lorenzo bini smaghi : how to strengthen europe ’ s financial stability framework? introductory remarks by mr lorenzo bini smaghi, member of the executive board of the european central bank, at the roundtable discussion of the cfs - imf conference “ a financial stability framework for europe : managing financial soundness in an integrated market ”, frankfurt am main, 26 september 2008. the views expressed reflect only those of the author. * * * it is certainly appropriate to reflect on ways to strengthen europe ’ s financial stability framework. at this stage our reflections are bound to be tentative, given that we are still managing the current crisis. what seems to be sure, even in the current phase, is that changes are required at all levels of the financial infrastructure, from accounting to prudential rules, from the oversight of rating agencies to risk management practices in financial institutions. this crisis should lead all parties involved to a deep rethinking of the role of financial industry and legislation in our societies. the starting point is well known : the very specific nature of financial markets which can function only to the extent that there is confidence. confidence in financial markets, and within financial markets, depends on many factors. regulation is only one factor. the second step of the reflection – which is often forgotten or treated in a partial way – is to recognize that the whole financial infrastructure is affected by conflicts of interest. the conflict is between individual and collective interest. unless these conflicts are identified and dealt with, at all levels, any reform of the framework is bound to be partial and dealing mainly with failures of the past, rather than address the challenges of the future. the problem is that, by their very nature, conflicts of interest are hardly recognized by those that are directly affected by them. this is why a sustainable reform requires the contribution of all parties involved. i will not list all the conflicts in the financial system, nor the remedies, but only provide some examples of what needs to be tackled, with a top down approach, from legislation to market participants. let me start with the first conflict of interest, at the political level, which involves those that are responsible for financial markets legislation. we know by now that those sectors of the financial markets that are less regulated are also more prone to be risk taker and thus more profitable, at least in certain periods. there is a clear incentive for market participants to have less regulation, at least for the part of industry in which they operate. there

turned down by some countries. maybe they could review this position in light of recent events. at the international level, in particular in discussions with the us, the aim of achieving common rules on a whole series of issues, such as capital requirements, accounting rules, offshore centres, hedge funds, has always bumped against the interests behind the ongoing competition between financial systems, in particular financial centres. similar conflicts of interest affect the supervisory authorities in the performance of their tasks of producing secondary legislation and overseeing financial institutions. in addition to contributing to the stability of their financial system, supervisory authorities have as implicit – and sometimes explicit – task, that of defending and promoting their national industry, within an integrated international financial market. to some extent this puts supervisory authorities in competition among themselves, which affects their regulatory and oversight tasks. the incentive to compete is in conflict with the need to cooperate, especially in a single market, particularly in the supervision of large and complex institutions. proposals have been put forward, in particular in europe, to establish colleges of supervisors in order to coordinate the oversight of financial institutions present in several countries. but it is difficult to know how well these colleges would be working in the presence of such conflicts of interest which create obstacles for the exchange of information, especially on critical institutions. developments of recent days tend to confirm this hypothesis. conflicts of interest emerge not only with respect to crisis prevention but also crisis resolution. authorities have an incentive to push the burden of adjustment, in case of a crisis, towards other institutions, either domestic or foreign. recent experience has shown that conflicts of interest hamper the necessary transmission of information on critical institutions from the supervisory authority to the central bank, even within the same country, in the hope that weak institutions would be bailed out by liquidity injections rather than by addressing the solvency problem. this makes contagion from individual institutions to the rest of the market more difficult to avoid. it also undermines confidence between financial institutions. the lesson to be learned is that if supervisory functions are entrusted to a separate authority, outside the central bank, voluntary cooperation between the two is not sufficient. there must be an obligation for the former to provide the central bank with a whole series of detailed informations. the same incentive exists at the international level, including within a monetary union, where the use of the inflation tax to help out weak banks would enable to spread out the cost to all taxpayers of the union rather than to only those of the country of origin. the superimposition