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Financial Reform: What Must Be Done

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Financial system reform has reached a critical point around the world. Pressure is building from the financial industry to slow reform and concerns about fiscal conditions risk drawing public and political energies away from the need to act on financial sector problems. Fortunately, the Group of Twenty (G-20) reaffirmed its commitment at a summit in Toronto on June 26-27 to a comprehensive reform agenda--and we must seize the moment.

We face five challenges:

First, we have to address both the micro-prudential and macro-prudential dimensions of financial reform. The micro-prudential framework―aimed at making individual financial institutions healthier―has to be set right. The Basel Committee is working on strengthening the bank capital and liquidity framework for this purpose and we cannot let these efforts be diluted by political pressures. Visible progress needs to be made by the time of the November G-20 summit in Seoul.

At the same time, a framework of macro-prudential regulation has to be created to deal with systemic risks that reflect interconnectedness and cyclicality. Its successful implementation, however, will depend critically on addressing the flaws in the micro-prudential framework. This important work is only just beginning and must be intensified.

Second, we must look beyond banks to nonbank financial institutions. Reforms need to make the entire financial system―not only the banks―safer. The reform agenda has so far focused on banks; in the area of nonbanks and the shadow banking system, the risk lies in not acting soon enough. Regulators, policy makers, and standard setters must speed up their work on markets and products, and nonbank financial actors.

Third, we must strike the right balance among three competing objectives--safety, efficiency, and regulatory certainty. We have to move ahead and finalize the core rules governing capital and liquidity. This is essential not just for making the financial system safer but also for providing more certainty to the market. At the same time, the actual calibration of the required levels of capital and liquidity must proceed cautiously to ensure that, before they are finalized, the impact of the various changes, both individually and collectively, on the financial system and the overall economy have been assessed.

Getting the calibration of the steady state impact right will prevent ending up with a system that is either inherently unstable, or that imposes an excessive burden on the financial sector, and ultimately on the economy.

Fourth, regulations must be both nationally appropriate and internationally consistent. There is a danger that the regulatory framework emerging from current discussions will not be adopted evenly. Some countries that were less affected by the crisis may not see the need for implementing some of the new reforms. In a financially globalized world, however, uneven regulations across borders will inevitably lead to a migration of risky activities to those countries with the easiest requirements. This would put their financial systems at risk and, in turn, endanger the global financial system.

Last but not least, in addition to regulation, we must reform supervision. A rule is only of value if implemented correctly. The quality of implementation in turn depends on strong supervision.

Unfortunately, supervision has come up short in this crisis. There are many examples where supervisors did not take effective and timely action. Supervisors need both the ability―powers, mandate, appropriate skills, and resources―to act and the will to act. I have written a separate blog on this.

In the lead up to the crisis, many supervisors lacked either an understanding of the risks being assumed by financial institutions and/or the will to challenge institutions. They were too deferential to industry, unwilling to interfere, and not sufficiently objective and skeptical about the industry's ability to manage its own risks. We must learn from this experience.

Given the task before them, supervisors require the support of the broader community of policymakers, government, and the public. There must be political support and a public expectation that supervisors will take decisions independently. These decisions will not always be popular. The supervisor's job is precisely to take away the proverbial punch bowl just as the party is getting started, and to require more conservative underwriting of loans to a sector when it is becoming "frothy." We must be in agreement on this.

If expectations and consensus do not exist, supervisors may not have the necessary moral, political or legal support to do what is required: to be rigorous and thorough, to be skeptical, to follow through with unpopular judgments and actions.

We have to work together to build the support among governments and the public for a commitment to strong supervision. This is something that must come out of this crisis. The IMF has intensified its focus on the quality of supervision in its regular financial sector surveillance and will work with the Financial Stability Board (FSB) and others to develop specific recommendations to strengthen oversight and supervision.

The G-20 has declared enhanced supervision to be the second pillar of financial reform; their support and focus on supervision will give an important emphasis to this work.

The financial crisis has exposed the need for reform of the financial sector. Under the leadership of the FSB, the IMF, the World Bank, and the standard setters, FSB member countries have embarked on an ambitious agenda to reduce the likelihood and costs of future financial crises. We must stay focused on this important goal and not allow the challenges before us to overwhelm us.

This post also appeared on the iMFdirect blog.