Choongsoo Kim: The challenges of surveillance and coordination
Speech by Mr Choongsoo Kim, Governor of the Bank of Korea, at the International
Symposium of the Banque de France: Regulation in the Face of Global Imbalances, Paris,
4 March 2011.
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I. Introduction
I would like to express my gratitude to Governor Noyer for inviting me to this symposium. I
also want to thank all the other Banque de France officials for preparing today's symposium.
As you will recall, last month G20 Finance Ministers and Central Bank Governors agreed on
indicative guidelines to address global imbalances.
The final indicative guideline should be approved at the coming April G20 meeting, and I am
sure that France as the G20 Chair will successfully demonstrate its leadership in producing
concerted and coordinated deliverables.
II. Global imbalances, surveillance and policy coordination
As President Sarkozy mentioned at the press conference in January, there have been
125 banking crises during the past 40 years, and their occurrence has picked up
extraordinary speed over the last 20 years. This clearly underlines how global imbalances
are now building up ever faster.
A financial crisis is no longer a "tail risk" with a low probability of occurrence. It should
rather be regarded as a "normal risk" that can materialize at any time and at any place in
new and diverse forms.
A capacity to pick up promptly on the build-up of fresh imbalances calls for preemptive and
proactive surveillance by central banks and supervisory authorities.
What is more, closer attention must be paid to the mounting importance of crossborder and
cross-institutional policy coordination in the process of resolving such imbalances.
On October 8th 2008, the US, Canada, the UK, the ECB, Sweden, and Switzerland together
decisively lowered their policy rates in a concerted move. The six of them demonstrated their
resolve to overcome the crisis through such international coordination, and this effectively
tamed the raging turbulence of market sentiment and helped restore stability.
This experience teaches us the valuable lesson that international coordination can lessen
market uncertainty in times of global crisis.
International coordination, therefore, is undoubtedly the key to resolving the global
imbalances. Arguably it was the framework of international policy coordination through the
G20 Summit that made it possible to overcome the global financial crisis earlier than
anticipated and allowed the swift introduction of Basel III.
On the other hand, there are a number of obstacles that stand in the way of the seamless
conduct of surveillance and policy coordination. I would now like to run through the
challenges that particularly strike me.
III. Challenges of surveillance and coordination
Let me first point out the four factors that complicate the exercise of surveillance.
1. Blurred designation of accountability due to the complexity of financial
instruments
First of all, the recent financial crisis is set apart from previous crises in the sense that it is
difficult to put your finger on the exact locus of responsibility for those specific elements that
gave rise to it. This very fact itself represents a substantial hurdle for surveillance. For
example, more than one thousand people were held criminally liable when many US savings
and loans associations folded in the 1980's. On the other hand, with the possible exception
of a handful of cases such as that of Bernie Madoff, no criminal prosecutions were
undertaken against the staff and management of financial institutions during the recent crisis.
Today, it is much more difficult to pinpoint those players who actually give rise to risk
because the "originate and distribute" model passes on and spreads out heavy risks into a
myriad of lesser risks. "CDOs (Collateralized Debt Obligations)", frequently cited of the major
causes of the sub-prime crisis, are a case in point.
When CDOs go through "originate and distribute" process numerous times, the riskcreating
entity cannot be clearly identified. For this reason, regulatory authorities were unable to fully
comprehend the trade mechanism and the relevant data of CDOs when Lehman went
bankrupt in September 2008.
The purpose of surveillance is "to detect problems ahead of time and correct faulty
elements". Nonetheless, if the structures and transactional processes of financial instruments
are too complex as with CDOs, in which it is too difficult to identify the problematic entity,
surveillance becomes a path fraught with difficulties.
2. Financial innovation incentives
Secondly, the incentives for innovation by financial market players themselves turn into
barriers to effective surveillance.
The market reacts spontaneously and swiftly to new regulations by innovating techniques
and products to circumvent them. Innovation on the part of market participants can be
expressed in other words as "the build-up of a new risk or imbalance that is not immediately
apparent to the relevant authorities."
During the period of transition to Basel III, banks will attempt to minimize the burden imposed
by the new regulations. This change in the regulatory environment will create new
sideeffects with the potential for triggering the eruption of new and unanticipated imbalances or
risk build-ups. I see this very point as throwing up the greatest challenge for surveillance in
the coming years.
For instance, Global-SIFIs that are subject to systemic capital surcharge requirements will
attempt to pass on the additional cost to their counterparties. These counterparties will, in
turn, react to such attempts. If unexpected side-effects or imbalances crop up during this
process, the need for additional regulatory measures will have to be discussed. In this case,
G-SIFI regulation may not fulfill its original objective of reducing systemic risk, but merely
give rise to the implementation of additional regulatory requirements. We may fall into a
vicious circle in which the imposition of one regulation itself gives birth to another and so ad
infinitum.
3. Missed risk factors
Thirdly, the difficulty of identifying newly emerging imbalances in a timely manner is another
stumbling block on the road to effective surveillance.
The complex network interlinking financial institutions is effective in diversifying the risks
during a business expansion phase. In a critical financial situation, however, the same
network functions as channel of risk contagion.
The aggregate risk of the financial system as a whole during a crisis is amplified and taken to
a much higher dimension than the simple arithmetic sum of firm-specific risks.
A lesson to be drawn from the global financial crisis is that regulatory authorities placed too
much emphasis on microprudential surveillance, and as a result, they ignored or indeed
turned a blind eye to the adverse effects of the accumulation of aggregate risk.
It was only after the recent crisis that the authorities came to realize that network systemic
risks expand as interconnectedness among banks intensifies.
The addition in Basel III of macroprudential overlays - such as countercyclical capital buffers,
forward-looking provisioning, and systemic surcharges for SIFIs - is based on the
repentance of the previous microprudential surveillance framework.
It is downheartening to say it but we must admit the very strong possibility that we may still
not pick up on newly emerging risks in a timely fashion. Regulators should bear this firmly in
mind and be appropriately humble in their approach, never underestimating what they are up
against.
4. Distorted incentive structure
Fourthly, I would like to point out two cases where incentive distortion challenges
surveillance.
If an attitude of forbearance prevails, it may well distort the outcome of surveillance.
When low interest rates remain in place for a long time, the market tends to blindly expect
that those bad loan assets that should be written off will revert to normal status. In turn,
forbearance toward the redemption of these loans comes to prevail, in what is known as a
game of "extend and pretend".
If this "evergreening practice" in the accounting treatment of delinquent loans as normal
loans becomes common, there can be little confidence in the outcome of surveillance.
Moreover, the symbiotic relationship between credit rating agencies and financial institutions,
and conflict of interest problems within the agencies themselves represent another factor that
threatens the credibility of surveillance outcomes.
According to a report in the New York Times (June 3, 2010), certain credit rating agencies
stand accused of distorting the rating outcomes in collusion with the issuer institutions being
graded.
This distortion of ratings can largely be seen as essentially a structural problem. In the
current structure of the "issuer-pays model", the issuers themselves pay the rating fees
and rating agencies are able to provide consulting services to these issuers. In order to hide
their assessment errors, credit rating agencies tend to persist in assigning high credit ratings
even when an issuer faces a high probability of insolvency. Of course, surveillance outcomes
using such less than adequate ratings undoubtedly hamper appropriate policy
decisionmaking. Recently, FSB has finalized proposals for reducing reliance on CRA ratings. I look
forward to this plan being put in place in the near future.
The obstacles to policy coordination can be classified into global and domestic dimensions.
1. Global dimension
As the interconnectedness of global economies has intensified, the need for international
policy coordination has grown to a great extent.
If a national jurisdiction imposes capital controls in the absence of policy coordination with its
neighboring jurisdictions, the risks may spill over to other neighboring countries as
opportunities for regulatory arbitrage open up.
We ought to take a closer look at the recent experience of those emerging market economies
that, after the onset of the financial crisis in September 2008, put in place a "blanket
deposit guarantee" and consequently transferred the risks to their peers and neighboring
countries.
In addition, emerging economies' excessive accumulation of foreign reserve to counter
sudden surges in capital outflows will itself accentuate global imbalances. International policy
coordination to resolve this problem is embodied in the global financial safety nets (GFSNs),
which took on detailed form at the Seoul G 20 Summit. In this context, notable advances
were achieved last year in the improvement of the IMF Loan Facility. There remain, however,
some aspects of it in need of further refinement. Therefore the French initiative set out this
year in this area is greatly welcomed and I look forward to its successful realization.
No jurisdiction is opposed to the idea of international coordination in principle, but when the
interests of individual countries are in conflict, when the benefits from coordination are not
obvious, or when there is no urgent call for it, then it is very hard to bring about international
policy coordination in practice. That at any rate was Korea's experience as the G 20 chair
last year.
It seems there is already a firm consensus among the G 20 member countries as to the
overarching imperative of policy coordination through the G20 framework for the
synchronous growth of the world economy. This being the case, it binds us all to put into
practice in all good faith what we may term the mutual trust built up through negotiation and
agreement.
2. Domestic dimension
From a domestic perspective, the coordination problem lies in the institutional arrangements
in relation to macroprudential policy. If the institutional setting for macroprudential policy is
not configured properly, its coordination with monetary, fiscal, and other policies may well
become problematic.
As macroprudential policies are thrust into the spotlight, it is possible, misguidedly, to take
the view that it is feasible to deal with inflation by means of macroprudential tools.
Accordingly, monetary policy is increasingly likely to be adversely affected by the
overzealous use of macroprudential tools. Hence, it is critical that there should be a clear
understanding that macroprudential policy does "not substitute" for monetary policy but
rather "complements" it.
IV. The way forward
Lastly, I wish to draw attention to the following two issues that may shed some light on the
trail that lies ahead.
First, potential imbalances in the future may arise from entirely new sources. As the
boundaries between differing spheres are being dissolved in the process of globalization and
increasing interconnectedness, social political and geopolitical risks once remote may well
spill over more easily to the real economy and result in increased economic risk.
One example springs readily to mind. The current events unfolding before us in the Middle
East are upping the geopolitical risks and triggering such economic threats as an oil price
shock and financial market turbulence.
I would like to call this "global systemic risk" as opposed to "financial systemic risk."
Piling Pelion on Ossa, in addition to international financial instability, international social
instability represents an issue that must be dealt at an early date in order to avoid a new
type of crisis. With this problem of social instability very much in mind, particular emphasis
was given to the "development issue" in the talks at last November's G20 meetings in Seoul.
It follows on from this that discussions are required within the G 20 framework on
surveillance and policy coordination with particular reference to "global systemic risk".
Next, the institutions with a mandate for global surveillance (such as the FSB and the IMF)
can be readily identified. On the other hand, it is difficult to clearly delineate exactly those
that are responsible for arbitrating conflicts between differing parties within the global policy
coordination framework. To my mind, this underscores yet again the imperative for a further
strengthening of the G20's role in international policy coordination.
Thank you for listening so attentively.