Marion Williams: Governing the global financial system1
Paper by Dr Marion Williams, Governor of the Central Bank of Barbados, for the Initiative for
Policy Dialogue Task Force on Financial Market Regulation, coordinated by Columbia
University, Manchester University, UK, 1-2 July 2008.
* * *
The paper is set against a background in which the regulatory world is grappling with the
realization that its regulatory regimes have been less than adequate to cope with the fast
changing pace of financial innovation, sophisticated securitization and unfettered financial
liberalization. It discusses the current global financial architecture, analyzes its strengths and
weaknesses, the developments which have led to questions about its adequacy and
suggests possible ways in which it can be improved and made more effective.
There is no single international oversight body in the financial world. The earliest institution
closest to being described as a global oversight body was the Bank for International
Settlements (BIS). It retains however, mostly a developed country focus, principally
European.
Within the BIS the most influential group is possibly the Basel Committee on Bank
Supervision (BCBS), a Committee which provides a forum for cooperation on banking
supervisory matters. It is this Committee which develops guidelines and supervisory
standards. Other supervisory groups have developed to cater to geographical needs. The
Caribbean Group of Bank Supervisors performs this function for the Caribbean.
The International Monetary Fund was set up after the BIS. An important role for the
International Monetary Fund is to provide lender of last resort facilities to many countries
both developing and developed. In addition to lender of last resort functions, it also provides
an important economic and financial monitoring function through its Article IV consultations
and in more recent years, Financial Sector Adjustment Programmes (FSAPs).
The International Organization of Securities Commissions (IOSCO) is an organization of
regulators of the securities industry whose objective is to cooperate together to promote high
standards of regulation, to exchange information and to provide mutual assistance and
generally protect the integrity of the securities markets.
Other International regulatory organizations include the International Financial Reporting
Standards (IFRS) body which issues standards adopted by the International Accounting
Standards Board (IASB).
The Financial Stability Forum (FSF) is of much more recent vintage. It was convened in 1999
to promote international financial stability. Its first major initiatives related to offshore centres.
It does not include developing countries among its members, but makes recommendations
and calls for their implementation relating to financial centres in both emerging markets and
in developing countries. The FSF comprises 12 countries (G7 plus Hong Kong, Switzerland
and Netherlands, Australia and Singapore including related institutions in those countries and
9 international standard setting organizations). The FSF is housed in the BIS.
The Financial Action Task Force (FATF) is an intergovernmental body whose purpose is the
development and promotion of national and international policies to combat money
laundering and terrorist financing. They comprise principally European and North American
countries with subsequent additions of Japan, Mexico, Singapore and South Africa. Several
International Organizations have observer status.
These groups sometimes coordinate with each other both through formal and informal
channels. The group with the most representative membership is however the International
Monetary Fund which is comprised of 185 members. However up until recently, the IMF had
not concentrated its resources on regulation of banks or on monitoring or evaluating the
innovations in the financial system and exploring its implications.
The FSF, if it widened its mandate to continual monitoring rather than issue-based
approaches could come closest to the kind of entity which has the track record needed to
coordinate regulatory and oversight functions of bank regulation, securities, insurance
accounting rules and payment system issues and monetary and financial stability issues.
The impact of innovation and the challenge for regulators
It is against the background of this regulatory framework and in the context of a philosophy of
financial liberalisation and integration of financial markets that innovative financial
technologies took off. Financial technologies however rapidly outpaced the regulatory
framework and it is now fairly well acknowledged that regulatory frameworks have not kept
pace with financial innovation.
Financial innovation has manifested itself in various ways, the most prominent being the
growing importance of new and complex financial instruments, new business models which
focus on multiple financial activities facilitated by financial liberalisation, and significant
developments in the area of securitisation and disintermediation. To this can be added the
rising importance of relatively new, largely unregulated players, such as hedge funds, private
equity firms, conduits and structured investment vehicles - SIVs, the constraints to financial
innovation seemed limitless and regulators were left behind in the process.
By the first half of 2007, financial market activity had expanded at a tremendous pace.
However, dependence on capital markets and on sustained market liquidity also increased,
as banks and other intermediaries placed greater reliance on their ability to "originate and
distribute" loans and other financial products. They also depended on the market to manage
their risk positions dynamically. The coincidence of greater levels of deregulation and
integration of capital markets implied that if a major problem arose it was more likely to
spread quickly across borders. This environment encouraged an increase in risk-taking as
many players "hunted for yield. Interestingly, the composition of investors also changed.
Measuring risk where credit can be sliced and diced
The widespread use of structured credits effectively lowered the compensation for bearing
credit risk and market risk to historically low levels. It is during this time that a market for
bearing risk through complex structures of credit derivatives flourished. There were a few
warning signals particularly about hedge funds, but not many warnings about securitisation.
Regulators were caught napping and the rating agencies did not spot the weaknesses.
There are two aspects to this problem, one is the absence of oversight bodies which were
monitoring and more importantly, which had authority to forestall this problem and the other
was the absence of rules or processes which would help to prevent its occurrence. There
was also clearly a need for internal corporate ground rules at the operational level. However,
securitization is here to stay as it is a critical factor in achieving financial flexibility in a world
of global flows. However, it is important that credit originators bear greater responsibility for
the credit worthiness of the credits they originate. Because of the difficulty of tracking risks in
securitised loans which have been leveraged several times, loan originators need to be
required to take more responsibility and to suffer some penalty for failure of the loans they
originate. A solution to this problem will require greater study by derivative experts, but it is
important that is addressed.
Concentration and risk management
Developing guidelines for risk management and requiring compliance to them are a core
remedy for this situation and adequate internal risk management measures and processes at
the level of the firm are very important. Portfolio concentration seems also to be an important
area which calls for attention. Sectoral concentration and instrument concentration are both
risk areas for which guidelines need to be developed.
Regulatory slips
In addition to national oversight level, something went wrong also with global regulatory and
oversight systems. The IMF did not see itself as having specific responsibility for these
developments and the BIS, while it did see itself as an entity with some responsibility for the
stability of the financial system, was a European dominated organisation, and most of its
clients were not experiencing these problems at home to the same degree as they were
occurring in the US. They did draw attention to the development, largely in the area of hedge
funds but did not appear to display alarm and were perhaps too hesitant in requesting
remedial measures from US regulators, in which jurisdiction the problem was escalating
most.
The initiatives which had been taken in the late nineties as offshore centres flourished, and
which gave rise to the Financial Stability Forum and the FATF did not replicate themselves
with the same aggression and with concerted action as in the case of the offshore centres
issue, nor did these entities evaluate the nature of the problem sufficiently quickly.
As cracks in the financial architecture surfaced and new vulnerabilities were exposed, it
became increasingly important that both market participants and policy markers improved
their understanding and assessment of threats to financial stability, and take steps, where
appropriate, to contain and reduce them.
The Financial Stability Forum (FSF); the International Monetary Fund (IMF) with their
emphasis on macro prudential indicators and early warning systems have recently been
active in the development of models to identify and assess potential sources of major
vulnerability to the financial system. This involves great degrees of dialogue by regulators
with practitioners, to understand better current approaches to measuring risks and to
encourage improvements and the sharing of best practices in stress testing techniques. The
former group lacks the network for so doing and the authority. The latter has that network but
presently lacks the track record of analysing financial markets, instruments, structures and
flows with a view to improving quickly on risk management techniques.
Size, market share and mega-financial institutions
The extent to which mega-financial institutions are at risk has not been highlighted a great
deal but may be a sleeping giant problem. Indeed, in the UK and in US the financial
institutions which failed were small financial institutions and not mega institutions. However,
when we look at the write-downs of debt the largest debt write-downs in North America have
been by the largest banks. If these have been larger relative to their size, then we would
have a greater problem. Indeed, preliminary indications are that there is a need to focus
more on size, governability, adequacy of internal controls and internal information flow as
increasingly important aspects of financial governance by oversight bodies of mega-banks.
Indeed many large banks have been increasing their capital by going to market, some
tapping into liquidity outside of their jurisdictions, even when regulators have not demanded
it. There may be some issues here of too light a regulatory hand and over confidence in the
role of the market. Responsibility rests with the CEOs as was evident in the firing of three
CEOs of three large financial institutions in the US recently. It emphasises that Information
flow, internal oversight systems, distributed decision making and incentive systems which
support good governance need to be an integral part of review by regulators, particularly so
in mega-financial institutions where distance from the operation can be a problem.
Innovation, financial market development and monetary policy
The role for central banks in influencing macroeconomic outcomes has also changed as a
result of the inter-connectedness of capital markets and the internationalisation of financial
flows. The development of deeper, more complete and more competitive financial markets
have strengthened the pass-through effect of central bank interest rates to market interest
rates and has led to a closer relationship between market and bank interest rates.
Consequently, the deepening of financial markets has served to amplify the effects of
monetary policy on bank interest rates, and ceteris paribus other variables such as inflation.
However a countervailing truth has also been evident. The major monetary policy
transmission channel through bank lending has become less important, yet new regulations
are still focusing on the quality of bank credit.
Widespread use of credit derivatives has meant that banks could respond more flexibly to
changes in financial market conditions, and may therefore not pass through each and every
change in the central bank's official short-term interest rate. Moreover, financial development
has not only broadened banks' options in terms of responding to interest rate changes; they
have also broadened borrowers' financing opportunities, reducing their dependency on bank
loans.
These developments have meant that there is a more urgent need for adequate amounts of
data which would provide policymakers with sufficient ammunition to try to maintain financial
stability. Indeed, in some jurisdictions investment banks, the key institutions in this
securitization boom fell outside the prudential purview of key financial regulators
Measuring stability
Initiatives to build robust financial stability indices have thus far not been good enough or
easily understandable by the market. Moreover interpreting them with sufficient precision in
order to home in on remedial areas in need, has been a fuzzy exercise.
The concept of financial stability involves various financial intermediaries, financial market
segments and infrastructure, for which a whole host of different quantitative and qualitative
indicators can be used. As a consequence, determining the degree of financial stability
remains a highly integrated complex task. It therefore means that the governance system
which has responsibility for ensuring financial stability must be able to monitor information
and analyse developments in several financial sectors and not just in commercial banks.
Recognition of the multi-faceted nature of ensuring financial stability contributed to the
concept of a single regulator as evidenced in the establishment of Financial Services
authorities in some jurisdictions and was intended to help to deal with the problem of the
widening scope of financial transactions and interconnectedness. It is beginning to appear
that it is becoming increasingly difficult for a single regulatory authority to fully grasp all the
intricacies of securities regulation, insurance, banking and derivatives use and all other
financial institutional arrangements simultaneously. It seems therefore that what is required is
not only greater depth of understanding by regulators in each specific financial area but also
greater collaboration among regulators in these areas with a view to collaborating to ensure
greater stability in the systems as a whole.
The role of calculating the feedback effects between financial system behaviour and the real
economy has traditionally been conducted by central banks on a national scale and by the
IMF on a global scale, and the latter still remains a very important role. The IMF may be well
positioned to evaluate these effects, but it is not clear that it is best positioned to set
regulatory criteria.
There therefore seemed to be a role for an oversight monitoring body with multiple oversight
responsibilities, but with the ability to access a wide range of inputs from various single
regulatory bodies with single regulatory responsibilities. The bodies which come closest to
this are the BIS and FSF, despite the drawback that they are not truly global institutions. It is
useful to note here that the BIS is the engine room of the FSF.
Given that feedback effects play a crucial role in assessing a financial system's vulnerability
to contagion and systemic-wide stress this is an area that some international oversight body
needs to concentrate on more intensively. Since this requires continuous monitoring and
interactive dialogue and risk management skills, a joint FSF/IMF collaboration may be
necessary.
Data availability and relevant data identification
With the exception of market prices and regulatory information, only a limited set of data is
available in a timely and manner and in a manner that facilitates international comparison.
For instance, financial intermediaries' financial reporting contains little information on risk
transfer mechanisms, and the use of off-balance sheet financial derivatives.
Methods have to be found also for handling the shifting demand for data in an environment in
which financial markets are constantly undergoing change. This is the regulators challenge.
At present, stability forecasting is often scattered with respect to risk categories, financial
market segments and structural or regulatory issues. While every national regulator should
be involved in this process, global recognition of this problem may be needed at the global
level. This must not be confused with any doubts about the skills and knowledge of such
special geographic groupings.
Central bank as regulator or financial services authority?
Having set guidelines, the issue of compliance is important. Over the years there has been a
simultaneous shift from a direct and administered system to market-determined and
markedbased systems of determining interest rates, exchange rates and other key financial
variables. However, the regulator or policymaker must still remain vigilant at all times to
ensure that private owners and management of financial intermediaries operate within
defined risk parameters, observe the standards, guidelines and codes diligently, comply with
prudential regulations and norms, and follow the best corporate governance practices. The
regulator who has responsibility for compliance may not necessarily be the regulatory which
sets the guidelines as guidelines can span regulatory authorities. The need for coordination
is therefore essential.
Even the role of governments in the process of underwriting balance sheets has been an
issue. In the UK it was Government which gave verbal undertakings to depositors about the
safety of their funds. In the US, the question also arose around the issue of central banks
bailing out financial institutions (which were not banks) and whether the use of funds which
would otherwise be available to the treasury, was appropriate. This issue of bailing out
financial institutions which central banks do not regulate also has implications for reporting
obligations and raises the spectre of the wisdom and practicality of a single regulatory
authority and the moral hazard of an institution which regulates but does not provide financial
support, and the information and regulatory needs of the authority which does. It is noted that
Northern Rock was regulated by the FSA and bailed out by the Bank of England.
Importance of real time information
The use of technology to produce an updated management information system on real-time
basis and the re-engineering of business processes and systems are the tools which can
help regulators to remain on the top of the potential problems. Also, in many instances, the
ability to regulate effectively is also dependent on the robustness of governing legislation,
rules and regulations, as well as the ability of legislators to act quickly in changing such laws
and regulations.
Very often financial regulators and legislators take years to enact laws and regulations while
financial activity is changing rapidly. In this situation, the regulatory system can be irrelevant
in the face of fast paced financial developments.
In this context, the content, characteristics, embedded risks and the accounting of the ever
growing array of financial instruments particularly derivatives, hedge products and other
similar products have to be fully understood so that guidelines governing them may need to
be revised and made relevant, and quickly. However, while some of these rules may be set
by securities regulators, it is banks which use securities, and the absence of appropriate
rules by securities regulators is affecting the stability of banks and near-banks who answer to
different regulators and who may need in extremity to be bailed out by a third regulator - the
central bank.
Common standards and disclosure requirements
Regulators have also to insist that there are common standards for valuation of assets and
liabilities and there are common yardsticks for measurement. It is not clear that these
standards should necessarily be accounting standards. Transparency and disclosure
standards have to be kept under constant watch and suitably upgraded so that the
innovators are obligated to provide the full range of information required to evaluate risks.
While the regulators should not stifle financial innovation, they should have the capacity to
understand the risks involved and disseminate them to the market participants.
The traditional approach of regulation, that is, mainly compliance-oriented with emphasis on
review of portfolios rather than evaluation of processes has diminished effectiveness in the
present dynamic landscape. The imperatives of market innovation demand a departure from
the current predominant approach towards a more proactive approach that forces banks to
recognise issues when they occur or, preferably, even ensure that the probability of their
occurrence is contained. This approach puts more emphasis on examining the bank's risk
measurement and management processes instead of simply reviewing its assets portfolio. It
demands that a bank's risk management processes should be scaled up to reflect risk
appetite and the complexity of operations. Specifically, the bank which engages in more
complex nature of businesses should be expected to have in place credible internal risk
measurement models and should assess and maintain economic capital, adequate to cover
the underlying business risks.
Capital adequacy
The emphasis on adequate capital has helped a great deal in the past but cannot in itself
ensure solvency and stability of the financial system in all situations. However, there are
some inherent rigidities which fail to cover many of the risks that banks assume in their
business operations. That's why capital adequacy concepts have been becoming less rigid
though it has been undermined through the use of regulatory capital arbitrage. The current
sub-prime crisis in the US is testimony to the effects of regulatory arbitrage and the impact of
regulatory loopholes, which can occur in even the most developed financial system.
While the BIS has been the most pro-active in trying to stay on top of these aspects of risk
measurement in the industry, it too has fallen behind. This could principally be because the
BIS has been concentrating principally on commercial banks, whereas the weaknesses in
the financial systems had moved to the securities markets.
Measuring fair value
Accounting guidelines and bank regulation guidelines do not always coincide. Recent
accounting mark-to-market rules of the IFRS are a case in point. Indeed, the role that
markto-market accounting may have played in the evaluation of assets of financial institutions in
recent months and in hampering the ability of creditor financial institutions to organize
workouts of debt with their customers has been a matter of some discussion. Accounting
rules tend to make the decision to reschedule or reorganize debt workouts a matter for
greater provisioning by the financial institution, thus discouraging workouts and the long term
prospect of recovery.
In the recent US case, earlier in the year, Government intervened and mandated that some
customers must be given time to reorganise their debts. However, accounting rules do not
predispose to making arrangements with ones creditors. The verdict is out on how the
Spanish solution of dynamic provisioning has solved the problem. The counter-argument is
that these system prolong the period over which debt is collectible and in the meanwhile
might be misrepresenting the value of the asset. Discussion and dialogue with the
accounting associations seem to be critical to resolving this problem which has the potential
for preventing recovery of debt over the longer term.
Review of Basel II Accord
The new Basel II Accord is expected to eliminate some of those anomalies, but it is not
perfect. Still, Basel II covers more comprehensive range of risks, better align regulatory
capital to underlying risks, integrates capital requirement to a larger framework and provides
for the role of supervisors in evaluating risk and market discipline. Since it provides options to
banks, it appears to encourage improvements in the risk management processes. Policy
makers have already realised the importance of this new accord, and presently it is in
different stages of implementation across the globe. However, the implementation in itself
demands even more concentrated efforts and capacity building both with regulators and
concerned stakeholders. However, following the sub-prime crisis in the US there are growing
concerns about the advanced internal based approach which gives banks flexibility to
develop their own risk assessment systems, in light of what happened in the investment
banking community when these institutions had total autonomy to do so and did not.
The role of market needs to be enhanced to discipline businesses indulging in excessive
risk-taking. But this is not going to be an easy task, especially in the economies that have
built-in safety nets which translate to negative incentives and which hamper market discipline
on one hand and in turn encourage excessive risk taking by banks on the other.
Moral hazard and market discipline
The usefulness of market discipline in augmenting the supervisory roles cannot be
overlooked, but has to be reworked. While some of these safety nets are indispensable, we
should seek ways to reduce associated moral hazard, and perfect the market discipline
framework to complement supervisory practices. The extent to which markets discipline
themselves is however being questioned and it is becoming clearer that there must be
penalties for inappropriate and risky behaviour which threaten system stability.
Improved disclosure about risk profile, risk management practices and performances and
related matters facilitates market discipline by enabling the market participants as well as
supervisors to assess the soundness of a bank given the level of risks it assumes. The
market assessment of the bank's soundness as reflected in the pricing of its products by the
market could be used as an indicator for devising effective policy responses.
A great deal of effort has been put into the introduction of Basel II by the BIS and in most
organizations there is a tendency to protect one's creation. However, it is important that
given the questions that have been raised about certain aspects of Basel II in the contest of
the sub-prime crisis and the moral hazard of self assessment, that the architects of Basel II
revisit some of the major tenets of the new proposed regulatory framework, especially the
advanced approach.
The role of ratings
In a Basel II-regulated world, and in a world where market discipline matters greatly, ratings
will become even more important. Ratings should reflect risk and prompt more responsible
behaviour by financial institutions who value their ratings. This too has its challenges since in
many instances pricing is based on a risk rating, itself the product of analysis of information
that has been provided to the ratings agency by the specific issuer. Following the sub-prime
fallout, the validity of ratings, rating agency modeling, methodology and their compensation
has been called into question. Therefore, any enhanced programme aimed at improving the
governance of the global financial system may require some changes to the ratings
infrastructure and the extent to which ratings reflect risk and are not overly influenced by
massive corporate profits of high-risk institutions. Indeed a special rating for risk may be
appropriate - that is both for risk in the firm and transferred risk - i.e. risk transferred by the
firm to the system.
There needs to be a series of major changes to plug the loopholes in the system and
regulators need to ensure that they are as proactive as possible.
Global liquidity management
Over the past several years the liberalization of the financial system has created the need for
liquidity to be provided, not to governments through the IMF as was the case in the past
through stabilisation programmes but directly to financial institutions. The internationalisation
of finance and the existence of mega -banks emphasises the need for liquidity support
across large financial institutions. This may very well be beyond the capability of monetary
authorities. There is a need to identify how this problem can be solved and how that liquidity
can be provided before the problems occur. What is more serious is that where these
problems are systemic and are not restricted to any individual bank, then access to liquidity
could be very problematic. This eventuality needs to be considered before it occurs.
Towards a revised global governance structure
The question of developing a multi-pronged over-arching monitoring body is an important
factor in a revised governance system. The nucleus of this exists in the BIS and the FSF and
the IMF. The BIS already has in place, in addition to the Basel Committee on Banking
Supervision, several useful sub-committees, for example, the work on Policy Development
Group which has a number of sub committees - on Risk Management and Modelling,
Liquidity, Definition of Capital, on Trading Book matters, and on Cross-border Bank
resolution. The down-side of this arrangement is the degree of possible tunnel vision since
most of the sub-committees arose out of Basel II Accord, which now appears needs some
modification in light of recent events.
One issue is global acceptability. Most of these groups, even the International Liaison Group
- that with the widest representation - falls short of international representation, of an
organisation like the IMF with 185 members. The question is, how much is lost in terms of
global stability by the exclusion of these countries? Is their inclusion in the IMF - albeit even
there in a notional way - enough, or are they destined to continue to be excluded on the
grounds that they are not systemically important?
The Financial Stability Forum attempts to function as a critical issues forum with
representation beyond banking. This Forum, despite its G7 focus includes a number of
international financial regulatory organisations. It trys to project that it is not an arm of the
BIS, but is housed in BIS. This comes closest to being a multipurpose oversight body, but
lacks global representation, something which probably needs to be remedied if it wants to be
considered a global body with the ability to speak to other countries with authority. This group
therefore, by reporting to the IMF is able to give itself some legitimacy. The report of the FSF
of April 2008 on enhancing market and institutional resilience is an example of its work; a
good analysis with general recommendations with specific recommendations promised later.
Who, however will determine whether and how the recommendations are implemented is the
key question? The IMF?
Summary
This paper attempted to analyse the international financial governance system, its strengths
and weaknesses and in the course of the paper a number of issues were ventilated and a
number of recommendations made.
They include:
- The need for clear rules and processes for securitisation and an oversight body
whose authority is observed in this regard.
- The need to better understand current approaches to measuring risk and to track
risks in securitised loans and to improve the internal reporting systems in
megabanks.
- The need to revise incentive systems so they do not reward those who transfer risks
to others.
- Focus on financial risk generally and not on bank risks in particular.
- Concretise measures of financial stability and develop international comparability.
- Conduct more in depth studies on financial system vulnerability to inflation.
- Develop a clearly defined role for a body with multiple financial oversight
responsibilities and determine whether this is the FSF and if so deal with its global
le