Speech

"The Global Financial Sector—Transforming the Landscape" By Christine Lagarde, Managing Director, International Monetary Fund

March 19, 2013

As prepared for delivery

Bonjour! Guten Tag ! Good day. It is a pleasure to be back in Germany and to be a part of this year’s Frankfurt Finance Summit. I would like to thank Dr. Lutz Raettig, the Chairman of the Board of Frankfurt Main Finance, for inviting me to participate.

Let me also thank Jens Weidmann for his very kind words of introduction. It is indeed an honor to speak today about financial sector reform, here in Frankfurt—for centuries the center of commerce and finance in the heart of Europe.

This year’s Summit examines “how regulation and crisis management will change the world’s financial landscape”. This is exactly what we are all working towards: a new financial landscape.

History shows that financial crises often alter the financial sector landscape. The terrain that emerges usually features restructured balance sheets, a stronger regulatory framework, and often a different population of banks. We can point to examples such as those in the Nordic and Asian countries after crises in the 1990s.

But there are also examples where there was little fundamental change, or where improvements weakened over time as the architecture failed to keep up with innovation. Take the United States ─ barely 20 years had elapsed between the resolution of the Savings and Loan crisis and the sub-prime debacle. While these were vastly different crises, as were their spillovers (unfortunately), real estate lending and the failure of regulation and supervision were common denominators. The industry did not learn the right lesson.

Here we are, more than five years into this crisis; has the “landscape” been transformed? In other words, have we built a stronger system?

Not yet. We have made progress, but there is more to do

Our job today as policymakers and regulators is to bring about change that is more effective and permanent; that results in a robust set of banks and also reduces the frequency and severity of systemic busts.

I would like to focus today on what we believe is needed to bring this about. Each is a necessary, but on its own, not sufficient condition for successful transformation.

1) Global regulatory reform─how close are we to a solid set of rules?

2) Balance sheet repair and banking union ─necessary and worthwhile

1. Global Regulation: Reform and Reinforce

Policymakers and regulators around the world and in Europe have laid out a comprehensive reform agenda. Many long nights were spent burning the midnight oil to negotiate agreements on regulation. I participated in just a few of those “nuits blanches”. I can tell you, what Otto Von Bismarck said is true: “Laws are like sausages, it is better not to see them being made.”

But the sausage-making did happen, and has produced some historic achievements. Agreements on global bank capital and liquidity regimes, and FSB standards on Effective Banking Supervision and Resolution Regimes are major steps forward. Here in Europe, deeper policy commitments have greatly reduced near-term stability risks.

My main concern is that progress is uneven. This risks un-doing some of our achievements.

The pace of implementation has been adjusted intentionally to support banks on the mend, but delays also reflect difficulties in agreeing on the way forward, and pushback from industry averse to changing outmoded and dangerous business models.

Let me address some of the key regulatory issues, beginning with bank capital and liquidity:

Capital and liquidity

Much has been done both on capital rules and liquidity standards as well as setting capital surcharges for globally systemically important banks.

We are, however, worried about uneven implementation of these rules, particularly the delay of Basel III in major jurisdictions. Different rates of implementation could contribute to dilution of overall minimum standards. These delays affect longer term business decisions, straining credit markets and spilling over to the real economy.

The IMF is also worried about national differences in the calculation of the riskiness of assets—the very basis for determining the capital needs of all banks, and the success of the new rules. Recent studies by the U.K. authorities, the Basel Committee, and the European Banking Authority have found a wide variation in bank risk weights with similar risk profiles. In an interconnected world, the lowest common denominator is connected to all.

Accounting

Progress with accounting standards is also mixed. For example, on this same issue of risk measurement, the two main accounting bodies, the International Accounting Standards Board and U.S. Financial Accounting Standards Board, have not reached agreement on a common approach for asset impairment, that is, whether to base it on expected or incurred losses.

This is not just an academic exercise. As you know, it materially affects the assessment of asset quality and valuation, which of course informs investors and regulators about an institution’s financial strength.

Too big to fail and resolution

What about resolution and the big banks? The FSB led the initial progress, and the United States and the United Kingdom recently moved forward on coordinating contingency plans when winding down failing cross border banks.

But some banks are still considered “too-important-to-fail,” due to their size, complexity, and interconnectedness. This is unacceptable.

The IMF estimates the implicit subsidy available to big banks in terms of lower borrowing costs at about 0.8 percentage points. Others have used this to derive a dollar figure for the five largest banks in the U.S. of about $64 billion, roughly equivalent to their typical annual profits — a gift from the taxpayer. While this may be a simplistic approach, it highlights the social dimension of the issue.

Pressure to address the moral hazard from this problem and facilitate resolution has fostered the development of regional initiatives to legislate banking activities or ring-fence operations, such as the Liikanen, Vickers and Volcker proposals, and the soon-to-be legislated German and French reforms. While well-intentioned, these separate plans could undermine common goals of harmonizing global standards if they are not well coordinated.

The bottom line is that we have yet to fix “too-big-to-fail”.

We need to forge ahead on three fronts to address the root cause of this problem: (1) regulation, like systemic surcharges; (2) intensive supervision; and (3) frameworks for orderly failure and resolution, nationally and across borders.

In the coming months, jurisdictions need to spell out plans to resolve each systemic institution, regardless of its size, inter-connectedness and complexity. In addition to cross-border collaboration arrangements, this requires an ability to impose discipline on the managers, shareholders and junior debt holders of large failed banks, using bridge banks or other resolution tools to preserve the liquidity of borrowers, depositors and other counterparties.

Over the counter derivatives

Progress on reform of derivative markets is too slow. We all agree that wider use of clearing houses—central counterparties—will raise transparency of over-the-counter markets and make the system safer. However, no authorities have met the deadlines to implement reforms.

First, available data shows that the increase in the value of centrally cleared contracts has been modest. For example, as of September 2012, only 10 percent of all credit default swaps were contracted through central counterparties. Second, data is limited, and almost nonexistent for commodity, equity and foreign exchange asset classes. This is a problem we need to address.

Recent headlines suggest that banks’ internal risk management systems are not keeping up with derivative innovation. For example, the loss by JP Morgan Chase of over $6 billion in the so-called London Whale case demonstrates the daunting complexity of assessing risks in these big institutions, and the glaring failure of risk managers and policymakers in this area.

Shadow banking

Back in 2009, when I was with the G-20 Finance Ministers, we made the point that regulation needed to cover “all markets, all products, and all operators”

On shadow banking, however, I am afraid there is not much progress to report. This is worrisome since regulators were largely in the dark before the crisis hit and since then, I suspect that funds have been migrating to new unregulated activities. For example, we have anecdotal evidence—because there is no official data—that trading is moving to unregulated hedge funds.

While “Guidance” on the monitoring and regulation of money market funds has been published, there is little consensus on actual implementation. There is other work in the pipeline at the FSB, but we need to see more concrete progress.

Compensation

Compensation? This has been in the headlines lately, particularly in Europe. Mark Carney stressed recently that “an important lesson from the crisis was that compensation schemes encouraged individuals to take on too much long-term risk and tail risk”.

From a financial stability perspective, the level and structure of compensation must align incentives with risk profiles, and ultimately with performance. The common goal here is to make sure that the structure of compensation curbs incentives for excessive risk taking.

The financial sector has a duty to live up to the highest ethical standards. To that end, the FSB forged consensus on compensation practices some time ago. We fully support these principles and encourage all jurisdictions to implement them.

Impact in Europe

Together with Outright Monetary Transactions and other liquidity support from the ECB, these reforms have helped to calm markets, particularly in Europe. Borrowers, however, particularly small business and households, have not yet felt the impact, and rates of lending to the real economy have not yet incorporated this framework of stronger discipline, nor the path towards banking union.

Some financial systems are still facing pressure and negative feedback loops between sovereigns and the real economy continue.

To fix this, troubled banks need to be recapitalized or wound down. This brings me to the second aspect of a new landscape—balance sheets.

2. Balance Sheet Repair and Banking Union – Necessary and Worthwhile

Balance Sheet Repair: The Missing Link in the Quest for Recovery

It is possible that delays in agreement on regulatory reforms reduced the drive to deal with needed balance sheet repair and bank resolution. Or has insufficient balance sheet repair acted as a brake on reform progress?

Either way, we need to move beyond this chicken and egg question and tackle both balance sheet repair and regulatory reform simultaneously. Further progress on the regulatory reform agenda is essential, but to get credit flowing in support of a recovery, banks have to be in a financial position to respond.

Again we can point to some progress: U.S. and European banks have substantially increased their capital ratios. During 2007-2012, the number of credit institutions in Europe declined by about 5 percent (20 banks were resolved and 60 banks have undergone deep restructuring).¹

But more needs to be done. Many banks are still shackled by the leftover effects of the crisis. This is the weak link in the chain of recovery.

We still see fragmentation in funding conditions—a direct result of concerns about the quality of bank assets—which is impairing the credit transmission to the real economy. In addition, peripheral euro area banking systems remain relatively weak, with capital buffers still low relative to impaired assets.

These banks are less able to absorb losses, which worsens the drag on new lending. This chokes off credit to viable firms and reinforces weaknesses in corporate sectors, perpetuating “zombie” companies as well as zombie banks.

There is a way out of this adverse spiral: clean up balance sheets and use a common backstop—the European Stability Mechanism (ESM)— for systemic cases. Enhanced disclosure and credible asset quality reviews will help restore confidence and banks should be urged to deleverage by raising equity and cutting business lines that are no longer viable.

Country authorities and the Single Supervisory Mechanism (SSM) should undertake selective asset quality reviews.

For direct recapitalization by the ESM, modalities and governance arrangements should be established as soon as possible.

Banking Union in Europe—Necessary and Worthwhile

Of course this is part of the bigger picture─full banking union in Europe. What exactly do we mean by “banking union”? We mean a single supervisory and regulatory framework, a single resolution mechanism and resolution authority, and a common safety net that includes deposit insurance and lender of last resort capabilities.

This integrated oversight framework is the logical extension of an integrated banking system, but it also plays a central role in the global process of transformation. In many ways it represents a microcosm of the aims of the global regulatory reform agenda.

Banking union will move responsibility for supervision and potential financial support to a shared level which would help contain systemic risks and curb moral hazard. This would remove destructive incentives for deposit flight and fragmentation, and weaken the vicious loop of rising sovereign and bank borrowing costs.

The IMF recently released two important papers on these issues, including last week the inaugural Financial System Stability Assessment for the European Union. And I would encourage you to take a look at them.

Let me first recognize the considerable progress on banking union so far: agreement on the Single Supervisory Mechanism; proposals by the EC to harmonize regulations on capital (CRR─the Capital Requirements Regulation, and CRD-IV, the Fourth Capital Requirements Directive), on resolution regimes, and for national deposit insurance schemes; agreement to draw on the ESM to recapitalize banks, with ECB supervision; and finally, commitment to a Single Resolution Mechanism with backstop arrangements to recoup taxpayer support over time.

“To do” list

Policymakers need to plow ahead with their “to do” list. Recent agreements are major steps towards a new landscape, but follow through will be critical. This means swift adoption of the various directives, and ensuring that they are in full compliance with global accords, namely Basel III and the FSB “Key Attributes”.

Other priorities include endowing the single supervisor with requisite resources and authority; implementing the common resolution and safety nets with a coherent, credible backstop; and setting up the resolution authority and insurance fund with access to common backstops.

Full embrace of this Union-wide architecture is needed to ensure durable financial stability, but also to sustain the currency union and the single market for financial services in Europe. This includes severing the link between weak sovereigns and future banking sector risks, otherwise, the impact of new rules and institutions on economic growth, and on the citizens of Europe, will be limited.

Conclusion: enlightened stewards of the financial system

Let me conclude: I asked earlier if the financial landscape been transformed? I would say not yet. I believe that we are making progress, but it is mostly in the wiring and the plumbing—essential elements of a solid structure, but under the surface. The structure is still half-built and not safe.

Weak banks are still a drag on growth. Balance sheet repair needs to be tackled at the same time as regulatory reform, in a mutually reinforcing manner. Finishing the business in both areas is necessary to reap the fruits of hard-won gains in regulatory reform and to restore the full functioning of the financial sector so that it can do its job of intermediating funds to borrowers and support growth.

I am an optimist, drawing inspiration from Martin Luther, who said “Everything that is done in the world is done by hope.”

…. But I am also a realist. Immanuel Kant, one of the greatest German philosophers, said that “using reason without applying it to experience only leads to theoretical illusions”. The free exercise of reason by the individual was a theme of the Enlightenment.

Hopefully, we are moving toward an “Enlightened” era in global finance and regulation, one based on experience and reason.

¹ European Union: Financial System Stability Assessment, IMF Country Report No. 13/75; http://www.imf.org/external/pubs/ft/scr/2013/cr1375.pdf