Speech

Policy Challenges for the Financial Sector: Evolving Risks, Evolving Response

June 1, 2017

Good Afternoon everyone.

We are delighted to host you here at the IMF today for the “Seventeen Annual Conference on Policy Challenges for the Financial Sector.” [1] In my opinion this is one more example of how collaboration, in this case with the Federal Reserve Board and the World Bank, can produce great outcomes. We value this event immensely, as it offers a unique opportunity to gather central bank governors and senior supervisors from many of our member countries to discuss the financial sector policy challenges we all face.

The theme of this year’s conference is about the changing nature of financial risks and the need to adjust policy responses appropriately. I would like to take a few minutes to explain what, in our view, are these risks and how we should respond.

Complete and Implement Reforms Without Dilution

This morning our Managing Director stressed the need to complete global regulatory reforms quickly and without dilution.

Completing and implementing the reforms is the most promising way to strengthen the financial system. As we, in this room, are well aware, the Global Financial Crisis revealed a number of regulatory weaknesses and many of these have been addressed during the last few years. Results are already visible.

The quantity and quality of bank regulatory capital has improved significantly. New liquidity requirements have enhanced banks’ ability to withstand liquidity shocks. The reforms have also set proportionately higher regulatory standards, supervisory expectations, and resolution frameworks for systemically important financial institutions, thus reducing the likelihood of the materialization of systemic risks and enhancing the ability to deal with them if they do materialize. Although some key aspects remain a work in progress, major progress can also be seen in other important policy areas such as crisis management, shadow banking, financial markets infrastructure and derivatives.

Despite a lot of progress in the regulatory reform toward meeting the policy objectives, it is not, and most likely it will never be, possible to claim victory. There are a number of reasons why, despite regulatory fatigue, efforts need to continue on regulatory reform: 

First, the policy agenda is not yet complete. Work in key areas remains incomplete.  Important examples are: strengthening CCPs (central counterparties)[2], addressing certain vulnerabilities of the asset management industry[3] and reducing risk weighted assets variation of banks capital ratios—the last piece of the Basel III enhancements yet to be agreed[4].

Second, in some policy areas implementation is progressing slowly and at a varying pace across jurisdictions. The implementation of the reforms to crisis management frameworks is one of the areas that I am concerned about. Even with strong regulation and supervision, crises will always come. In order to mitigate the risks associated with crises—most importantly the risk that taxpayers will need to foot the bill—a sound resolution framework, along the lines of the Financial Stability Board (FSB)’s Key Attributes for Effective Resolution Regimes, is critical.

Many of you have gone through the Fund/Bank Financial System Assessment Program, known by its acronym FSAP. One important aspect of each FSAP is thorough assessment of the crisis management framework. Over time we have seen impressive progress but fragilities are still evident.

In many countries, the mandate for resolution is not clear and coordination mechanisms among agencies and authorities are not effective. A lack of independence and inadequate legal protection for supervisors create risks of decisions being delayed or even avoided. Resolution powers are often insufficient. Operational recovery and resolution plans, with appropriate cross border coordination, are available in only very few places.

Supervisors should ask themselves how they would handle the failure of their largest financial institution and not stop working until they get to a satisfactory answer.

The third reason why we can’t consider our policy work done is that new forces shaping the financial system are constantly generating new risks that may require appropriate regulatory responses.

The most striking example of these forces is FinTech. New technologies offer opportunities to unbundle the financial services industry bringing many new players and directly impacting the banking sector. Banks can certainly use FinTech to become more efficient but technology can—and in some places already is—putting more pressure on business models of an industry already under strain.

FinTech developments will also challenge conduct regulation. Consumer and investor protection issues will arise and need to be addressed. It is an old but persistent problem that many consumers and investors may not be able to understand the risks of financial products.

The current discussion on these issues often take for granted a trade-off between regulation and financial innovation. But this is not necessarily true. Smart regulation can actually benefit tech innovation by providing legal certainty and fostering the cooperation among private players. And tech innovation can support strengthened regulatory compliance in some areas. Achieving a strong synergy should be our goal.

The fourth reason is that as with any robust public policy process, an evaluation of the effectiveness of new regulations and some fine tuning to address unintended effects is important. Evidence so far does not suggest reforms had a disproportionate cost to the financial system but a more thorough assessment is necessary as we gain experience.

The FSB has proposed a comprehensive evaluation framework to conduct this assessment. The challenge is to make the framework operational and analyze both costs and benefits. Given the interlinkages between the various post-crisis measures, we caution against a piecemeal approach and recommend a comprehensive review of post-crisis reforms. We should not jeopardize hard-won financial stability achievements 

Improve Supervision

The term “regulatory reform” is not appropriate to cover all the initiatives that aim to address lessons from the Global Financial Crisis.

The Global Financial Crisis has revealed weaknesses not only in regulatory frameworks but also, more broadly, in the supervision framework. Quite often supervisory powers, resources and processes were not enough to allow appropriate assessment of risks and timely action to reverse unsustainable practices. The supervisory attitude had become increasingly laissez faire and “light touch”. But the experience of the Global Financial Crisis changed the understanding about supervisory work. The post-crisis consensus is that supervision needs to be more comprehensive and intrusive. Good supervision requires learning to say “no”.

This new vision for bank supervision was consolidated in the revised Basel Core Principles for Effective Banking Supervision. The core principles are a framework of minimum standards for sound supervision and regulation practices that are universally applicable. The proportionality approach embedded in the methodology of the principles allows implementation and assessments commensurate with the risk profile and systemic importance of a broad set of banks. Thus, the BCP are a very useful tool for countries to assess the quality of their supervisory systems.

Most countries are aware of the importance of supervision and are making efforts to improve it. But, again, FSAPs have revealed common weaknesses that can undermine the effectiveness of the supervisory process. These weaknesses include:

• Weakness in institutional framework. Supervisors may have mandates that do not give sufficient weight to financial stability. They may suffer a lack of operational independence or effective legal protection, which in turn prevents timely corrective actions. We all know that this is a difficult area and the FSAPs reflect the struggle many of you have.  Our Basel Core Principles assessments reveal that only very few of independence-related principles across countries are rated as “compliant” without qualification.
• Lack of skilled resources. The foundation of supervision is sound supervisory judgment. Supervisors need to understand and be able to rigorously question and challenge industry practices to ensure robust risk management and effective implementation of regulations. This difficult task requires strong technical skills and experience in dealing with financial institutions that many countries do not have.
• Inappropriate credit risk standards and enforcement. Standards for credit risk management are often weak. Many supervisors need to take a more active role in assessing loan classification to underscore prudent provisioning practices. Authorities need to develop the capacity of supervisors to challenge bank management valuation of loans and should provide banks with conservative guidance on loan classification.
• Weak corporate governance. We have found that in many cases, Chief Risk Officers are not senior enough in the bank hierarchy and do not have appropriate incentive to flag risks to the board.  Banks’ Board of Directors need to play an active role in the risk management framework. They should be held accountable for the effectiveness and independence of the risk management function within banks. This is key to create the preconditions for sound business practices and reliable supervisory data.

The self-assessment of supervision compliance with the Basel Core Principles is a very useful exercise that helps to create a road map to sounder supervisory practices.

Financial Stability versus Credit Provision

Let me conclude by commenting on a growing tension that we have seen in some countries. After a long period of strong, and sometimes excessive, credit growth, some jurisdictions are experiencing a credit slowdown.  Accustomed to the “feel good” factor that exists in credit booms, there is a temptation of trying to prolong the boom phase of the cycle by relaxing prudential requirements.

We certainly agree that a sustainable deepening of the financial sector can help tackle developmental needs and that policies for the financial sector should promote effective, deep, and inclusive financial markets.

But policies for achieving financial deepening and greater inclusion should not give rise to undue stability risks. Sacrificing prudential regulation to boost credit in the short term rarely pays off: Healthy and stable credit provision is underpinned by resilient and well-capitalized banking systems. Structural and legacy issues, and not prudential regulation, are often the main impediment for sound credit provision.

Policies to increase financial deepening should focus on improving fundamentals: creditors’ rights; cost efficiency; legal and regulatory frameworks; taxation and financial literacy. These issues are complex and require time to achieve meaningful results, but they are the best way forward.

Thank you.

[1] The conference was organized jointly by the Board of Governors of the U.S. Federal Reserve System, The World Bank Group, and the International Monetary Fund.

[2] CCPs become a crucial part of the strategy to reduce systemic risks but, as discussed yesterday, important work to increase the resilience, conduct stress tests, assess interconnection, and develop recovery and resolution plans still need to advance.

[3] Work to address structural vulnerabilities of asset management, particularly in relation to maturity mismatches, liquidity and leverage are ongoing, but are only expected to be completed next year.

[4] Strong differences on the calibration of the capital floor has delayed the completion of the Basel III framework.