Global financial reform fails to make the grade

The head for Global Financial Stability at the IMF says that reforms of financial systems across the globe are headed in the right direction, but there is much still much work to be done to encourage both simpler and safer structures.

The global reform agenda aims to make the financial system safer while allowing it to provide the intermediation services needed to fuel strong and stable economic growth. The reform is well underway, but there is still a long way to go.

The intentions of policymakers are clear and positive, and there have been a host of reforms in the right direction. The system, however, remains vulnerable; the pre-crisis financial structures have not changed much, and they will need to change if the goal is to be reached.

How we measure progress

IMF 2012, chapter 3 is an interim report on the progress made towards a safer financial system. It begins by setting out some ideals.

– Compared to the pre-crisis period, the financial system should be more transparent with better governance.

– Both regulators and investors should be able to understand the location of risks, and investors should be able to price them properly.

– The system should have less leverage and be made less prone to booms and busts.

In part, this could be accomplished with stronger financial institutions that are better equipped to withstand the distress of downturns by holding more and better loss-absorbing capital and higher liquidity buffers.

– The reformed system should allow risks to be diversified – reaping the benefits of interconnectedness and globalisation, but without the risk of destabilising contagion or rapid retrenchment of cross-border flows.

– Resolution of unviable financial institutions should occur in an effective and timely manner with a minimum cost to customers and taxpayers.

IMF collects proxies for various elements of intermediation structures with the abovementioned desirable features of a financial system in mind; 45 countries are covered.

The research focuses on the features of financial systems related to the crisis, especially those features that need to be addressed to achieve the goal of a stable and effective system.

These include:

– large, dominant, and highly interconnected institutions

– the heavy role of non-banks, and

– the development of, for instance, complex financial products.

The focus is on three intermediation features:

– Market-based or not: the extent to which financial intermediation is market-based – the hallmark trait of the US, with a big non-bank financial sector, active capital markets and banks conducting activities other than borrowing and lending (non-traditional banking).

– Size, concentration, interconnectedness: features related to the size and scope of different financial activities within a country – like the size and concentration of its banking system and how connected certain parts of the financial system are, through say, interbank markets.

– Globalisation: measures about how connected the financial system is to the rest of the world through banking systems and the importance of the country in global markets.

The next thing the study does is try to tie the reform agenda to how it could reasonably be expected to alter the various financial structures. Using both quantitative and qualitative information and a dose of judgement, a list of ‘priors’ were set out concerning how reforms could affect financial structures. The expected outcomes – including intended as well as unintended consequences – are presented in Table 3.3 of the report.

How are changes tied to regulatory reforms?

In an effort to quantify ‘progress’, we examine empirically the effects of progress on implementation of the Basel capital reforms on the various elements of financial structures and test our priors. We use the difference-in-differences method, as this technique allows us to estimate the impact of a policy by comparing the policy-induced outcome to what would have happened without it. Since Basel 3 has yet to be implemented fully, our results rely primarily on progress on Basel 2 and 2.5, where there is sufficient variation across economies to be able to discern differences statistically.

While the results should be interpreted as very preliminary, it finds that results are in line with the priors (see Table 3.5 in the report). Progress on Basel capital rules are driving banks to alter their liability structures to economise on regulatory costs. We also witness this trend in the raw data (Figure 1).

Progress is also muting the severe drop in securitisation – a result we believe is tied closely to the fact that the countries that have made the most progress on Basel 2 and 2.5 are in Europe, where securitisation is being used to produce postable collateral at the ECB. Lastly, progress is linked to lower globalisation. This is suggestive of greater home bias among those countries further along in implementation – a worrisome result (though perhaps again driven by the heavy weight of European countries in the sample). Such a trend should be watched carefully lest the benefits to cross-border risk sharing become impaired.

Figure 1. Non-traditional banking (Average of two ratios: non-loan assets in per cent of total assets and non-deposit interest-bearing liabilities in per cent of total liabilities)

Source: IMF staff estimates.

Note: The relative size of nontraditional to total banking activities is constructed as average of the following three ratios: banks' non-interest income over total income, banks' other earning assets over total assets, and banks' other interest bearing liabilities over total liabilities. Data for individual countries and cross country averages are shown.

Good effort, but requires follow through

So, overall, are the reforms moving the structures in the right direction – to a safer financial system? Our answer so far is: ‘somewhat, but not enough.'

There are a couple of good reasons for the lack of progress.

– Some regions are still in a crisis.

Measures aimed at preventing deeper financial system distress, and bolstering nascent economic growth, remain in place, and tend to slow the adjustment process.

– There are built-in, long implementation periods (Figure 2) (Basel Committee on Banking Supervision 2011a and 2011b) for the agreed reform agenda.

Nonetheless, there are elements, such as the Basel 2.5 international banking rules and the market’s anticipation of the Basel 3 implementation, that are promising: many banks hold more and better loss-absorbing capital and have begun to divest themselves of activities they view as less profitable.

Figure 2. G20 regulatory reform agenda: Key elements and progress


The problematic structures are still with us

Overall, however, the basic financial structures that we found problematic before the crisis are still with us:

– Financial systems are still overly complex.

– Banking assets are highly concentrated, with strong domestic interlinkages.

– The too-important-to-fail issues are unresolved.

– Banking systems are still over-reliant on wholesale funding.

As some activities become costly, some banks will get out of those businesses, but others with enough scale economies will stay in, making these activities even more concentrated – the fixed income, currency, and commodities trading business line is one such activity.

The good news is that, overall, globalisation has not been seriously harmed, with the exception of crisis-hit economies in Europe. But this also means that the potential for contagion – with bad outcomes from one country affecting the financial system in another – is still present. Moreover, the fragmentation currently underway in the EZ is a reminder that globalisation has a downside that needs to be offset with, at a minimum, appropriate risk management techniques, good governance within institutions, and effective cross-border resolution schemes.

Figure 3. Three-bank asset-concentration ratio

Source: IMF staff estimates.

Note: Data for individual countries and cross country averages are shown.

Figure 4. Wholesale funding ratios (non-deposit liabilities in per cent of total liabilities)
Source: IMF staff estimates.

Note: Data for individual countries and cross country averages are shown.

What to do?

Given the still-vulnerable financial system, what should be done? By taking stock of all the regulatory reforms to date we can see some areas that still need to be addressed. These areas include:

– More discussion on what it takes to break the 'too-important-to-fail' conundrum, including a global level discussion of the pros and cons of direct restrictions on business models.

We can already see that both the Volcker Rule in the US, which aims to force banks to divest their trading businesses, and the Vickers commission proposals in the UK, which would ringfence retail banking from investment banking activities, will have effects beyond their respective jurisdictions. The European Commission’s new Liikanen report, with recommendations for the EU banking system, should also be included in such a discussion. A global perspective is sorely needed.

– We need further progress on recovery and resolution planning for large institutions, especially cross-border resolution.

– Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector.

– Careful thought about how to encourage simpler financial products and simpler organisational structures.

Even with new rules on the books, their success depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer. Policymakers need to press ahead. We are not encouraging a sprint, but simply a brisk, purposeful walk towards the goal of a safer financial system.

Laura Kodres is Assistant Director and Division Chief for the Global Financial Stability Analysis Division in the Monetary and Capital Markets Department, IMF. This article is an amended version of chapter 3 of the IMF's Global Financial Stability Report and appeared at Republished with permission.