Next steps on the road to financial stability
Crises always accelerate the process of change. Two years after the collapse of Lehman Brothers, it is not surprising that the signs of a deep transformation in the financial landscape are very visible. Two main driving forces are at work.
The first is a different perception of risk. For many years an optimistic view that underestimated the level of risk and overestimated its dispersion across participants had become the conventional wisdom; that view has been wiped out by the crisis. A re-pricing of risk of all sorts, higher volatility, reduced valuation of certain assets, more careful examination of credit quality and greater attention to the longer-term sustainability of debt positions – as highlighted by the recent sovereign debt crisis in Europe – are all manifestations of this changed perception. Business models are being reassessed according to their ability to manage risk. Complexity and opacity of financial instruments are no longer rewarded; the demand for transparent, complete and accurate information has increased.
The second source of change is policy driven. After Lehman, any remaining doubts on the need profoundly to reform the financial sector were dispelled. It became clear that a common, internationally co-ordinated approach, involving both advanced and emerging economies, was needed.
At the prompting of the Group of 20 leading economies, and under the co-ordination of the Financial Stability Board, the weaknesses highlighted by the crisis are being tackled. A fundamental step was taken last weekend with the agreement reached by the Basel committee’s governing body on new bank capital and liquidity standards. These standards will markedly increase the resilience of the banking system, including by constraining the build-up of excessive leverage and maturity mismatches that proved the tinder for this crisis.
At the same time, the Lehman case reminds us that other, more deep-seated problems need to be addressed. Lehman was the first global systemically important institution that was allowed to fail during the crisis. It was also the last. The public will not, and should not, accept more such bail-outs. Addressing the problem of “too big to fail” is therefore the next central step in the reform programme.
The work under way in this area has several dimensions. First, systemically important institutions must have loss-absorbing capacity beyond the minimum standards agreed for the banking system in general last weekend. This loss-absorbing capacity could include a combination of equity capital surcharges, contingent convertible capital and mechanisms to “bail in” creditors. The former would increase the resilience of such institutions on an ongoing basis, while the latter instruments would strengthen market discipline.
Second, systemically important institutions will operate with correct incentives only if an effective resolution framework is in place. Many countries lack the powers, the tools and the operational capacity needed in this area. Effective regimes must enable the authorities to resolve financial crises without systemic disruptions and without taxpayer losses. They should include powers that facilitate “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including the establishment of a temporary bridge bank to take over and continue operating certain essential functions. Statutory powers enabling the resolution authority to bail-in senior debt holders would expand the options for going concern resolution.
Third, we need to improve cross-border resolution capacity. Global banks have substantial operations across multiple jurisdictions and thousands of legal entities. In the absence of a global resolution regime, we need not only effective regimes at the national level, but also strong capacity for such regimes to co-ordinate across borders. Assessments of resolvability are part of the recovery and resolution plans being developed by and for the largest international financial institutions. If home and host authorities deem that a bank’s structure is too complex to be resolved in an orderly way, they should demand changes to its legal and operational structure.
Fourth, the effectiveness and intensity of supervision needs to be strengthened both for banks in general, and for systemically important institutions in particular, given the wider damage their failure would cause. Countries need to strengthen supervisory mandates, independence, resources and methods.
Fifth, core financial market infrastructures must be strengthened to reduce contagion risks and to ensure that critical infrastructure is not itself a source of systemic risk. A key source of the risk transmission is the network of major institutions’ exposures to each other; not least in the over-the-counter derivatives and in funding and repo markets. Central clearing arrangements can simplify and greatly reduce the risks associated with this web of counterparty exposures.
The FSB and its members are developing measures in all the above areas and will present their recommendations to the November G20 summit in Seoul.
Last, a central lesson of this crisis was the lack of effective system-wide oversight. One of the blind spots, and an important contributor to the crisis, was the regulatory arbitrage that developed in the shadow banking sector. This sector continues to play an important role in credit intermediation and liquidity transformation, but outside the capital and liquidity regulatory framework that applies to banks. As we strengthen the requirements for banks, we must make sure that we also capture within the regulatory perimeter the sources of systemic risk currently outside it. This will be a priority for the FSB’s work in 2011.
(FT)
The first is a different perception of risk. For many years an optimistic view that underestimated the level of risk and overestimated its dispersion across participants had become the conventional wisdom; that view has been wiped out by the crisis. A re-pricing of risk of all sorts, higher volatility, reduced valuation of certain assets, more careful examination of credit quality and greater attention to the longer-term sustainability of debt positions – as highlighted by the recent sovereign debt crisis in Europe – are all manifestations of this changed perception. Business models are being reassessed according to their ability to manage risk. Complexity and opacity of financial instruments are no longer rewarded; the demand for transparent, complete and accurate information has increased.
The second source of change is policy driven. After Lehman, any remaining doubts on the need profoundly to reform the financial sector were dispelled. It became clear that a common, internationally co-ordinated approach, involving both advanced and emerging economies, was needed.
At the prompting of the Group of 20 leading economies, and under the co-ordination of the Financial Stability Board, the weaknesses highlighted by the crisis are being tackled. A fundamental step was taken last weekend with the agreement reached by the Basel committee’s governing body on new bank capital and liquidity standards. These standards will markedly increase the resilience of the banking system, including by constraining the build-up of excessive leverage and maturity mismatches that proved the tinder for this crisis.
At the same time, the Lehman case reminds us that other, more deep-seated problems need to be addressed. Lehman was the first global systemically important institution that was allowed to fail during the crisis. It was also the last. The public will not, and should not, accept more such bail-outs. Addressing the problem of “too big to fail” is therefore the next central step in the reform programme.
The work under way in this area has several dimensions. First, systemically important institutions must have loss-absorbing capacity beyond the minimum standards agreed for the banking system in general last weekend. This loss-absorbing capacity could include a combination of equity capital surcharges, contingent convertible capital and mechanisms to “bail in” creditors. The former would increase the resilience of such institutions on an ongoing basis, while the latter instruments would strengthen market discipline.
Second, systemically important institutions will operate with correct incentives only if an effective resolution framework is in place. Many countries lack the powers, the tools and the operational capacity needed in this area. Effective regimes must enable the authorities to resolve financial crises without systemic disruptions and without taxpayer losses. They should include powers that facilitate “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including the establishment of a temporary bridge bank to take over and continue operating certain essential functions. Statutory powers enabling the resolution authority to bail-in senior debt holders would expand the options for going concern resolution.
Third, we need to improve cross-border resolution capacity. Global banks have substantial operations across multiple jurisdictions and thousands of legal entities. In the absence of a global resolution regime, we need not only effective regimes at the national level, but also strong capacity for such regimes to co-ordinate across borders. Assessments of resolvability are part of the recovery and resolution plans being developed by and for the largest international financial institutions. If home and host authorities deem that a bank’s structure is too complex to be resolved in an orderly way, they should demand changes to its legal and operational structure.
Fourth, the effectiveness and intensity of supervision needs to be strengthened both for banks in general, and for systemically important institutions in particular, given the wider damage their failure would cause. Countries need to strengthen supervisory mandates, independence, resources and methods.
Fifth, core financial market infrastructures must be strengthened to reduce contagion risks and to ensure that critical infrastructure is not itself a source of systemic risk. A key source of the risk transmission is the network of major institutions’ exposures to each other; not least in the over-the-counter derivatives and in funding and repo markets. Central clearing arrangements can simplify and greatly reduce the risks associated with this web of counterparty exposures.
The FSB and its members are developing measures in all the above areas and will present their recommendations to the November G20 summit in Seoul.
Last, a central lesson of this crisis was the lack of effective system-wide oversight. One of the blind spots, and an important contributor to the crisis, was the regulatory arbitrage that developed in the shadow banking sector. This sector continues to play an important role in credit intermediation and liquidity transformation, but outside the capital and liquidity regulatory framework that applies to banks. As we strengthen the requirements for banks, we must make sure that we also capture within the regulatory perimeter the sources of systemic risk currently outside it. This will be a priority for the FSB’s work in 2011.
(FT)
posted by Jiu Zhuang at
10:04 AM
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