Mark Carney: Some current issues in financial reform
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Institute of
International Finance, Washington DC, 25 September 2011.
* * *
Thank you for the invitation to speak today. In the hope of addressing some of your
concerns, I waded through the more than 1,000 pages of reports and notes that the Institute
of International Finance (IIF) has produced over the past year. Your messages have been
consistent, if not always concise, so I would like to focus on three particular concerns about
the financial reform agenda you have recently expressed:
1. the consistency in implementation across jurisdictions;
2. the possibility of substantial regulatory arbitrage in the shadow banking system; and
3. the macroeconomic impact of the reforms.
Before I do, allow me a general observation.
The G-20 is undertaking a radical and comprehensive program to strengthen the regulation,
supervision and infrastructure of the global financial system. Its ambition can hardly be a
surprise. Four years ago, manifest deficiencies in capital adequacy, liquidity buffers and risk
management led to the collapse of some of the most storied names in finance and triggered
the worst financial crisis since the Great Depression. The complete loss of confidence in
private finance - your membership - could only be arrested by the provision of
comprehensive backstops by the richest economies in the world. With about $4 trillion in
output and almost 28 million jobs lost in the ensuing recession, the case for reform was clear
then and remains so today.
Let me now turn to your issues.
Consistency in implementation
Authorities are increasingly hearing concerns about the pitch of the playing field for Basel III
implementation. Everyone is claiming to be a boy scout while accusing others of juvenile
delinquency. However, neither merit badges nor detentions will be self-selected but, rather,
determined by impartial peer review and mutual oversight.
It is important to remember that the Basel rules have always been, and continue to be,
international minimums, rather than a "one-size-fits-all" approach. There are legitimate
reasons why implementation may differ across countries.
Some countries will implement Basel III faster than others. The current transition period to
2019 for Basel III has been variously described as enlightened, leisurely and generous. It
reflects a lowest-common-denominator compromise that gives the time needed to rebuild
capital buffers in those crisis economies that are furthest from compliance. Some countries
may decide it is not in their best interests to take full advantage of this flexibility.
Indeed, how quickly the new rules are adopted is bound to be a function of both the current
health of the financial system and the macrofinancial environment in each jurisdiction. In
Canada, we expect banks to be fully compliant with Basel III (2019 definitions) by early in the
transition period, which starts in January 2013. This reflects the strong starting positions of
Canadian banks and the benefits of building capital in the face of currently buoyant credit
expansion.
Some will adopt tougher rules. Countries such as Sweden, Switzerland and the United
Kingdom, with very large banking sectors relative to their domestic economies, have
signalled their preference for higher loss-absorbency capacity. In these jurisdictions, since
the failure of a major bank would have disproportionately large consequences, additional
prudence is desirable.
Finally, there will always be countries that opt for a tighter interpretation of the rules, even as
they adhere to the international minimum standards. For example, national supervisors may
take a more conservative approach to approving bank internal risk measurement systems
under the advanced measurement approach of Basel II.
I would stress that in order to foster a race to the top, Basel III permits better rules, but it is a
minimum standard. As the IIF has emphasised, it is vital that we prevent regulatory
fragmentation. In this regard, there are several new measures that will help to contain
unwarranted differences in implementation across countries. For example, the new leverage
ratio acts as a backstop that effectively limits differences in risk weights. Speaking from
experience, we in Canada know that the leverage ratio protects banks from risks that people
think are low but are, in fact, high.
In addition, policy-makers are significantly enhancing the mutual-surveillance processes that
each jurisdiction accepts as part of its membership on the Basel Committee on Banking
Supervision (BCBS). In particular, the Financial Stability Board (FSB) and the
standardsetting bodies, including the Basel Committee, are jointly developing an
implementationmonitoring framework that will coordinate activities and include annual progress reports on a
country-by-country basis to the FSB and G-20, as well as less frequent, but more in-depth,
peer reviews.
Ad hoc reviews of new legislation and regulations could also be conducted. In this regard, a
review by the BCBS of new European and American rules would be welcome to build
confidence today in the consistency of application in major jurisdictions.
Coordinated FSB/BCBS monitoring mechanisms will be in addition to the International
Monetary Fund's (IMF) annual Article IV surveillance and the IMF and World Bank's periodic
independent assessments across countries of compliance with international standards.1
All in all, while there will be legitimate reasons for some countries to adopt standards more
quickly or to go beyond international minimums, there will be much less scope in the future
for countries to give their banks a competitive advantage by not fully implementing the
agreed global rules.
If some jurisdictions do not comply, I am certain that you will let us know. The IIF's
commitment to fair application and peer review would complement official initiatives, and I
urge you to develop a more formal approach.
In the end, it is in your interests to comply. While there will be periods of exuberance during
which aggressive banks and jurisdictions can sail close to the wind, financial history suggests
that well-capitalised institutions and transparent systems will ultimately have premium
ratings, valuations and outcomes.
Regulatory arbitrage
Let me turn to your second issue: regulatory arbitrage.
There are valid concerns that the recent measures will push risk into shadow banking. Even
as reforms make the core of the financial system more resilient, they increase incentives to
move classic banking activities, such as maturity transformation and credit intermediation, to
the unregulated periphery.
This tendency is of particular concern, given the role the shadow banking sector played in
the run-up to the crisis. In the final years of the boom, when complacency about liquidity
reached its zenith, the scale of shadow banking activity exploded. The value of structured
investment vehicles, for example, tripled in the three years to 2007, and credit default swaps
grew sixfold.
The feedback to the regulated sector was pernicious. Financial institutions, including many
banks, had come to rely on high levels of market and funding liquidity. For instance,
shortterm money markets, particularly repo markets, were the predominant source of financing for
the one-third increase in the gross leverage of American investment banks, as well as British
and European banks. The system's exposure to market confidence was enormous.
The crisis exposed how boom-bust liquidity cycles cascade through the shadow banking
sector and reverberate on the regulated core. Market forces proved inadequate to manage
these swings between confidence and despair.
Today, despite the fact that shadow banking, or as we prefer to call it, market-based
financing (MBF), is at least as large as the regulated sector in most jurisdictions, it is often
unregulated and/or overseen by authorities without a systemic focus. This should change.
As it does, regulation and supervision must strike a balance between mitigating systemic
risks and realizing the benefits from financial deepening. Properly structured, shadow
banking can increase efficiency, provide diversification, and spur competition and innovation.
It has the potential to make the system more robust, provided it does not rely on the
regulated sector for liquidity or pretend to provide it with liquidity in times of stress. However,
experience also teaches that shadow banking activities mutate, usually through complex and
highly leveraged instruments, into regulatory gaps created by the response to the last crisis.
With all of this in mind, there are four broad categories of regulatory initiatives under
consideration. The first, and most important, is indirect regulation through limits on the size
and nature of banks' exposure to shadow banking entities. Examples include tighter
consolidation rules for bank-sponsored conduits and higher risk-based capital requirements
for liquidity lines. These measures will help to reduce opportunities for regulatory arbitrage, in
which banks seek to reduce capital or liquidity requirements by organising transactions
wholly or in part through shadow banking entities while retaining much of the underlying tail
risk.
The second approach would try to address systemic risks in shadow banking For
directly.
example, macroprudential measures are being considered to address procyclical haircut and
collateral rules for securities lending and repo transactions. These measures could do much
to dampen liquidity cycles.
Contagion could be further constrained by strengthening financial market infrastructure. In
Canada, in the coming months, a central counterparty (CCP) for repo transactions will be
launched. This repo CCP will strengthen counterparty credit risk management, reduce
collateral and balance sheet requirements via netting, and reduce the impact if there were a
failure of one of its participants. By helping to ensure that core funding markets are
continuously open, the heart of the financial system will be more resilient to shocks.
The third approach is to regulate shadow banking activities themselves, such as money
markets and exchange-traded funds (ETFs), through disclosure obligations or restrictions on
certain financial transactions and instruments. This will require dynamic monitoring of the
financial system and coordination across authorities.
Finally, the FSB is examining the possible regulation of shadow banking entities, such as
hedge funds, that may pose systemic risks by limiting their maturity transformation and
leverage. This last option should take into account the relative size of these institutions and
the cumulative impact of other measures.
Whatever decisions are taken in the coming months, no one should be tempted to declare
"mission accomplished." In order to maintain systemic resilience, the monitoring, supervision
and regulation of shadow banking will need to be dynamic.2
The recent loss incurred by UBS on its Delta One trading desk demonstrates the need for
vigilant risk management of complex new products. Fortunately for the system, the loss was
manageable, given the increased capital buffer at the bank, and a broader liquidity squeeze
was avoided. The FSB has been prescient in highlighting the risks associated with synthetic
ETFs.3 Synthetic ETFs are sometimes being used to fund illiquid collateral which, if financed
on a bank's balance sheet, would carry a higher risk weight. The potential for a procyclical
liquidity cycle needs to be monitored carefully.
Reform of the shadow banking sector offers an opportunity to ensure the consistency of the
overall financial reform package. For example, capital rules will have to balance risks to
institutions with the benefits of incentivizing direct and indirect settlement of standardized
derivatives through CCPs. Liquidity standards and market infrastructure should reinforce the
continuous availability of core funding markets. In this manner, both systemic resiliency and
efficiency can increase.
As authorities examine measures on a comprehensive, system-wide basis, adjustments may
need to be made. Liquidity standards are one example. The Basel Committee and the
Committee on the Global Financial System (CGFS) are currently using the observation
period to review contentious design issues concerning the Liquidity Coverage Ratio (LCR),
such as uncertainty regarding how the liquid assets can be used in times of stress, and how
the liquidity rules are supposed to operate in tandem with the new leverage ratio
requirement. They are also examining potential unintended consequences on the
commercial paper market and market-making for equities. The FSB's work on shadow
banking will shed more light on the intersection among these standards, key markets and
economic performance.
These issues need to be addressed before the new rules are fully implemented.4 There
would appear to be little value in delaying decisions on potential amendments to the LCR
beyond early in the new year. Work on the Net Stable Funding Ratio (NFSR) will take longer.
Macroeconomic implications of financial reform
Let me now turn to your third, most fundamental, concern. Based on the current challenging
economic outlook, some argue that we should revisit the pace and breadth of financial
reforms. This position is based on two questionable propositions.
The first is that the prospect of financial reforms is contributing to current economic
weakness. A corollary is that delayed implementation of the Basel III capital rules, for
example, will somehow strengthen the recovery.
Really?
Weak credit growth in the crisis economies is often cited as supporting evidence. However,
the fact that household credit is flat to falling in the United States and the United Kingdom
can hardly be a surprise. American and British households are overleveraged. With personal
net worth substantially lower following the crisis, the need to rebuild balance sheets in an
environment of economic uncertainty is quite naturally weighing on credit demand. In the
vast array of countries that did not experience a home-grown financial crisis, the issue has
been that household borrowing has been too robust, despite adherence to a common
timetable for implementing Basel III. The issue in the crisis economies is primarily one of
demand, not supply.
More broadly, the G-20's comprehensive reform program seeks to boost confidence in global
financial institutions and markets by providing a path to a more resilient system and an end
to government support. It is hard to see how backsliding would help. Indeed, at a time when
the conviction of policymakers across a range of issues is being called into question, there
appears to be little value in feeding this concern.
Moreover, recall that the implementation timetable for Basel III begins in two years and ends
in 2019. It is difficult to believe that prolonging this implementation phase even further would
have a material impact on real economic outcomes. If some institutions feel pressure today,
it is because they have done too little for too long, rather than because they are being asked
to do too much, too soon.
The second proposition is that, once implemented, the reforms will substantially reduce
global growth. A recently released IIF report estimates output losses during the transition
phase that are more than an order of magnitude greater than those produced by the Bank for
International Settlements, the Bank of Canada, the IMF and other public institutions and
academic bodies.
Allow me to raise a few of the many problems with the IIF's analysis. The IIF study assumes
banks pay out most of their earnings and therefore must rely heavily on external sources to
raise capital. Debt-fuelled consumption is a central driver of output growth in its econometric
model, despite the obvious bias to reduce debt in most major economies. Monetary policy is
assumed to be in suspended animation until 2020. While I would welcome the time off, this
presumption is inconsistent both with the range of unconventional tools that central banks
have and the medium-term prospects for the global economy. The estimated impact of the
reforms on the cost of bank debt exceeds the increase experienced during the crisis! It is
hard to see how more capital, better liquidity and stronger infrastructure would lead to such a
result. Put differently, the IIF is suggesting that the current public subsidy of the financial
sector is massive.
Finally, the analysis assumes that all of these reform efforts are for naught as it includes
none of the benefits. Given the recent experience, no one would argue that financial crises
are without costs, and only the most jaded would argue that their probability and severity
cannot be reduced.
Countries like Canada and Australia, with well-capitalized and well-managed banks, did not
experience any failures or bailouts. Partly as a consequence, their economies have
substantially outperformed those of their advanced-economy peers. Our estimates indicate
that even if Basel III were to reduce slightly the probability of such crises in the future, the
potential gains would far exceed the cost of marginally slower growth. The Bank of Canada
estimates a net present value of Basel III for G-20 economies is 30 per cent of GDP in
present-value terms, or about $US13 trillion.5
In short, while the worsening global economic outlook has implications for bank performance,
it does not provide a rationale for delaying the implementation of Basel III.
Conclusion
To conclude, critics of reform generally succumb to three world-weary arguments:

any rule will be arbitraged;

any insurance will promote greater risk taking; and

there will always be financial crises.
Such fatalism should be rejected. In no other aspect of human endeavour do men and
women not strive to learn and to improve. The sad experience of the past few years shows
that there is ample scope to improve the efficiency and resilience of the global financial
system. By clarity of purpose and resolute implementation, we can do so. The current reform
initiatives mark real progress.
The fundamental objective of the G-20 measures is a resilient, global financial system that
efficiently supports global growth. Our destination should be one where financial institutions
and markets play critical - and complementary - roles to support long-term economic
prosperity.
This requires institutions that are adequately capitalized, with sufficient liquidity buffers to
manage shocks. It also requires that market forces be allowed to determine the relative sizes
and boundaries of the banking and shadow banking sectors; and that the market decides
which firms prosper and which firms fail.
The FSB has a clear role to oversee and coordinate the development of the G-20 reforms. It
should provide a system-wide perspective and assess the total impact of reforms. It must
strive to resolve any conflicts that may arise between regulations that are locally optimal but
systemically inconsistent. It must balance the need to guard against regulatory arbitrage with
the value of preserving diverse risk-taking strategies and productive innovation. Finally, it
must ensure consistent implementation across jurisdictions to build an open and competitive
system.
It is also important not to lose sight of the limitations of regulation. New and better rules are
necessary, but not sufficient. People will always try to find ways around them. Some may
succeed, for a while. That is why good supervision is paramount. Rules are only as good as
the supervisors who enforce them, and good supervisors look beyond the letter of the rules
to their spirit.
Of course, belief by the industry in the appropriateness of the measures will also aid their
application. As you are well aware, you have the ultimate duty to ensure your institutions
bear responsibly the risks you are taking. We have all learned from the events of the past
few years, and so I look forward to a continued constructive dialogue with the IIF as we
develop and implement this vital agenda.
See also:

Financial System Reform Initiatives Mark Real Progress, Says Mark Carney,
Governor of the Bank of Canada (Press Releases)