Mario Draghi: Challenges to financial stability and the proposals of the
Financial Stability Board
Address by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial
Stability Board, at the 12th Conference of the ECB-CFS Research Network "Learning from
the Crisis: Financial Stability, Macroeconomic Policy and International Institutions", hosted by
the Einaudi Institute for Economics and Finance, Rome, 12 November 2009.
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1. The crisis and the new regulation of finance
Conditions in the financial markets have been improving steadily since last spring, but neither
risk premiums nor funding costs have come back to their pre-crisis level. At the onset of the
crisis it became soon clear that the international community had to work together closely to
find a way out of it. It was the first lesson we learnt: before the crisis, governments,
regulators, and the financial services industry had for years been affected, in more than one
dimension, by a sort of collective and pervasive blindness. The tremendous macroeconomic
imbalances that had been accumulating for years, market developments also stemming from
regulatory mistakes that had made regulators' knowledge obsolete, the new and crucial role
of intermediaries' balance sheets for the transmission of monetary policy, were all
phenomena that were either ignored or downplayed in their importance. Surprisingly, though
it was widely recognized that risk was being priced and trade globally, this did not lead to
greater international cooperation in financial regulation.
The rapid spread of this devastating financial crisis has vividly demonstrated the power and
force of global integration. If banks all over the world over-extend leverage and under-price
risk, a mere change in sentiment in the US housing market can be a sufficient catalyst for a
widespread collapse in confidence. Market liquidity evaporates, and credit supply contracts
as the global financial system comes under severe strain. After the failure of Lehman's,
markets actually froze across the globe, and extraordinary intervention was needed to
prevent systemic collapse. World trade slumped as demand plummeted. A "great recession"
was inevitable in most advanced countries.
Then it was rapidly acknowledged that international co-operation should become an essential
feature of the management of this crisis.
Financial systems were underpinned by public capital injections, massive exceptional
liquidity support and funding guarantees. And there was a widespread loosening of
macroeconomic policies. Authorities worked closely together to alleviate particular pressure
points, such as the shortage of US dollars in foreign currency swap markets, through the
introduction of temporary bilateral swap agreements. And now, as market conditions
improve, there is a clear recognition of the need to co-ordinate across countries the exit from
support measures, particularly where spillover risks are significant.
Clear political leadership for this has been provided by the G20, designated as the premier
forum for international economic and financial co-operation.
One key objective of such co-operation is to achieve radical changes to the financial system
regulation. In an integrated system, where level playing field concerns are very real, this
requires international policy development and consistent implementation. In this area, the
Financial Stability Board - which I have the privilege of currently chairing - plays a key role.
2. The role of the Financial Stability Board
The Board was established earlier this year by the G20 to lead, co-ordinate and monitor
progress in strengthening financial regulation and to drive the development and
implementation of policies to support global financial stability. It succeeded the Financial
Stability Forum, but incorporated a substantial expansion of the membership to include the
large emerging economies. And at the same time, the mandate was broadened and
enhanced. The strengthened mandate is now enshrined in the FSB Charter that took effect
from the Pittsburgh Summit last September.
So why do we need a Financial Stability Board? What is the distinctive role the Board plays
in strengthening the global financial system? How does the Board work to deliver the key
objectives set by the G20 Leaders? And what are the key priorities in the coming months?
The strength of the FSB lies in its membership. It brings together in one organization senior
level representatives (heads or deputies) from all the relevant actors: regulatory authorities,
central banks and finance ministries from 24 jurisdictions spanning the major financial
centres across the globe. Indeed, to ensure broad coverage, and thus to improve the
effectiveness of policy design and execution, membership is wider than the G20. And these
national representatives are joined on the Board by the heads of the key international
standard setting bodies and by high-level officials from the major international financial
institutions.
By harnessing the common aims and collective responsibilities of this membership, the
Board is uniquely placed to promote global financial stability. A number of objectives follow.
A primary role of the Board is to undertake the diagnosis of regulatory, supervisory and
financial policy changes needed to maintain financial stability. To deliver on this, it is our task
to ensure that the work of national authorities and the international standard setting bodies is
appropriately prioritized, effectively coordinated and focused on the health of the financial
system as a system, that gaps in the regulatory agenda are identified and filled, and that
overlaps and inconsistencies are avoided.
Second, as I will illustrate further below, many financial stability policy goals, such as
resolving the "too big to fail" problem, span a wide range of issues that require input,
expertise and action from a number of standard setting bodies and national and international
agencies. The Board will oversee these multi-dimensional work programmes, to balance the
potential solutions from individual work streams, and to offer consistent advice to political
leaders on how to develop a strong policy framework.
And third, the Board will promote consistent implementation and follow through of agreed
policies and standards.
3. Developing financial stability policies
A key responsibility - and a starting point for much of the FSB's work - is to identify sources
of vulnerability in the global financial system and how best to reduce them. There are
conjunctural as well as structural components to this assessment and, as this crisis has
amply demonstrated, these components interact.
While we regularly review trends in global financial system to identify areas where risks may
be building, our primary focus is the identification of structural weaknesses: market failures,
such as the misalignment of incentives, collective action and coordination problems;
weaknesses in market infrastructure; and information asymmetries and shortfalls. Such
"fault-lines" in the fabric of the financial system highlight the need for regulation and
supervision.
It is vital that the authorities work closely together to deliver common and consistent solutions
to identified system-wide vulnerabilities, given the potential for arbitrage and regulatory
competition and the risks of conflicts between uncoordinated national policy objectives. A
collective diagnosis is the necessary foundation for a well coordinated and effective
response.
Following the onset of the financial crisis, an urgent and immediate task of the FSB's
predecessor, the Financial Stability Forum, was to undertake a thorough assessment of the
main sources of the crisis, the weaknesses revealed and lessons for policy. In April 2008, the
FSF produced a report committing its members to a wide range of concrete actions to
strengthen financial system resilience. A further set of recommendations, focusing on ways
to reduce the procyclicality of the financial system, to improve co-operation in cross-border
crisis management, and to strengthen compensation frameworks, was published in April
2009. Together, our 2008 and 2009 reports were major inputs into the Declarations by
Leaders at the Washington and London summits on an action plan to strengthen the financial
system. We have since been asked to oversee, drive forward and co-ordinate
implementation of the action plan, and strengthen it where needed.
The key message is straightforward: we need major changes. We need to build a system
which is less leveraged, where capital and liquidity buffers are much stronger, where all
institutions or infrastructure capable of posing significant risk are subject to appropriate
oversight and safeguards, and where no institution is too big to fail. And we need a
systematic effort to reverse the misalignments in incentives that came to characterize part of
financial system.
All this requires a regulatory and prudential framework which pays much more attention to
system-wide interconnections and the health of the global financial network. We
consequently need to focus much more on the difficult, but also crucially important,
challenges of designing and implementing a macroprudential system of regulation. This will
ensure that the financial system is a source of stability that supports the economy under
stress, not a source of weakness that amplifies strains and causes major economic damage.
In undertaking this collective diagnosis and drawing up a work programme, an important
element of the FSB's role has been to ensure that there is sufficient focus on key areas that
cut across the responsibility of different international agencies and groupings. Two good
examples, high on the policy agenda, are procyclicality and compensation.
There will be major corrective measures to mitigate the procyclical tendencies of the system.
Banks will be required to build up a capital buffer during the expansionary phases of the
cycle to draw on at times of generalized difficulty. It has already been proposed to mandate a
significant increase in the capital charges on trading activities and exposures to securitization
instruments. The FSB's proposals are being addressed within the framework for capital
regulation, driven by the Basel Committee; those on provisioning, accounting and valuation
issues are taken forward by the accounting standard setters with input from the regulatory
community; those on margining practices in securities and OTC derivatives markets are
being pursued by the Committee on Payment and Settlement Systems and the Committee
on the Global Financial System.
We are now entering a critical stage in the regulatory reform process: we have to take some
difficult decisions. The Basel Committee will test those affecting the capital framework
through a comprehensive impact assessment in 2010, and phase them in as financial and
economic conditions improve.
Principles on compensation were published in the spring. The FSB followed up with
implementation standards in September, which were endorsed by G20 Leaders at the
Pittsburgh Summit. The new rules apply to top management and to anyone who has the
power to make decisions with a significant impact on the balance sheet of a bank. They
provide that a good part of compensation should be variable, dependent on the bank's
performance, but with payment deferred for at least three years and in the form of securities,
and with a claw-back clause in the event of unsatisfactory performance by the bank or the
executive. The aim of these rules is to counter excessive risk-taking, the pursuit of short-term
gain and opacity in compensation. They emphasize disclosure and the control function of the
board of directors and the shareholders. Above all, they extend regulatory jurisdiction to the
sphere of executive compensation.
Action is now urgently required by national authorities and by the standard setters for the
banking, securities and insurance industries to implement these principles consistently. A
first check on their application is scheduled for March 2010.
4. Rolling back moral hazard risk
At the top of our current agenda is the need to resolve the "too big (or too complex/too
interconnected) to fail" problem. The problem has been around for years, it has not been
addressed and, by objective measures, our actions to save the financial system this time
have expanded the problem. The FSB have committed to propose measures to reduce the
risks posed by systemically important institutions by October 2010.
Work will progress under three broad, complementary approaches.
The first is to reduce the probability and impact of failure of a systemically important
institution. Options under consideration include strengthening the resilience of the institution
through higher prudential requirements, contingent capital, or limitations on higher risk
activities, and policies that lessen the impact of failure and the associated contagion risks
through constraints on size and/or connectedness.
The second approach is to improve the capability of the financial system to deal with failure,
through ex ante contingency planning to develop individual de-risking, and through further
steps to improve national and international crisis resolution frameworks.
The third approach is to strengthen the core financial infrastructure to withstand failure,
including through arrangements for central counterparties, OTC contract design and
collateralization practices.
Given significant differences in financial structures and systems, there is unlikely to be a one
size fits all answer to the moral hazard problem. But the underlying challenges and the
necessary approaches to them are broadly similar across jurisdictions. Many of the policy
approaches discussed have level playing field implications for the structure of international
banking and financial activity.
We need therefore to ensure that the policies adopted to meet these challenges are
consistent and coordinated, do not promote arbitrage that undermines their effectiveness,
and do not impose unnecessary constraints that lead to fragmentation of the global financial
system.
5. Strengthening policy implementation
The FSB have been successful in formulating a common agenda that has gained widespread
political endorsement. But that is not enough. Effective, timely and consistent implementation
of agreed policies and standards at national level is essential: first, to resolve collective
action and coordination problems; second, to prevent harmful arbitrage, spillovers and
regulatory competition; and third, to preserve the benefits of a level playing field across the
global financial system.
It is ultimately up to the national supervisors and regulators to implement the measures they
agreed upon within the FSB. Responsibility for the surveillance on the actual implementation
belongs to the IMF.
However, one should also underline that all 24 member authorities have committed in the
FSB Charter to implement international financial standards, and to undergo periodic peer
reviews of their adherence. These peer reviews will be of two kinds - country on country
reviews, and thematic reviews which examine implementation of agreed policies in a given
area across the membership.
We will begin conducting peer reviews in January, starting with a review of the
implementation of the FSB's Principles for Compensation that I spoke about earlier. More
generally, to further bolster international consistency in rulemaking, our members will
participate in an information network to monitor the national implementation of all new
measures agreed by the FSB and G20 to strengthen global financial stability. That network
will be drawn on in future thematic reviews.
The FSB aims to lead by example to strengthen observance of international financial
standards across the globe. Independent, published, peer reviews of implementation of
standards within member jurisdictions will encourage a "race to the top" in terms of
adherence. They will also reinforce the credibility of the FSB.
6. Concluding remarks
International cooperation has limited the economic impact of the crisis, avoiding the worst
scenarios. Still, difficult challenges lie ahead of us: how to recover a balanced, sustainable
growth path; how to build a new financial regulatory framework that reflects the lessons
drawn from the crisis.
The FSB has been created to improve the design and implementation of financial policies
across the globe. The current framework has been shown to be seriously wanting and has
posed enormous economic costs. It is consequently vital that authorities diagnose the current
problems thoroughly and take bold and radical action to remedy the current deficiencies. The
need to strengthen the resilience and robustness of the global financial system is clear and
paramount.
There is a major work programme ahead for international regulatory bodies, for national
authorities, for the IMF and for the Financial Stability Board itself. In many areas, such as the
"too big to fail" problem, there will be no easy answers. In others, such as introducing a
macro-prudential or systemic approach to financial regulation, both academic and policy
thinking is still at an early stage. And as the situation improves, the power of vested interests
contrary to any substantive reform gets stronger. Nevertheless, we must take action in the
near term in all areas.
Can we prevent the next crisis? Almost by definition of the word "crisis" the response to this
question is bound to be negative, but what we can and should do is to make our financial
system more resilient when the next crisis will hit it. After all we have shown that we are able
to learn from experience. This crisis had all the potential to generate the same devastation as
in 1929, but this time both the structure of the real economies was more robust, and the
policy reaction was more perceptive and eventually successful.