GESolutions 2008 - Strengthening the Global Financial System

GESolution 1

Enhance transparency by standardization of complex financial contracts and shifting the trading of derivatives onto regulated exchanges.

Consensus to improve transparency and accountability has routinely been reached after every financial crisis. But since the financial system is evolving continuously, the battle is never over. As the system generates new complexity and obscurity over time, regulation and supervision need to evolve accordingly. Yet transparency is required to help restore market confidence, notably in the market for derivatives such as credit default swaps.

Standardized contracts would reduce complexity and uncertainty. The development of exchange-based trading (as opposed to over-the-counter trading) should be encouraged since this is conducive to standardization, more liquid markets and greater ease of pricing avoiding large counterparty or trading positions on the balance sheets of banks.

Regulators should devise new methods to improve the quality of disclosure. For example, the Senior Supervisors Group has proposed a template for this purpose, but there has been little momentum to follow through on this initiative for large numbers of systemically relevant financial institutions.

GESolution 2

Strengthen regulation and supervision of all systemically relevant financial institutions – both in the banking and shadow-banking sectors – but avoid regulatory overkill by focusing on simple rules on capital adequacy.

Financial institutions above a certain threshold size should be required to meet “basic disclosure requirements.” Capital requirements for risky and complex exposures have to be reviewed and probably raised. This should pertain to the systemically relevant financial institutions not just to the banking sector, but also in the “shadow banking” sector (which includes money market funds, hedge funds and financial insurers) across all the relevant countries. International cooperation should help enforce best practice and prevent regulatory arbitrage.

But regulatory overkill should be avoided to prevent financial innovation being stifled altogether. This calls for relatively simple rules and regulations such as clear minimum capital-asset ratios combined with higher risk capital requirements for proprietary trading positions and for hedge funds, recognizing the operational risk they are running.

As supervisory authorities do not currently have responsibility for promoting the stability of the financial system as a whole, macro-prudential supervision should be explored further, with a view to enabling supervisory authorities to join fiscal authorities and central banks in providing safeguards against financial distress.

GESolution 3

Make bailouts come at a cost; tougher supervision and tighter capital standards are the price financial institutions have to pay for official rescue operations meant to stem systemic risk.

Central banks should be cautious in bailing out financial institutions. Considering that highly leveraged institutions have increasingly been rescued recently (for reasons of being “too big to fail”), the still relatively narrow regulatory domain needs to be aligned with the expanded domain of liquidity support by central banks. Clearly, the principle to be applied in normal times for isolated failures has to be distinguished from crisis management measures.

Governments often impose only soft constraints as a quid pro quo for capital injections. Thus, the shareholders often retain their capital and the managers remain in place, even as they receive taxpayers´ capital.

Shareholders should lose part of their capital and the management be replaced, to reduce moral hazard. But this measure alone is insufficient, since it leaves the financial system undercapitalized. Furthermore, it appears that stockholders often exert little discipline on financial institutions, even when workers own a large share of them. Thus, government capital injections should be accompanied by burden sharing with debt holders and other counterparties.

GESolution 4

Address the procyclicality of the financial and regulatory system by adjusting mark-to-market accounting and by introducing flexible capital adequacy requirements.

While current mark-to-market accounting clearly exacerbates the cycle, simply suspending it when crisis looms is not the solution. But limiting mark-to-market accounting to assets and liabilities with a short term of, say, less than a year, may provide a reasonable option.

Minimum capital-asset ratios should be raised during boom periods and relaxed in a slump. Specifically, to moderate excessive bank lending during a boom and encourage the build-up of reserves, regulatory capital adequacy requirements might be raised to the extent that the growth in bank asset values exceeds a predetermined level. This approach has numerous practical complications, but then so does the central bankers´ task of setting interest rates today to control inflation in 18 months time.

GESolution 5

Eliminate conflicts of interest and promote competition in the credit rating market.

Financial market regulation should not rely on the ratings of credit rating agencies. In particular, central banks should no longer base their collateral rules on the assessment of fixed-income products by these agencies.

Should rating agencies continue to be given a role in financial market regulation, then conflicts of interest must be reduced by preventing any agency from participating as a structuring consultant and a rater in the same transaction. Furthermore, the special status of the three rating agencies should be mitigated by introducing more competition into the credit rating market.

GESolution 6

Replace the Basel II accord, in order to ensure systemic stability by factoring both illiquidity and insolvency risks into capital adequacy requirements and to deprive credit rating agencies of their regulatory influence.

Redesigning capital adequacy requirements in another reform of the Basel Accord would be insufficient to contain systemic risk: microeconomic best practice does not ensure systemic stability. At the same time, the classical distinction between insolvency (of highly leveraged institutions) and (global) illiquidity is increasingly blurred, considering that fragile balance sheets of large financial institutions involve systemic risk due to disorderly unwinding of exposures.

GESolution 7

Gear monetary policy towards price stability first and foremost but, to avoid asset price bubbles, leave open the possibility of “leaning against the wind.”

Relying on interest rates to prick asset price bubbles would be a mistake: for the rest of the economy, the cure would be worse than the disease. Monetary policy may curb excessive credit growth and thereby prevent inflating unsustainable booms.