Mario Draghi: The social market economy and the solutions to the global
financial and economic crisis
Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial
Stability Board, for the European People's Party high-level policy debate on "The social
market economy and the solutions to the global financial and economic crisis", EPP Statutory
Congress, Bonn, 9 December 2009.
* * *
I am very pleased to be here to talk about progress in finding and implementing solutions to
the global financial crisis. You have decided to focus today and tomorrow on issues that are
critically important to our economies and our citizens. And I am honoured to have this
opportunity to speak about where we are in terms of financial regulatory reform, what has
been achieved to date and the priorities ahead.
One year after the climax of the financial crisis, market conditions have eased significantly
and a degree of confidence in the financial system has returned. However, the market
reaction to Dubai's woes is a reminder that they remain unusually vulnerable to shocks.
The crisis has implied a massive transfer of debt from the private to the public sector. Fiscal
positions have deteriorated across the board at an unprecedented pace. Public deficits in the
G7 countries have surged from 2% of GDP in 2007 to 10% today. The limits set by the
Stability and Growth Pact will be exceeded until 2014 at least for the euro area. Although
necessary and unavoidable, those extraordinary borrowing needs, combined with long-term
fiscal challenges on healthcare, pension systems and climate change, will lead to public debt
in excess of 100% of GDP in OECD countries in 2010 (up from 74% in 2007).
It is no surprise therefore that markets have been recently more sensitive to accumulating
debt burdens in government and quasi-government sectors. Sovereigns represent an
increasing share of transactions in credit protection markets (CDS), as market participants
challenge the assumption that they are risk-free. Government auctions have faced from time
to time unsatisfactory demand, even for highly-rated issuers. Sovereign CDS premia remain
volatile and elevated. Markets also show more discrimination across countries. While
developed countries come under funding pressure, emerging countries with low debt levels
are now able to issue long term, as shown by the recent 50-year bond of China, sometimes
at fixed rate and in local currency, which was unimaginable just a few years ago. So there is
a way out, but governments need to communicate credibly their medium-term plans to
restore fiscal sustainability, in order to limit upward pressure on their funding costs and to
retain their ready access to global markets. That is important not only to deliver fiscal
prudence, but also to avoid adverse spill-over to the rest of the financial system given their
pivotal benchmark status.
On the funding front, there are also heightened risks of crowding out. Global refinancing
needs are firmly skewed towards shorter term maturities. Estimates differ, but bank and
corporate bond redemptions hover around USD 3 to 4,000 billon annually from 2010 to 2012,
double the annual amount of the mid-2000s. Roll-over of government debt will come on top
of those needs. Leveraged borrowers such as high-yield companies also face refinancing
pressure. And securitization markets are thawing only very slowly.
Overall, markets will need to refinance higher debt levels with lower average quality and with
a reduced tolerance towards leverage, in a time window when support schemes will
progressively unwind. Such absorption pressure may well lead to higher and more volatile
funding costs. Therefore, it is now time that financial institutions and corporates engage
proactively in lengthening their debt profile and tapping global markets in an orderly fashion
given the risk that they may otherwise be forced to raise funds under less attractive terms.
Amidst these challenges, restoring a well functioning market-based economy also requires
exiting from the exceptional financial sector support measures introduced since 2007.
Clearly, the timing, speed and modalities of exit involve important trade-offs, and judgment
will need to be used. Implementing exit strategies will require striking an uneasy balance
between exiting too early and too late. This underscores how important it is that we resolve
the regulatory issues in front of us, which will be part and parcel of our ability to exit this crisis
with confidence in the resilience of our financial system.
Bolstering the resilience of the financial system is a broad project encompassing a
considerable number of related measures. It involves multiple layers of policy authorities
across countries and sectors. And it requires coordination and a joined-up international
response, both for making our policies effective and for establishing a level playing field.
Driving forward a coordinated global regulatory response has been the key role of the G20
Leaders and of the Financial Stability Board, which I have the honour to chair.
Much policy development has been achieved - more than meets the eye - that when
implemented, will result in a very different financial system than the one that brought us this
crisis: a more resilient, disciplined, less procyclical and less leveraged system; one where the
perverse incentives to excessive risk taking - with private gains and socialised losses - that
characterised the recent past will have been removed. Substantial progress has been made
on a very broad front, and we have now not only a consensus internationally on the
objectives of the reform agenda, but a broad commitment to consistent implementation at the
national levels.
To name just a few of the significant changes that have already occurred: we have closed
loopholes and corrected shortcomings in the bank capital and liquidity frameworks; we have
addressed weaknesses in accounting standards; improved risk management and disclosure
standards for financial institutions; introduced new standards and principles on sound
compensation; and we have enhanced oversight of credit rating agencies and hedge funds.
But we are far from done. Work is underway in critical areas, and implementation of the full
set of needed reforms will require political will and perseverance. We simply must take the
steps that are needed to ensure we can exit this crisis confident that we have put in place a
much stronger system for the future.
A lot of what needs to be done requires international consistency because finance is global.
It is therefore of critical importance that, as we set out a constructive path for reform in our
respective constituencies, we work to ensure that this takes place with a view to preserving
the advantages of integrated global financial markets and a level playing field across
countries and sectors. The Financial Stability Board takes this very seriously.
Completing and implementing financial reform thus remains a key imperative - both
nationally and internationally. Let me now speak to some of the areas where critical
decisions in the months ahead will determine whether credible reform is achieved. I will leave
aside the issues of reform of national and regional oversight structures, and focus on bank
capital and liquidity, compensation, accounting, derivatives, and addressing the moral hazard
posed by institutions that are too big to fail.
•
Improving bank capital is clearly the single most important project to build greater
resilience into the system. Through the Basel Committee on Banking Supervision,
we have now agreed the key measures needed to strengthen the capital framework
- raising the quality and quantity of capital; introducing a leverage ratio that will
constrain bank leverage; and requiring banks to create countercyclical buffers that
can be drawn down during bad times. Proposals on the first two will be developed
by the end of this year and on the last by the middle of next year. A comprehensive
impact study and the calibration of the overall capital level will be undertaken by
end-2010, looking at the cumulative effect of all the reforms and how they interact.
In other words, there will be no simplistic layering of the different elements. The
changes to Basel II will be substantial, and they will be phased in over an extended
period so as avoid any adverse interaction with current conditions.
• Regulation is being substantially enhanced on bank liquidity as well. The Basel
Committee will issue for comment early next year a new minimum liquidity standard
directed at ensuring global banks hold sufficient high-quality liquid assets to
withstand a stressed funding scenario specified by supervisors. This too will be
subject to an impact assessment.
• On countries are taking actions to implement the FSB standards
compensation,
issued in Pittsburgh and others will be following shortly. These standards address
the structure and governance of compensation; they also call on firms - on public
policy and prudential grounds - to restrict compensation levels so long as this is
needed to retain and build the necessary level of capital. This is an area in which it
is absolutely essential that authorities take robust collective steps if they are to
dispel expectations that business can go on as usual. The FSB is now launching a
review of the actions taken by authorities and firms, focusing on consistency and
effectiveness at achieving the intended results, and will propose additional
measures as needed.
•
On accounting, we have seen progress in the revamping of financial instruments
accounting. But we are quite some distance from achieving the objectives of
improved, converged standards that are less complex and less prone to amplifying
economic cycles. This is a difficult area that we are pursuing vigorously through
dialogue between the accounting standards setters, prudential regulators and other
stakeholders. But we must do so in way that respects the integrity and
independence of the standards setting process.
•
Last but not least, we must reduce the moral hazard posed by institutions that are
too large, or too complex, or too interconnected to fail. The large-scale support we
provided in this crisis to stave off systemic collapse has materially worsened moral
hazard risks. Why should our financial firms now believe that authorities will not
stand behind them if conditions were to turn again to the worse? Moreover, many of
our banks have become larger, not smaller as a result of crisis-related mergers.
Moral hazard risks pose a large prospective burden for taxpayers and are a serious
threat to the maintenance of a market-based system. So what is to be done?
•
At the Pittsburgh Summit, the G20 Leaders called on the FSB to propose by
endOctober 2010 possible measures to reduce these problems. We are now evaluating
approaches under three headings, while recognising that there will be no silver
bullet or a one-size-fits all solution in this area:
- First, of a systemically
reducing the probability and impact of failure
important institution. The aim is to link capital and liquidity charges more
closely to the externality or spill-over costs of failure. Here, we will be
investigating a capital surcharge for systemic importance, as well as what role
new capital instruments, such as contingent capital, or other insurance
schemes could play. We will also consider options to incentivise structures
and business models that support effective supervision.
- Second, improving resolution capacity, by establishing credible resolution
frameworks for large interconnected financial institutions - frameworks that
have the ability and funding to preserve the continuity of a failing institution's
core functions, and the authority to impose losses on shareholders and
unsecured creditors Work is also underway to improve ex ante crisis
preparedness and resolution, including through the use of "living wills". We
must recognise, at the same time, that achieving effective resolution of
crossborder entities will ultimately require addressing very difficult issues - such as
recognition and harmonisation of resolution regimes, and how to share across
borders the costs of a resolution.
- Third, strengthening the core financial infrastructures and markets to
reduce contagion risks, including by moving over-the-counter derivatives onto
exchanges or central clearing platforms. Action in this latter area can shrink
the risk exposures arising from interconnectedness that contribute to
authorities having no choice but to bail out systemically important financial
institutions.
Let me conclude with two general remarks.
First, effective work to strengthen the global financial system requires policies that are well
designed and will be robust over the long run. This necessarily takes time. It is important,
therefore, that governments send a strong message that they are determined to see these
reforms through. Where international policy development is ongoing, it needs continued
support; where such policy work has concluded, we need commitment to consistent national
implementation.
Second, given the commitment G20 Leaders have made to coherent approaches as we
improve financial regulation, we must strive to overcome inconsistencies in final rule-making
and implementation at the national and regional level so as to achieve a level playing field.
The FSB will monitor this by undertaking regular peer reviews among FSB members - both
country-by-country, and by topic across the entire membership. The fundamental value of
our peer reviews will be the dialogue and constructive engagement of our members towards
the common objective of a well regulated, open, and market-based financial system.
In a global context, it is of course critically important that standards are raised everywhere. In
the FSB, we have embarked on a process to identify the non-co-operative jurisdictions that
fail to implement internationally agreed standards in the prudential and regulatory area. We
are developing a toolbox of measures that will incentivise adherence to reforms in these
jurisdictions.
We are working closely with the IMF in these areas, which has a key role in surveillance of
the global financial system, and, together with the World Bank, are well-established
assessors of authorities' implementation of key financial sector policies and standards. We
will also collaborate closely with the new European Systemic Risk Board and the European
financial supervisory structures that have now been put in place. Our shared goal is a
stronger and more resilient international financial system in which threats to stability are
engaged earlier, are better cushioned when they materialise, and where protections are
adequate to give our citizens and countries confidence in an open and integrated financial
system.