Why sound institutions and smart regulation matter


Remarks by Angel Gurría, OECD Secretary-General, delivered at the Berlin conference on “Financial Market Regulation after Pittsburgh – Achievements and Challenges”

Berlin, 20 May 2010

Chancellor Merkel, Minister Schäuble, Commissioner, Excellencies, Ladies and Gentlemen:

The Swiss writer Max Frisch said:
A crisis is a productive state; you simply have to get rid of its aftertaste of catastrophe.

The strong and effective reactions of governments and central banks, the strengthened cooperation of advanced and emerging economies in the G20, the endorsement of Financial Market Reform at the G20 Leaders’ Summits and, more recently, the reaction of European Leaders in support of the Euro are all different and important pillars of this “productive state”.

But the crucial questions remain: Have we been “productive and effective” enough? Are the institutions sound? Do our rules and regulations provide the right incentives? And is our institutional architecture well-equipped to promote productivity and growth in the long term?

Global consistency is the key principle that should be respected in the reform process - we must further strengthen the links between macro management, fiscal consolidation, structural reforms, and prudential regulation and surveillance.

1. Credible exit strategies and sound fiscal consolidation are needed more than ever

Both stages of the crisis, the one which started in August 2007 and the current sovereign debt one are about too much leverage: in the private sector first and in the government sector now. The first leg of the crisis saw private debt insolvency being transferred onto the public balance sheet in various ways. With public solvency now being questioned by the market, the room to keep putting things onto the “pay later” bill has significantly diminished.

Securing fiscal sustainability is of the utmost urgency. Public Deficits are too large in many OECD countries and debt levels are exceeding 100% of GDP on average. For many countries there is a risk that unfavourable dynamics are sparked off as increasing debt levels raise risk premia, adding to the debt burden while holding growth back, with further adverse consequences on debt sustainability.

We welcome the strong reaction by the European Council in combination with the impressive fiscal consolidation and structural reform package in Greece, as well as the bold adjustment measures recently announced in Spain and Portugal. We will continue to work with those countries to support their reform efforts in areas such as taxation and tax compliance, labour market, innovation and public sector reform.

When restructuring is forced upon a country by a crisis, the costs and the pain are much worse than when reforms are addressed under controlled conditions and with medium-term recovery in mind. This is why countries should think, plan and communicate clear exit strategies now and to combine them with structural reforms to harness new sources of growth, like innovation and green growth.

In this context, international coordination and cooperation is a sine-qua-non in this agenda. This is why the G20 Framework for Strong, Sustainable and Balanced Growth is such an important policy approach to deal with the current crisis.

An additional risk to the global environment is the situation in Asia, where overheating due to large capital inflows is leading to rising inflationary pressures. There are two features about the institutional architecture that are important to keep in mind when thinking about the situation in Asia. First, exchange rate flexibility could alleviate some of the pressure on monetary policy in emerging economies, allowing more scope to address domestic inflation.

Second, the risk of this region backing away from open markets, for example with new capital controls or other measures that impede cross border flows needs to be avoided.

2. Sound institutions and smart financial regulation will be crucial

Improved macro management and structural reform has to be accompanied by consistent and reinforcing prudential rules for the financial system. There are four features of the financial crisis that are particularly important to address:

First, too-big-to-fail institutions took on too much risk driven by innovations and regulatory arbitrage with no effective constraints on leverage.

Second, capital rules proved to be pro-cyclical in the way they operated in practice.

Third, we saw insolvency resulting from contagion and counterparty risk driven mainly by the capital market activities of banks (as opposed to traditional credit market).

Finally, the lack of efficient resolution regimes fostered a culture of growing profits for short-term private gain, while socializing any losses that might arise. This issue, of course, is not independent of too big to fail considerations.

Regulatory reform is proceeding at several places and levels. In the United States, the proposal includes the possible separation of certain proprietary trading, hedge fund and private equity activities from “banking”. The Basel Banking Committee is revising the Basel II capital rules and proposing new liquidity ratio rules. Last year that Committee also proposed new trading book reforms. The Financial Stability Board (FSB) is seeking to insure an internationally coherent framework for financial reform. The European Union is drafting its own related directives. Finally, the European Central Bank also has sets of rules for its operations with banks, and these too have had to be adjusted in recent weeks.

So what sort of financial system are we creating? At this stage we simply do not know what costs might arise from overlaps and inconsistencies in this multi-level reform process; nor how they might interact in a future crisis. Nor do we fully understand how the grey lines between banks, insurance companies, reinsurers, investors, hedge funds and other shadow banking entities will be redrawn as a result of new incentives for arbitrage that might arise. All these financial firms operate in different jurisdictions with different regulators and supervisors responsible for them. Often supervisors at the national level are setting rules for banks and other financial institutions that operate in markets that go well beyond national borders, and which interact with other institutions outside of their jurisdiction.

The new quantitative impact study of the Basel Banking Committee will only take into account its own proposals, and cannot be expected to include all the other institutional changes and interactions going on at the same time.

3. The institutional architecture – how can we make it strong and sustainable for the future?

The institutional architecture for financial regulation is a concern for us at the OECD. The financial system, in essence, is a system of “promises”. Each promise should be treated in exactly the same way from a regulatory perspective. But the present structure does not necessarily foster this: It provides incentives for banks and other institutions to introduce innovations to allocate capital and risk so as to minimize capital requirements and to maximize short-term private gains, rather than acting in the most efficient way from the perspective of long-term growth. These efforts lead to shifts in the dividing line between banking and shadow banks that are very difficult to anticipate in advance.

It is for this reason that we at the OECD favour the simple understandable ex-ante rules. Among all those on offer, we place most emphasis on the following:

First: a leverage ratio on all bank assets. Why? Because the biggest problem is the shortage of capital. A leverage ratio can be set in a way that avoids the shifting of promises, and ensures that minimum requirements are met. Once accounting standards are brought into line, it will greatly facilitate international coordination. It will be important to meet the deadline to decide and announce what the new capital rules will be by the end of this year. This will remove an element of uncertainty which is currently holding back lending. Subsequently it will be important for countries to move together to achieve such rules over a reasonably short period to avoid creating new arbitrage opportunities.

Second, we favour the idea of a capital buffer over the minimum requirement, so that through restrained dividends, buybacks and bonuses in the good times capital can be built above the minimum and, subsequently, can be run down to the minimum in a crisis. This is consistent with counter-cyclical capital rules and other dynamic provisioning proposals that we fully support.

Third, we favour separation of certain investment banking activities from commercial banking to minimise contagion and counterparty losses within and between banks due to losses that arise from capital market activities in a crisis. The whole point of commercial banks having capital is that it should be there in a crisis to absorb losses, and to reduce the damaging economic effects of deleveraging. While separation will help to reduce the “too big to fail” problem it does not eliminate it. Capital market banks may still be too large and systemically important. They should be supervised, subject to capital rules where trading book requirements are appropriate to the risk they take, and they should be accompanied by resolution regimes including living wills.

Chancellor Merkel, Minister, Ladies and Gentleman:  we have to work in the next months on a new institutional architecture for financial reform at both the macro and the micro level. We have to do much better in reducing the role of perceived national self interest in the financial reform process, and focus on improved coordination and consistency and to encourage banks to go back to their most important function which is to lend

We need such new architecture of financial reform to be combined with sustainable fiscal consolidation strategies, structural reforms and efforts to explore new sources of growth to build a stronger, cleaner and fairer world economy after the crisis. The three C’s: Cooperation, Coordination and Consistency are key to overcome the current and avoid another C – another crisis. Toronto in June and Seoul in November can be milestones in this respect – as can Berlin today!


Useful links:

Regulatory Reform in the Financial System - Article by Angel Gurria distributed at the conference

Gurria Says Euro ‘Not Too Far From Where It Should Be’ - Bloomberg TV

World Economy: From crisis to recovery - Latest OECD work on the financial and economic crisis


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