Tiff Macklem: Raising the house of reform
Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to
the Rotman Institute for International Business, Toronto, Ontario, 7 February 2012.
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Introduction
It is a pleasure to be here this morning. I want to thank the Rotman Institute for International
Business, and particularly its co-directors, Wendy Dobson and Ig Horstmann, for inviting me.
Like many of us, I have benefited tremendously from Wendy's insight, her ruthless truth
telling and her sage advice on international issues. Ig Horstmann was one of my professors
in graduate school. And I owe him a debt of gratitude for turning an enthusiastic student of
macroeconomics on to the importance and utility of microeconomics - training that has
proven invaluable in grappling with issues of financial regulation. My remarks today combine
both these elements - international economics and financial regulation.
I want to talk to you about the imperative of completing the reform of the global financial
system.
Some are calling for a slowdown of the reform process, arguing that a weak global recovery
and elevated uncertainty are good reasons to ease up on implementation.
The global economy is certainly underperforming. The euro area appears to have fallen back
into recession, with a sovereign debt crisis that poses clear and present downside risks. In
the United States, housing and labour markets have proven stubbornly slow to recover, and
there is a large fiscal adjustment still to come.
But the current challenges are not an excuse for delay. Quite the opposite - they underscore
the urgent need to make the financial system more resilient. In a risky world, the need to
make the financial system safer and restore confidence is vital. If there is a reproach to be
made, it is that progress has not been faster.
The G-20 Leaders' 2009 plan of action to strengthen the financial system was appropriately
sweeping. It included:
 enhanced transparency and disclosure so markets work better;
 larger capital and liquidity buffers to make banks safer;
 broadening the span of regulation and oversight so that all systemically important
financial institutions, markets and products are included;
 stronger infrastructure so that core financial markets continue to function in periods
of stress; and
 credible and effective resolution regimes for all financial institutions so that no
institution is too big to fail.
With the architecture for their house of reform sketched out, the Leaders assigned
responsibility for the detailed design and construction to the Financial Stability Board (FSB).
Now, almost three years later, construction is well underway.
But it's a big house with several wings. The foundation has been laid and the framing has
been completed. Some wings are even ready for occupancy, while in others the walls are still
going up.
In my remarks today, I will focus on the key prerequisites for completing construction and the
challenges of moving in. I will organize my remarks around the three Cs essential to get to
completion: the need to be comprehensive, coordinated and consistent.
Reform must be comprehensive, spanning institutions, markets and products, from inception
to resolution.
Reform must be coordinated across its many elements, across jurisdictions and with
stakeholders.
And reform must be implemented in a consistent manner around the globe.
Comprehensive
To ensure the reforms are comprehensive, work began at the core of the financial system
and is now moving outward to the periphery. Three wings that will house the reforms to the
core are now ready to move into.
First, the new Basel III capital rules have been finalized and are now being implemented over
a suitably gradual transition period. The new standard substantially increases the
lossbearing capital that financial institutions must hold and establishes a new limit on leverage.
This is a significant strengthening of the global rules, effectively raising the minimum global
capital requirement sevenfold.
Second, a methodology to assess systemic importance has been developed, and 29 banks
have been identified as globally systemic. These banks are required to have additional
lossabsorption capacity tailored to their systemic importance, ranging from 1 per cent to 2.5 per
cent of risk-weighted assets, to be held in common equity. They will also be subject to closer
scrutiny by bank supervisors.
Third, to be able to resolve firms - no matter how large - without disruption to the economy
or cost to taxpayers, the FSB has developed a new international resolution standard. Work is
now turning to the implementation of the Key Attributes for Effective Resolution.
By the end of this year, global systemically important financial institutions (SIFIs) will have
completed:
 resolvability assessments;
 recovery and resolution plans; and
 institution-specific, cross-border co-operation agreements so that home and host
authorities are better equipped to deal with crises.
The sooner we move in, the sooner we roll back too big to fail.
Other wings of the house are at various stages of construction. Permit me a few words about
each.
Liquidity standards
The construction of new minimum standards to enhance banks' liquidity buffers is well
advanced, but needs some remodelling before completion. The current definition of
highquality liquid assets is too narrow, focusing only on sovereign debt and cash. This may have
the unintended consequence of increasing segmentation and reducing liquidity in some
financial markets. Consideration should be given to broadening the definition to allow for a
continuum of asset types, with suitable haircuts and limits.
Systemically important financial institutions
With additional protections for global SIFIs agreed, work is now under way to extend extra
resiliency requirements to banks that are not globally systemic but are systemic at the
national or domestic level. This includes developing an appropriate methodology for
identifying domestic SIFIs, and outlining prudential measures to mitigate the risks they pose.
Given the significant differences across countries in the structure of national banking
systems, this framework should adopt a principles-based approach so that regulators have
the flexibility to focus on the additional requirements that will be most effective within their
domestic context.
The systemic risks posed by other types of financial institutions and financial infrastructures
are also being reviewed. The International Association of Insurance Supervisors (IAIS) is
developing a methodology to identify activities of insurance companies that are systemically
important on a global scale, including both traditional insurance and ancillary activities. Once
the nature of their systemic activities has been identified, consideration will need to be given
to any additional buffers that may be required - a task made more difficult by the lack of an
international prudential accord for insurance companies.
The Committee on Payment and Settlement Systems (CPSS) and the International
Organization of Securities Commissions (IOSCO) are currently developing safety and
soundness principles for financial market infrastructures, such as central counterparties
(CCPs). Work is also under way to examine the systemic activities of other types of non-bank
financial firms or so-called shadow banks.
Shadow banking
Drawing the systemic elements of shadow banking into the regulatory net was a central
element of the G-20 Leaders' reform vision. They agreed that regulation and oversight
should depend on the nature of the activity - not legal structure - and that like activities
should receive like treatment.
In many countries, including Canada, market-based financing or shadow banking is at least
as large as the traditional banking sector. Shadow banking spans a range of activities,
including repurchase agreements, mortgage-backed securities, other types of securitization,
short-term debt instruments and money market mutual funds. The sector provides
competition to traditional banking and is an important source of diversification and innovation.
But it also entails many of the same risks that are inherent in traditional banking.
Like the credit intermediation of banks, shadow banking involves liquidity and maturity
transformation, often with some degree of leverage. Moreover, as the financial crisis made
painfully clear, the systemic risks of shadow-banking activities can be magnified by the
interconnectedness of the financial system - stresses within shadow banks can be
transmitted to the core of the financial system in unforeseen ways.
Foundational elements to achieve more comparable treatment are now in place, including
enhanced disclosure requirements, the new consolidation accounting standard and minimum
risk-retention rules. But much work is needed on the full range of policy options to control
systemic risks in the shadow-banking sector. These include: direct regulation of the activities
of shadow banks; indirect regulation via links to the traditional banking sector; targeting
specific products; and various macroprudential measures.
By the end of 2012, the FSB, with the relevant standard-setting bodies, will develop policy
recommendations on shadow banking in five priority areas:
 the interactions of regulated banks with shadow banking entities and activities;
 money market mutual funds;
 other shadow-banking entities;
 securitization; and
 securities lending and repos.
Policy reforms in all of these areas should be guided by four considerations.
First, with the capital and liquidity standards applied to banks set to increase, we can expect
to see new incentives for activities to migrate to the shadow-banking sector, increasing the
need for timely reform.
Second, the reforms must strike an effective balance between the benefits of shadow
banking, in terms of competition, diversification and innovation, and the risks related to
regulatory arbitrage and systemic vulnerabilities.
Third, given the important differences in the structure of shadow-banking activities across
countries, the best means of mitigating systemic risks is likely to differ across jurisdictions.
But given that shadow-banking activity crosses national borders, there is a need for a
coherent global approach to these issues.
Fourth, the reforms and the approach to monitoring the sector must be flexible and
adaptable, since changes in regulation and innovation can lead to rapid expansion and
mutation of shadow-banking activities.
Central counterparties for OTC derivatives
The final element of the comprehensive reform plan is mitigating contagion between sectors
and institutions in the financial system. The house needs firewalls.
Recognizing this imperative, the G-20 Leaders mandated that all standardized OTC
derivatives contracts should be traded on exchanges or electronic trading platforms, where
appropriate, and cleared through CCPs. In addition, all OTC derivatives trades should be
reported to trade repositories.
The architecture for trade repositories is converging on a global platform, although important
issues of data access are still to be worked out.
For CCPs, the basic architecture has yet to be resolved. There are two competing designs -
global and local - and each has its costs and benefits.
The global design has the greatest potential to reduce fixed costs, maximize netting benefits
and economize on collateral. At the same time, these very benefits would concentrate
clearing risk in a small number of very large global CCPs. They could also create a
competitive advantage for the largest global banks, serving to reinforce their systemic
importance.
The alternative is a more distributed model in which local CCPs are established to clear OTC
derivatives transactions outside the United States and the European Union. While this design
would reduce concentration and provide for greater competition, it could result in an overly
fragmented architecture, with local CCPs that are not sufficiently efficient and robust.
To inform decisions on architectural design, the FSB, working with the standard setters, is
coordinating efforts to develop adequate safeguards for a global architecture, especially with
regard to access, cross-border emergency liquidity arrangements, co-operative oversight and
resolution.
The goal is to complete the work on these safeguards by June so that each jurisdiction can
make an informed choice about its preferred clearing architecture this year.
Coordinated
Let me now turn to the second C - coordinated. Reform elements must be balanced,
coherent, mutually reinforcing and well integrated. The FSB's overarching role is to ensure
global coordination across all the elements of reform and across countries.
Coordination across the elements means we must consider the combined effect of the totality
of the reforms, including both their cumulative impact and their interaction. We should avoid
overreliance on one instrument, and strive for balance. For example, as the experience of
some firms in the financial crisis highlighted, even strong capital levels, by themselves, do
not provide adequate protection. While important, capital buffers need to be buttressed with
sound risk management, a leverage cap, liquidity requirements and measures to limit
contagion.
Coordination across countries requires a coordinating process. Historically, responsibility for
financial sector policy has been spread across national agencies as well as international
standard-setting bodies. The crisis underscored the importance of the FSB's key
coordinating role.
Now chaired by Bank of Canada Governor Mark Carney, the FSB is acting on a clear remit
from the G-20. As the general contractor in the reform process, the FSB coordinates all
aspects of construction. Over the past four years, the FSB has undertaken much of the policy
work itself through its standing committees, while other aspects of construction have been
subcontracted to international standard-setting bodies, including the Basel Committee, CPSS
and IOSCO.
The FSB's responsibilities loop from conception to feedback. The FSB takes the lead in
identifying critical financial vulnerabilities, developing new policies and then assessing their
implementation and effectiveness (Figure 1).
These efforts are being undertaken in coordination with the private sector. Broad consultation
is essential to effective design. To steal a line from the late Michael Mussa on the perils of
seeking input from just one kind of specialist, if you only consult plumbers, every room is
going to have a toilet. Reform proposals are being developed in consultation with the
financial community and released for public commentary and input from industry round
tables.
Consistent
That brings me to the third C - consistent implementation.
If the new global standards are to promote international financial stability, they must be
consistently implemented across the major financial jurisdictions. Consistent does not mean
one size fits all. Most standards, such as the Basel capital rules, are international minimums.
Countries can adopt stronger rules or, as Canada is doing with Basel III, implement more
quickly than the generous maximum phase-in period.
The monitoring of implementation is coordinated by the FSB's Standing Committee on
Standards Implementation, which I chair. Assessment has proceeded along two
complementary tracks: country reviews that examine the implementation of standards in a
single FSB member country, and thematic reviews that focus on one element and assess
implementation across the 24 FSB member countries. Six country peer reviews have now
been completed, most recently for Canada and Switzerland. And five thematic peer reviews
have examined implementation across the full FSB membership on topics ranging from
compensation practices at banks, to mortgage underwriting standards and deposit insurance
systems. So the FSB peer review system is up and running.
But already it is time for expansion.
To assess consistency in the implementation of major reforms, we are significantly
enhancing the resources devoted to monitoring, and coordinating implementation-monitoring
activities across the standard-setting bodies and the FSB. This will include annual progress
reports to the G-20 on a country-by-country basis, as well as less-frequent but more in-depth
peer reviews in priority areas.
Some commentators are concerned that the FSB lacks the authority to enforce the rules, and
have argued that it must evolve to a treaty-based organization with the power to sanction its
members. While this may ultimately prove to be the case, so far, this has not been
demonstrated. The FSB is making good progress on the basis of consensus and
cooperation. Peer reviews have reported that implementation is moving ahead, have identified
remaining gaps and have increased the focus on impediments to implementation. Countries
that are not complying have been called out.
But tougher tests lie ahead, and it is essential that the spirit of internationalism and
cooperation is sustained. Implementing Basel III is the biggest and most immediate test.
The Basel Committee is taking primary responsibility for monitoring and reporting on national
implementation of Basel III. The committee will first look at whether each member's financial
system legislation is consistent with the Basel III requirements, and then at whether the
riskweighting rules are applied similarly across countries. It will conduct and publish
country-bycountry reviews and provide the FSB with an assessment of progress and gaps. If there are
material deviations from Basel III, they will need to be fixed. Full and consistent
implementation is imperative.
Conclusion
Allow me to conclude. The global financial system must be flexible enough to respond to the
dynamics of the global economy. But it must also be able to retain its structural integrity in
the face of powerful cross-currents generated by multi-polar economic development, rapid
technological innovation and increasing financial globalization. The reforms we are
constructing to house the financial system will allow us to track and identify emerging
vulnerabilities and promote its stability. The goal is a dynamic and resilient financial system
that serves the needs of households and businesses in good times and in bad.
The FSB is building the reforms on a foundation of consensus among G-20 members.
Despite its small size, the FSB has accomplished a great deal in just two and half years. Now
it needs to reach out and network to foster closer relationships with international financial
institutions, standard-setting bodies and non-member countries.
The FSB also needs to be placed on a more secure footing if it is to be an enduring pillar of
the international financial architecture. To that end, the G-20 Leaders agreed at the Cannes
Summit last November that the FSB should expand its resources, and gain legal personality
and greater financial autonomy. This will extend the FSB's capacity to coordinate, monitor
and assess financial reform.
But, ultimately, it is up to the FSB's member countries to ensure that the house of reform
becomes the home to the financial system. Full implementation is the responsibility of every
member. We should expect no less.
Thank you.