that get into trouble. As we learned during this crisis, such institutions can present tremendous risks to financial stability.

Financial sector taxation

Let me turn now to another “hot topic”, namely financial sector taxation. The IMF has been asked by the G-20 to consider how the financial sector might contribute to the burdens associated with government interventions to repair the banking system.

At the outset, it is important to remember that the issue should be considered within the context of the overall burden—of taxation and regulation—on the financial sector. This burden should not become so heavy that it hampers its efficient contribution to economic growth and well-being.

We intend to review the range of options available to address this issue, and also to take a broad perspective, which includes evaluating the trade-offs between taxes and regulation on the financial sector.

In assessing the options, our work will be guided by two objectives. First, how can we make the financial system safer, so that it poses less systemic risk? And second, what can be done to reduce the financial burden on taxpayers of a financial crisis—and address legitimate goals of fairness and equity?

This is clearly an important issue that deserves careful thought and broad-based discussion. We at the IMF will be consulting widely, with the financial sector as well as civil society, before making our initial report to the G-20 next April.

International coordination of financial regulations

It is understandable that supervisory authorities should focus on the health of domestic financial institutions and protecting domestic customers. But there may be times when putting broader concerns first may actually be in the best interest of all affected nations.

This is why we need an agreed framework of cooperation for dealing with cross-border firms. This applies also to reform efforts underway here in Europe. I see four essential areas where such cooperation is needed: regulation, resolution tools, depositor and investor protection, and enhanced information sharing.

Regulation. One of the key lessons of the crisis is that we must reduce the scope for regulatory arbitrage. Key aspects of prudential regulation must be applied consistently across countries and across financial activities.

Resolution tools. It will be very important to agree on common criteria for triggering early action when a financial institution gets into trouble. While we should expect frameworks to differ across countries, it will be important to get systems in place that allow for a rapid and relatively straightforward resolution.

Depositor and investor protection. The framework should bring some consistency to the amount of protection given to depositors and investors, and should feature explicit coordination principles.

Enhanced information sharing. Home and host country supervisors must be granted clear legal obligations and powers to share information amongst themselves in a timely fashion, and also with local counterparts, leaving open the possibility of joint inspections. The supervisory colleges set up by the Financial Stability Board have already taken important steps in this regard.

Now what is the Fund’s role in regulatory reform?

Let me be clear that we are not a global financial regulator—nor do we aspire to be! That is obviously the responsibility of national regulatory and supervisory agencies—and in the future, perhaps also of regional agencies. The FSB is also a critical player in developing and implementing regulatory, supervisory and other policies in the interest of financial stability.

Having said this, we do take very seriously our responsibility to support national and multilateral efforts to strengthen financial regulation. We are contributing to the formulation of new regulations. Here I see an important role for us as an “objective and honest broker”, to help resolve differences that may arise between countries as they seek to agree common standards. We are also contributing our extensive knowledge of how well these standards work on the ground in our member countries.

But our main role involves monitoring the implementation of the agreed framework through our surveillance. And we have stepped up our monitoring of the adoption and implementation of new standards and regulatory changes as part of the evolving framework of macroprudential supervision, in line with the G-20’s request for us to do so. We are working to make the Financial Sector Assessment Program more nimble, and the assessments of financial standards more risk-focused. This will enable us to sharpen our focus on key implementation issues and undertake more thematic assessments.

We also provide extensive technical assistance in the area of financial regulatory reform, and thus can support our member countries as they implement the agreed framework. For example, the Fund will be able to provide assistance as countries introduce more flexible resolution frameworks that allow them to deal with complex financial institutions.

Finally, we are also sharpening the focus of our surveillance on systemic risks. For example, we have developed, in collaboration with the FSB, an Early Warning Exercise that covers both advanced and emerging market economies. I am hopeful that this new tool—and others in development—will strengthen our ability to see the risks coming down the road, and provide fair warning.

Closing thoughts

The financial reform agenda is without doubt challenging and complex, and meaningful progress will take time. But I do worry that as the economy recovers and financial markets normalize, the urgency of reform engendered by the crisis will wane—and with it, possibly, the commitment to make the regulatory changes required to foster the development of the financial sector that we wish to have.

I believe it is critical for us to move with speed and determination to reform the financial regulatory framework, and thus reduce the risk of future financial crises. For it is clear to me that the citizens of the world will refuse to pay for another bail-out. They will probably respond instead with calls for protectionism, which would reduce international cooperation.

We cannot allow this to happen. We have gained too much from our increased global interconnectedness to see these gains disappear on account of our lack of effort.

It would indeed be a tremendous loss if we missed this historic window of opportunity to revamp the financial sector framework. We must act now to build a safer, more stable financial system that can support sustainable economic growth over the long term.

It has been a pleasure speaking to you this afternoon. Thank you for your attention.