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Symposium 2009

Proposal - Balancing Risk Taking and Financial Regulation

The Challenge

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Challenges

The financial crisis has, so far, caused losses in the financial sector exceeding USD 1 trillion, wiped away USD 1.2 trillion in the market value of the top-20 financial firms alone and forced governments to provide USD 3.6 trillion in funds for rescue measures. It has also triggered the deepest global recession since the end of World War II. Reform of the global financial system is needed and must provide solutions for the following questions:

  • How can we resolve the incompatibility between open, integrated financial markets and the fact that financial regulation, the tools for crisis management and the ultimate resources for rescue operations are still essentially anchored at the national level?
  • How can we strike the right balance between safeguarding financial stability, on the one hand, and maintaining the innovative power of financial markets, on the other?
  • What is the right balance between limiting the systemic risk that individual institutions can cause, e.g. by limiting their size or the range of activities they can engage in, and exploiting the benefits that large and diversified financial institutions can provide for their clients and for financial stability?
  • What is the right balance between a consumer’s individual responsibility, also with regard to their choice of financial products, and the need to protect unsophisticated consumers from unsuitable selling activities and products that are too risky for them?
  • How can we phase in tougher rules for the financial industry so that it does not stifle the impending recovery?
  • What are the right exit strategies for the current, massive government assistance measures?

 

Solutions

  1. Macro-prudential supervision must become a central pillar of the supervisory system.
    In all large financial markets, chiefly in the EU and the U.S., there are plans to appoint systemic risk supervisors. They must have the authority to identify all threats to financial stability, irrespective of their source, and to recommend remedies. A stringent follow-up on these recommendations on an “act or explain” basis must be ensured.
  1. The financial system must become less cyclical.
    Financial systems have always been prone to boom-and-bust cycles. Arguably, this tendency has been aggravated by the transition to a more markets-based financial system. Regulatory changes such as more risk-sensitive capital requirements, fair value accounting and performance-related pay have accentuated this tendency. Changes must be made in these areas as well as in macroeconomic policies, especially monetary policy, to reduce cyclicality.
  1. Banks’ risk management needs upgrading.
    Room for improvement exists in almost all areas of risk management. These comprise, to name only the most important ones, the institutional structures for risk management, the methodologies used for risk modelling including the routines for reassessing these methodologies at regular intervals, the vetting of new products, liquidity management, funding structures and risk aspects of compensation practices. Global banks, working together in the Institute of International Finance (IIF), have presented a comprehensive catalogue of measures, which are now being implemented.
  1. The regime for capital requirements must be revised.
    Banks individually and the financial system collectively will need to hold more capital of higher quality in response to pressure from investors, depositors, rating agencies and supervisors. Capital increases should not be across the board, however, but geared to those areas where deficiencies have been revealed. Specifically, this will entail higher capital requirements for securitizations and the trading book. The crisis has also revealed the need for major conceptual changes in the design of capital requirements. In particular, the current VaR-based calculation for trading book assets underestimates risk after a long period of benign market conditions. Finally, measures are needed to make the capital regime less procyclical. The building of capital buffers in good times, which can then be drawn down in bad times, appears to be one promising option for this.
  1. Liquidity risk requires more attention.
    Supervisors as well as market participants have falsely assumed that liquidity in financial markets would always be ensured and available. Higher liquidity reserves and better liquidity management are therefore urgently warranted. New rules must not create trapped pools of liquidity within individual jurisdictions, as this would raise, rather than reduce systemic risk.
  1. Supervision needs to be comprehensive and extend to all systemically relevant market participants and structures.
    Over recent decades, many new actors emerged outside of the banking system. These new players provided diversity and helped boost liquidity. But many of them operated not just outside of the banking system, but outside of the regulatory system, as well – and this has now come to be known as the “shadow banking system”. The existence of such a system is not acceptable. Supervisors must have the right to designate institutions as systemically important and subject them to supervision. A risk-based approach should be pursued here.
  1. Stronger market infrastructure to bolster the resilience of the global financial system.
    The financial infrastructure must be able to function as a shock absorber, enabling it to withstand the failure of major market participants. The use of central counterparties is one example of how to insulate the financial system from the fallout of failed institutions.
  2. New financial products require an adequate market infrastructure to support a stable market development.
    Many market participants in innovative market segments such as securitizations and derivatives lacked the ability to properly price and assess these instruments – which forced them to rely excessively on the judgement of rating agencies. There was also a severe lack of transparency in some of these markets. The markets for these products will only recover if reliable price signals and a robust pricing infrastructure can be established. For this to happen, we need to have a pooling of information on transaction volumes and prices.
  3. Remuneration schemes in the financial sector must be restructured to improve the alignment of individual incentives with the objectives of sustainable profitability and stability.
    Compensation schemes are already being reformed. The changes being implemented emphasize a risk-adjusted measurement of performance as well as a longer-term horizon for assessing profitability.
  4. We need mechanisms – at the national and international levels – to deal with the failure of systemically important institutions.
    Failure, even of large institutions, must be possible in order to maintain the necessary market discipline. An internationally consistent intervention and resolution scheme must be developed for complex global financial institutions to enable an orderly winding-down of their operations.
  5. Exit strategies
    Central banks must develop strategies to drain money from the system once the recovery is on a firm footing in order to prevent inflationary expectations. The sale of government stakes in financial institutions must be coordinated to avoid competitive distortions and a clustering of re-privatizations, which would weigh down prices.

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