Speech

Opening Remarks at the High-Level Meeting on "The Emerging Framework for Financial Regulation and Monetary Policy" by John Lipsky, First Deputy Managing Director, IMF

April 23, 2010

Good morning, and welcome to this High-Level Meeting on “The Emerging Framework for Financial Regulation and Monetary Policy”. Today’s meeting is the result of a collaborative effort between the Financial Stability Institute of the Bank of International Settlements (BIS) and the Fund’s Institute and Monetary and Capital Markets Department.

As the most severe financial and economic crisis of the Post WWII era is winding down, the world’s attention has turned increasingly to the design and implementation of a new financial landscape in a post-crisis world. The G-20 leaders, working with the IMF, the Financial Stability Board (FSB) and other standard setting bodies, are proposing a series of reforms devoted to reshaping the regulatory and supervisory environment. Today’s program will provide an important forum to discuss the reform proposals, their implications for policy setting, and their impact on the economy and the financial system. I hope that the ideas generated here will inform the debate that is going on in many capitals of the world.

In my remarks this morning, I will address the challenges for a new financial regulatory framework and the role of monetary policy in preserving financial stability.

Clearly, the primary source of the financial crisis was the action of financial market participants. Many of the largest banks and financial intermediaries, through weak risk management, built up enormous leverage that was funded through the wholesale markets. Capital standards were less than stringent and insufficient attention was paid to liquidity and credit risk outside the banking book. Moreover, many of the institutions that were the source of the problems fell outside the perimeter of the existing regulatory framework.

At the same time, the crisis demonstrated vividly that the existing micro-regulatory and supervisory frameworks were inadequate. To reduce the likelihood of future crises, banks clearly will be required to hold more--and higher quality, capital, and to better align required capital with risk. Equally important, banks need to hold sufficient liquid assets as insurance or as a buffer against funding shocks—simply monitoring liquidity risk is no longer adequate. Financial institutions also will need more robust risk management systems, accompanied by a culture of strong corporate governance. Financial disclosure that is both accurate and informative should be required to enhance transparency and strengthen market discipline.

The crisis also demonstrated the importance of regulators augmenting their monitoring of the financial health of individual institutions by appending macro-prudential elements to their toolkit. In particular, regulators need to have a better understanding of the exposure and interconnectedness of systemically important financial institutions, both to each other and to the nonbank financial sector. They also need to develop rules to counter the financial system’s naturally procyclical tendencies.

Discussion of these issues in international fora such as the G-20, the IMF, the FSB, and the various international standard setters is fairly advanced, including proposals for countercyclical capital buffers and through-the-cycle provisioning requirements. There is less progress and consensus, however, on the issue of how best to address the issue of “too-important-to-fail” (TITF) institutions or how to address risks arising from the interconnectedness within the financial system.

Of all the regulatory/legal challenges highlighted by the crisis, the issue of “too-important-to-fail” (TITF) institutions perhaps has the highest profile. The last-minute resolution of some firms, the unexpected failure of others and the massive “bailouts” provided in still other cases has made clear the need for progress. Agreement on how best to address this problem has not yet been reached although there is a broad consensus that no institution should be allowed to be in a position of being either too big or too interconnected to fail. A range of preventive measures are being considered, such as special capital and liquidity requirements related to the institution’s size and systemic importance, as well as special resolution regimes and a requirement for systemically important institutions to prepare “living wills.”

A potential additional tool—ne that the G-20 asked the Fund to assess—would be a levy on the financial sector in order to make “a fair and substantial contribution toward paying for any burdens associated with government interventions to repair the banking system”. To the extent that such a charge was risk-based, it could help to discourage financial institutions from taking on excessive risk. It would also ensure that financial institutions contribute to the fiscal costs associated with financial sector failures and therefore, address the public policy concern that financial institutions are able to privatize gains but socialize costs arising in the financial sector.

Many of the TITF institutions are internationally active, raising important issues associated with their cross-border operational structure. The failure of TITF institutions in this crisis has put under scrutiny the roles of home and host country supervisors, the sharing of the cost of failures between home and host countries, and the pros and cons of foreign banking operations taking the form of branches versus subsidiaries. As a result, the potential conflicts that may arise when cross-border banks with extensive international operations are supervised, regulated—and in the event of a failure—resolved at a national level have been given high profile.

Addressing this challenge will require actions on two fronts—coordinating preventative supervision and developing robust resolution regimes. The establishment of supervisory colleges for large, internationally active financial institutions represents the first steps taken in the direction of preventative supervision. But this alone is not sufficient, and there needs to be active engagement and interaction of the supervisory colleges.

The gap in current cross-border arrangements reflects the lack of agreement on insolvency frameworks and resolution regimes. Such frameworks often represent strong national interests and are integral parts of national regulatory and legal traditions. These may be technically difficult and politically controversial to change, so progress in this area will require strong political will. The need for greater compatibility in cross-border resolution frameworks has been recognized for many years, but the crisis has shown that the time has come for action.

I should emphasize that while regulatory reforms are critical to building a more resilient financial system, sound regulation has to be accompanied by an effective supervisory regime. Of course, supervisors and regulators do not live in a vacuum. Supervisors have to function in the real world, where politicians’ objectives may not always be aligned with those of supervisors. Nonetheless, political support for strong and effective supervision is an essential component of serious and lasting reform in the financial sector.

In any case, supervisors must ensure that institutions comply with the underlying objectives as well as the letter of the regulation; weaknesses in the institutions’ systems must be identified promptly and addressed appropriately to prevent them from spreading. Broadly, an effective supervision regime should have the following components:

• Clear objectives and mandates, sufficient operational independence and adequate resources.
• An appropriate mix of supervisory approaches and techniques, including on and off-site work focusing on identifying emerging risks both at the firm level and system-wide.
• A broad range of remedial actions that can be taken if regulated firms do not play by the rules, and an approach combining rules-based actions with supervisory judgment.

Of course, the proposals have cost implications for the financial system. Therefore, an important criterion for evaluating the impact of reform proposals should be that they achieve a balance between introducing more constraining regulation and supervision to limit prospective risks, while at the same time meeting the objective of maintaining the financial system’s ability to innovate, to allocate capital effectively and to pursue promising investment opportunities. The reform proposals should be internationally coherent, in order to reduce the risk of disjointed policies, distorted capital flows and regulatory arbitrage.

Let me now turn to the role of monetary policy in preserving financial stability. Before the crisis, macroeconomists and policymakers generally agreed that keeping inflation low and stable—and keeping public debt sustainable—were critical elements for economic success. Indeed, since the late 1980s there had been a substantial decline in inflation in both emerging and advanced economies, and inflation rates became increasingly stable and less dispersed across countries. At the time, this was generally attributed to central bank independence and to the enshrinement of price stability as the overriding monetary policy objective.

The decline in inflation was accompanied by decreasing global macroeconomic volatility. The perception of low risk translated into lower volatility in financial markets and led many to believe that financial stability had been achieved in a durable manner. As the crisis has shown, however, vulnerabilities and threats to macroeconomic and financial stability may develop even under a seemingly tranquil surface of stable prices, relatively healthy public finances and low financial market volatility.

Many tenets of the pre-crisis consensus—notably low inflation and fiscal discipline—remain valid, but others need to be reassessed. In particular, the crisis has raised the issue of whether financial stability—including asset price performance—should be an explicit goal of policy, and if so, how it should be achieved. In that context, the following points are important to consider:

• It has been noted that monetary policy is a blunt (and possibly ineffective) tool to deal with specific financial risks, so restoring and maintaining financial stability should be achieved mainly through an enhancement of a prudential regulatory framework with a systemic (macro-prudential) dimension.
• While monetary policy should remain geared toward maintaining price stability, policymakers should take into account macro-financial linkages and the risk of financial imbalances. In particular, they should consider the possible impact of interest rate decisions on financial stability.
• Financial regulators and central bankers alike should take into account the systemic consequences of monetary policy actions, such as the higher risk-taking and increased leverage resulting from a period of low interest rates in a low inflation environment like the one that preceded the current crisis.

Let me close by thanking you for joining us today, and I welcome you to what I am sure will be an engaging and fruitful day of discussions.