While the short-term challenges that threaten the system are real, and should be dealt with promptly using a variety of policies, it would be wrong to let them weaken our commitment to financial reform
Dismissing calls to weaken or reconsider global financial reforms in the face of short-term setbacks in global recovery, Jaime Caruana, General Manager, Bank for International Settlements, argues that it is more important than ever to continue reforms and see through what has already begun. Caruana lays out in a recent address before the 2012 ADB Financial Sector Forum four principles he feels should guide these ongoing reform efforts.
First, financial stability is about resilience and should be prepared for in advance of the next crisis. The system should be equipped with reliable and effective buffers – capital, liquidity, sound infrastructure, strengthened resolution – that will prevent macroeconomic surprises, or problems at a specific institution or market, from harming the broader financial system.
Second, preserving financial stability involves a wide range of policy areas. These policy areas must necessarily include sound monetary and fiscal policies; consumer protection; safeguarding of the financial infrastructure; and improved market discipline through enhancement of the transparency of firms and markets, particularly via stronger accounting standards. None of these policy areas will operate effectively on its own, and must be coordinated and implemented with the others.
Third, a globalized financial system requires global rules. This does not mean, however, identical rules in every country, but rather consistent approaches from jurisdiction to jurisdiction to prevent regulatory arbitrage.
This does not mean that identical rules must be applied for every country or region. But it does mean that, to be effective, financial regulation and supervision should be guided by broadly consistent approaches. The alternative is a race to the bottom as market players seek to arbitrage across divergent national regimes – and no financial centre would want to win such a race. In this respect, policymakers worldwide have a lot to learn from the reforms that were put in place in many emerging economies, especially in Asia, in the aftermath of the crises of the late 1990s. A key lesson is that, done right, financial reform can provide a foundation for strong, sustainable growth.
Notably, one area Caruana feels is critial to the reform agenda is shadow banking. In order to be effective, reform efforts must address the risks that may come from the shadow banking system, including the risks posed by regulatory arbitrage.
Shadow banking can perform valuable functions, including facilitating alternative sources of funding and liquidity and providing banks and investors with a range of vehicles for managing credit, liquidity and maturity risks. However, as the financial crisis has shown, the shadow banking system can also contribute to systemic risk, both directly and through its interconnectedness with the regular banking system. It can also create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the system.
Therefore, it is important to monitor the evolution of shadow banking. Where called for,we should enhance the oversight and consider regulation of the shadow banking system in areas where systemic risk and regulatory arbitrage evidently pose risk.
Fourth, Caruana stresses that we should stay focused on the end result we want to achieve, namely a system characterized by less leverage, better liquidity management, sounder incentives, less moral hazard, stronger oversight, and more transparency.
As we learned during the crisis, these goals are vital for protecting the system from shocks. In implementing them, policymakers should work to reinforce and enhance the discipline provided by markets. Banks and other institutions that incorporate these objectives into their business models are already being rewarded by the market with higher valuations and lower borrowing costs.
Key to removing some of the uncertainty and doubt about reforms is setting appropriate timetables and sticking to them.
We should monitor implementation for unintended consequences. But at the same time we should set out the endpoints as clearly as possible. This will aid the decision-making of banks, firms and households, by providing them with an unambiguous vision of the framework of financial regulation that we are aiming for.
The challenges Caruana sees are daunting, but not insurmountable. Chief among these are:
- Consistently implementing what has already been agreed, especially with respect to stronger bank capital.
- Building a resilient financial system given a still weak recovery.
- Completing the regulatory agenda in the given time frame.
- Ensuring adequate oversight in the forms of macroprudential oversight, and more proactive prudential supervision.
Despite these challenges, lasting recovery requires a sound financial system. Therefore, according to Caruana, this is no time to turn back on global financial reforms.