Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey: Prevent Institutions Becoming Too Important to Fail, Says IMF
April 24, 2010
- No agreement yet on how to address the problem
- Tax on financial sector could help
- International coordination needed for best results
Policymakers, learning lessons from the global financial crisis, agree that in the future no financial institution should be considered too important or too connected to others to fail, according to the IMF.
Oversight of financial system must ensure that financial institutions comply with both intent and letter of regulations (photo: Newscom)
IMF SPRING MEETINGS
Agreement on how best to fix this problem has not yet been reached, but a number of possible solutions are in the works, said John Lipsky, First Deputy Managing Director of the IMF, in a speech April 23 during the global lender’s Spring Meetings in Washington, D.C.
Speaking at a day-long meeting on financial regulation and monetary policy, Lipsky’s remarks highlighted the IMF’s views on preventing institutions from becoming too important to fail, which were also outlined in a chapter of the Global Financial Stability Report.
Capital, liquidity requirements
A number of measures to prevent institutions becoming too important to fail are being considered, including higher capital and liquidity requirements tied to a financial institution’s size and importance, as well as adoption of legal regimes that provide for the orderly resolution of failing institutions.
One potential tool that would complement these regulatory reforms, according to Lipsky, and one that the G-20 group of advanced and emerging economies has asked the IMF to assess, would be a levy, or tax, on the financial sector.
To avoid overburdening financial institutions, any tax or levy would need to consider the impact of the higher capital and liquidity requirements. If such a charge was risk based, it could help discourage financial institutions from taking on excessive levels of risk. It would also make financial institutions contribute to the costs associated with bank failures, said Lipsky.
Lipsky said that while the crisis laid bare the inadequacies of financial regulation and supervision, the main source of the financial crisis was the action of market participants. To help avoid future crises, Lipsky said banks will be required to hold more and higher quality capital, as well as more liquid assets to serve as insurance against future shocks to the financial system.
The global impact of the collapse of “too-important-to-fail” financial institutions has highlighted the issues that arise from the national regulation of cross-border banks, and exposed gaps in current arrangements. Lipsky said the crisis has shown the time has come to design rules and resolution regimes to better address failed cross-border financial institutions.
Stronger supervision
Lipsky said reforms to financial regulation must be accompanied by stronger supervision— that to be effective, regulations must be properly implemented. Stronger supervision would require
• a clear mandate and independence for supervisors
• identifying risks to the financial system as well as individual firms
• corrective action if firms do not play by the rules.
Lipsky said political support for strong and effective supervision is an essential part of any serious and lasting reform of the financial sector.
Oversight of the financial system must ensure that financial institutions comply with both the intent and the letter of regulations, and any weaknesses in a firm must be caught and fixed quickly, to prevent them from spreading.
The reforms should be evaluated to achieve a balance between limiting risk, and allowing the financial system to innovate, allocate capital, and pursue investment opportunities, said Lipsky.
Still waters run deep
Lipsky said the recent crisis has shown that threats to economic and financial stability may develop under a seemingly tranquil surface of stable prices, healthy public finances, and steady financial markets.
While many of the basic tenets of the pre-crisis consensus on monetary policy—particularly low inflation and fiscal discipline—remain valid, said Lipsky, others need to be re-examined.
The crisis has raised the issue of whether financial stability, including the performance of asset prices, should be an explicit goal of monetary policy.
In this context, Lipsky noted a number of issues to consider, including achieving financial stability through a prudential regulatory framework, rather than through the more blunt instrument of monetary policy. Policymakers should also consider the impact of interest rate decisions on financial stability, while regulators and central bankers should take into account the consequences of monetary policy actions on the overall financial system.