Don’t Forget Financial Sector Reform

By John Lipsky

There is a broad consensus on at least one conclusion from the turmoil of the past few years: Fundamental changes are needed in the global financial sector.

Some of these changes seem relatively clear:

  • Risk management of many financial firms needs strengthening
  • Compensation schemes need to be re-evaluated
  • Capital standards need to be bolstered
  • Regulation needs fundamental reform
  • Supervision needs to be improved
  • And financial institutions’ balance sheets need to be freed of the burden of impaired assets.

Nonetheless, important tradeoffs will have to be addressed—and political hurdles surmounted—before significant progress can be achieved.

In particular, restoring economic growth will require renewed credit flows, while some of the needed reforms may limit the ability of financial institutions to meet this need, at least in the near term.

And looking beyond the next few quarters, policymakers will have to balance the need for a dynamic and innovative financial sector with the objective of managing risk and reducing the likelihood of systemic crises.

Risk of slippage

In my Jackson Hole blogs last August, I singled out reforming financial sector regulation as a key task facing policymakers. This remains true today, but there is a risk that it will slip down the list of priorities as growth engines are starting up again and financial conditions have improved.

After all, reforming financial regulation is politically difficult, and no doubt some will worry that it could complicate efforts to get credit flowing again.

In addition, there is still a lot of anger directed against those institutions viewed as responsible for the crisis in the first place, especially since many of these same institutions received taxpayer funding in order to resist the crisis.

In some countries, policymakers are responding by enacting one-off taxes on financial sector bonuses. However, no one—including the proponents of these measures—considers them to be a substitute for the more fundamental reforms needed to help avoid future crises.

Key principles

In fact, there is broad agreement on the key principles of financial sector reform.

  • First, the perimeter of regulation needs to be widened to encompass all systemically important institutions.
  • Second, macro-prudential elements need to be added to existing regulation, which today focuses almost exclusively on individual instruments and institutions.
  • Third, (and this is already in train), regulatory standards on capital and liquidity must be strengthened to better reflect firm risk exposures and risk profiles.  Almost certainly, this will imply increased capital buffers and new limits on risk-taking.
  • Finally, a robust resolution regime is required for large, complex financial institutions that operate in multiple jurisdictions.

In making the reform effort operational, the Financial Stability Board (FSB) will take the leading role in coordinating the development of new global standards for regulation and supervision. These standards subsequently will be adopted and implemented at the national level. The IMF’s unique role is to conduct independent monitoring of the implementation of the agreed standards.

Strengthened supervision

While the need for enhancing regulation has received much of the attention, bolstering supervision also is critical.

Even today, notable risk management deficiencies persist in many important financial institutions.  Improving the performance of supervisory authorities means increasing the resources devoted to this task, and providing the backing needed to make sure that supervisory recommendations are taken seriously.

Of course, bank boards play a key role in setting and monitoring risk management standards, and in many cases, their oversight function needs to be sharpened. The design of compensation schemes also is relevant, and the FSB already has promulgated standards that will help reduce concerns that compensation schemes are promoting excessive risk-taking.

Beyond regulation and supervisory reforms, the question remains, “Who should bear the cost of crisis mitigation?”

Burden sharing

It is natural to ask whether the financial sector itself should shoulder at least some of the burden, both as an incentive to reduce the risk of future crises, and for reasons of fairness.

The G-20 Leaders, in their Pittsburgh Summit Communiqué, asked the IMF to investigate how the financial sector could make “a fair and substantial” contribution to paying for government interventions to repair the system, and we anticipate providing leaders with an options paper at their June Summit.

The issue of burden sharing is complex and contentious, but—despite the widespread practice of paying for deposit insurance through a banking levy—up to now that question has received little systematic attention. And discussions that have taken place recently have tended not to focus on the potentially important tradeoffs involved in designing a sound regulatory system.

As part of that debate, governments must face the challenge of balancing the need for more constraining regulation that limits the cost of future crises against the need to promote effective financial intermediation. An important element in that debate is whether taxes applied to more risky financial activities—either directly or indirectly— could be designed to reinforce or possibly substitute, to some extent, for stricter regulation.

The public debate also seems to be divided about the purpose of a new financial sector charge or tax. For example, the issue of whether and how to recoup the costs of the net support already provided in the current crisis would lead to a different set of policy options than the issue of whether and how to create a mechanism to cope with potential future costs. Both issues are relevant and related, but they need to be analyzed independently.

Perhaps most notably, there has been widespread public discussion about the advisability of a tax on financial transactions. This is sometimes referred to as a “Tobin tax,” reflecting an early 1970s proposal by the late Nobel laureate James Tobin. However, Tobin’s specific proposal was restricted only to foreign exchange transactions, and was intended to suppress transactions, not raise revenue. While some of the current supporters of a financial transactions tax intend it in Tobin’s sense, others have extolled such a tax as a potential source of earmarked revenues for a variety of purposes.

The IMF’s analysis will cover the issues and options broadly. These options, including—but not limited to—a financial transactions tax, will be evaluated in terms of their potential to reduce distortions and improve systemic efficiency and effectiveness. The pros and cons of creating a fund in advance of future crises also will be addressed.  This analysis will be supported by an evaluation of more technical issues such as the definition of systemically important institutions, the perimeter for the supervised financial sector and implementation of any regulatory changes needed to support financial stability. See also my interview with IMF Survey online.

In short, the entire reform effort won’t be either quick or easy, but the potential payoff could be significant in terms of underpinning long-term growth, and enhancing systemic stability.  Actual implementation will require sustained cooperation and focus.  Improved global governance—including of the IMF—will aid this effort, and this will be the subject of the next piece in this series.

2017-04-15T14:42:30-05:00January 7, 2010|


  1. Miroslav January 8, 2010 at 4:07 pm

    Please make sure that 30-year-old ideas are not treated as correct policy responses simply because of the association with a Nobel Prize. Actually, there is very little research supporting Tobin’s normative ideas (see Liu and Zhu 2009 for a recent example of such support), in fact volatility is generally found to increase as a function of transaction costs.

    Only a theoretician like him could escape Popperian falsifiability for so long and maintain his idee fixe, the 0.5% tax rate on currencies until 2001 (while Forex spreads tightened to 0.00001).

    Actually, his ‘modest proposal’ was pretty comprehensive, and he did not stop from trying to tax everything “denominated” in foreign currency, including coin, equities and even international trade payments (for goods, services, and property). See his (in)famous ‘sand in the wheels’ paper (Tobin 1978, p.158-159, )

  2. Per Kurowski January 8, 2010 at 6:24 pm

    The principal pillar of the current financial regulations that of discriminating the capital requirements of banks based on perceived default risks is utterly wrong.

    Not only did it cause an excessive demand for AAAs and which, naturally, given the shortage of real AAAs, was met with the fabrication of false AAAs, but it also provides additional benefits to those who having reached the top of credibility, the AAAs, least needed it. To benefit the AAA rated with low capital requirements amounts by definition, to the mother of all pro-cyclical regulations.

    The largest source for misallocation of funds, namely the fact that the borrowing by AAA rated governments are still benefitted with a zero capital requirement, shows clearly that the faulty group-thinking that led to the current crisis keeps on going as strong as ever.

    Also the exponential increase in the importance of the credit rating agencies is causing the whole system to end up as dumb followers of a human very fallible GPS system, that has already once failed, “subprime mortgages”, and that is bound to fail over and over again, every time more explosively.

    Nothing of the above is even mentioned in what the author calls the “broad agreement on the key principles of financial sector reform.”

    To have a Financial Stability Board, a veritable clone of the Basel Committee thinking, to be the sounding board for financial regulatory reform is almost laughable, were the implications not so tragic.

    The regulators are obviously trapped in their current paradigm and, if they cannot get out of it, they have to be thrown out of it.

    The minimum think we need is that they clearly specify the objectives for the financial sector as just not defaulting sounds as ambitious as not having you kid to fall once while learning to walk.
    Our banks should be the best instrument for the society to take the right and best risks… not the experts in avoiding them.

    Our banks are not there only to avoid default risks or to be a safe-mattress for the depositors our banks are there to help society to move forward to grow and to generate sustainable jobs.

    To see how there are now calls for tightening up the capital requirements of banks only to have bureaucrats make the credit allocation decisions is almost criminal behavior.

    There is nothing wrong with having the public purse to pick up the cost of a bank crisis, if the banks had been doing their best in helping society… but it is a horror story having to foot that cost when a crisis like this has resulted from banks assisting a real estate property boom that brought so little.

    Per Kurowski

    I am a former Executive Director of the World Bank, 2002-2004 and I have been arguing against the Basel Committee bank regulation paradigm for more than a decade.

  3. S. Simpson January 8, 2010 at 6:34 pm

    “Improved global governance” is an unfortunate expression that causes increasing Main Street fear and disparagement. Highly respected financial academics regularly warn of the serious consequences associated with any form of transactions tax. Experienced tax specialists are publicly terming the idea of a transaction tax as “wildly reckless” and “crazy”.

    Present discussions on “global” money collection experimentation appear to be politically motivated, social engineering attempts to cut across the sovereign rights of independent nations–via a central agency.

    It is clear that some less financially astute nations are wrongfully eyeing the perceived potential tax benefits to be delivered from hard working, responsible financial sector industries. That may well be the present perspective of some present (temporary) politicians, but it would not be in the wider global interests for long-term jobs, or erring well-managed nations who mistakenly succumbed to questionable external pressures.

    “Global” imposition (interference) in the rights of independent sovereign nations to determine, manage, and maintain their financial affairs according to their individual political, financial, cultural and social variables, is absolutely unacceptable.

    One nation that has already rejected the transactions tax idea (in addition to United States Treasury Secretary Geithner, and Canada’s leadership) is Australia. (Prime Minister K. Rudd’s 17 December 2009 announcement): “In terms of Tobin taxes or aviation taxes, of course, that’s not the view of the Australian Government…”

    Mathematic modelling shows that a tax on transactions, even as low as 0.001%, would shut down millions of jobs, trickle down to Main Street, impacting the financial sector so that almost zero-transactions tax revenue would occur due to the disappearance of job-generating activity. Concomitant loss of national income tax revenues from presently employed workers would follow.

    An iniquitous financial transactions tax would severely damage small investors, large investors, retirees, self-supporting families, small businesses, particularly impacting on agriculture, so acquiescing countries would bear the brunt of an insidious, possibly irreversible strangulation of jobs at every level. Amongst all and sundry, from transactions tax proposals alone–farming communities are now experiencing further business uncertainty and stress.

    In addition, the wiser of the present crop of political leaders would certainly reject the potential fiscal strangulation effects of any type of transactions tax, not only for its potential revenue and jobs harm, but because the idea represents unacceptable external governance over their independent populations.

    Some countries did not enter a recession, their banks did not fail, they are progressing well under their own steam, applying responsibly self-defined unique taxation regimes, under sound treasury management, without external interferences and constraints. The constituencies of those nations in particular would feel very let down if their current leaderships signed on to any form of global transactions tax commitment.

    I feel very concerned that the IMF is even considering a global tax proposal.

    Governments are extremely temporary, so leaderships that may be foolishly persuaded to sign their constituents into any permanent global financial markets control now, may soon be followed by alternative governments that would dismantle it.

    This is an unhealthy, potentially divisive, and seriously bad idea.

    The IMF, and all professionals associated with this unsettling discussion, have a duty and perfect opportunity to end the uncertainty as quickly as possible.

  4. Anthony Schippers January 9, 2010 at 8:27 am

    The financial crisis started out from the bad lending behaviours of banks and bad loan securitization in unregulated illiquid over-the-counter markets–that’s where the regulation is needed and where the burden sharing should take place.

    If the G-20 decide to introduce a transaction tax, no matter how small it is, banks, who should be targeted for burden sharing, would :
    – Move their trading activities to an untaxed jurisdiction.
    – Move their regular exchange trading to OTC (most derivative volume is already OTC)
    – Obtain exemptions as liquidity providers.This would be tempting for authorities after realizing a lack of liquidity is affecting the market place. It is the case in the UK with the stamp tax and it is the most unfair market we can think about.
    – Widen bid/ask spreads based on the rate of the tax for their market making activities. That’s basic finance 101: Let’s say I’ m a market maker on derivatives. My margin of profitability is 0.01% per trade (it should be a lot lower in real derivatives world ). If you tax me 0.01% per trade, the only thing I can do to survive is to widen my bid/ask spreads by at least 0.01%, in which case the cost of the tax is reported on liquidity takers like investors, hedgers, producers, pension funds…

    The Tobin tax is sold as a Wall Street tax, but really is a tax on Main Street. If you want to tax Wall Street, you need to tax financial institutions directly, by an insurance levy, a tax on profits, on bonuses…That’s what the Obama administration is currently preparing and what should be preferred over the populist Tobin tax.

    Most participants in the stock and derivatives regulated markets never made real estate loans, never had acess to OTC CDS and CDO markets, never asked for, nor received, aid from taxpayers. Those with whom the burden should be shared are not those that would effectively pay the Tobin tax.

  5. Per Kurowski January 9, 2010 at 4:41 pm

    When regulators decide that lending to a small unrated business, for instance, needs to be backed up with 8 percent in bank equity, while when lending to AAA rated enterprises 1.6 percent suffices, the difference amounts to a regulatory tax which discriminates based on perceived risks. I am not sold on the idea of a Tobin Tax–most definitely not some of the really silly versions of it–but, when compared to the “risk-tax”, a minuscule Tobin tax that does not discriminate and perhaps even serves as a small “give it a second thought” incentive is a much less harmful source of distortion.

    And to argue about distortions when the IMF sanctions that their bosses, the governments, can borrow from banks without the banks being required to put any capital at all, just proves how distorted the regulations themselves have become.

    The only way “the financial sector could make ‘a fair and substantial’ contribution to paying for government interventions to repair the system” is obviously by being more efficient in all ways on how they perform their financial intermediation function. Asking them anything else, like performing some community service for which they are not prepared, will just make matters worse.

    How do you achieve more efficiency in the financial sector? By making sure real competition exists by allowing banks to fold fast an easy and by not favoring larger banks as Basel II does, and by eliminating regulatory interferences, like that of the oligopolistic importance assigned to the credit rating agencies which have now turned these into real Frankenstein’s monsters running amok all over the markets.

  6. Miroslav January 11, 2010 at 6:55 am

    It is harder than you think not to succumb to the Tobin tax sales pitch, Mr Kurowski … most journalists did. Even some economists do, regardless of all those non-falsifiable terms such as “excessive volatility.” “long term overshooting,” or indeed “speculation” itself (half of which is liquidity providing according to SEC).

    But seriously, how can anyone know a priori that something is ‘miniscule’ (‘tiny’, etc.)? Aren’t such terms relative? So why not compare them to some benchmark to see how tiny they really are?

    How about couching Tobin in terms of a ‘sales tax’ on stocks? It would be imposed anyway in the same manner as sales taxes, i.e. by local governments/exchanges, because residence is generally used as the connecting factor under int’l tax laws (almost all FTT taxes imposed in the past had to provide ex-country exemptions, because Tobin’s original idea of taxing foreign residents is probably not legal anyway).

    So an average sales tax in the United States (according to the Economic Policy Institute, who first came up with this sales tax analogy) is about 5%. Now, Anthony below has already revealed that his margins are as thin as 0.01%. And I have reasons to believe him, seeing e.g. same-size fixed-distance (i.e. single-firm) prices quoted outside of regular business hours by US market-making firms. These are only a few cents apart (on stocks worth 20-100 dollars).

    So a 0.25% tax on Main Street sales would indeed be tiny, because these businesses can already afford 5% sales taxes, simply because their average markups are much higher than most customers suspect. If you forced Main Street to quote two-sided prices you would probably see they are 50-100% apart. So your typical $30 stock would not cost 30.05 to buy and 30.00 to sell, but perhaps 29.99/59.99 (ever wondered how can they survive those -50% bargains?)

    If on the other hand, market makers (and other liquididy-providing stock traders) operated with monopoly powers in tiny regional niches, with no transparency whatsoever, they could easily afford a 5% Tobin tax. But please ask yourself if you would really want to buy and hold a mutual fund with its typical 70% annual turnover?

    Vanguard has estimated that over the past 10 years transactions costs on their trades (which for such behemoths means mostly bid/ask spreads and market impact) have fallen by more than 50%, resulting in approximately $1 billion of annual savings to their investors (as per the Malkiel/Sauter article in WSJ). And I believe these savings would be gone post-Tobin, because it would restore near-monopoly powers to those who could afford the exemptions. Stock exchange membership fees do not come cheaply these days, and these firms would have to be exempted as official liquidity providers (most intermediaries are already exempted in the UK, even OTC stock betting shops – an entirely new ‘spread betting’ industry was spawned by this tax). Imagine the media outcry by the way (‘Banks exempted from tax on bank transactions’)

    We can’t really expect rational agents to avoid reaping monopoly markups–the ‘competition’ among these fellows we have already witnessed before the advent of direct access, low-commmission brokers–stock price spreads in the 80’s were not 0.01%, but 10-50 times higher, and Vanguard had to pay up – meaning you and me. I’s good to see there are still some deficit hawks left out there in the sky, but did you really know it would be you who’d contribute to the Treasury coffers? I thought we wanted to tax banks, not Per Kurowski.

    And I do agree Tobin’s shortcomings are almost as difficult to explain to the media as Basel/VaR shortcomings were for yourself and Mr. Taleb… which why such faulty but well-promoted (by unions/JP Morgan, respectively) ideas are probably always a foregone conclusion–the end-user notices our warnings only after the idea has spectacularly blown up.

    Talking of which, perhaps there is a glimmer of hope. And we did have some early adopters of the FTT tax on a smaller national scale – just read the Wrobel (1996) report on the Swedish experience with the FTT tax. Or indeed Australia halving the rate two times and each time the tax revenue rising (talk about the Laffer curve). So maybe thanks to the enlightented IMF folks we won’t have go back to the 80’s and re-live the 50-cent spreads on stocks, with taxable volumes dropping so much that the tax rate would have to rise (Swedish style) before you can even say ‘negative feedback’. (I hope mine was at least neutral.)

  7. Anthony Schippers January 11, 2010 at 12:48 pm

    Distortions between actors of finance is fine, in my opinion, when only a few actors represent a systemic risk and can cause economic turmoil. It would even be a lot easier to implement on a global scale. You just have to choose a few criteria to define which institutions can be considered risky in their activities, identify them, and tax them directly (like corporate taxes). It’s much easier than to coordinate every exchange, clearing house, etc.

    A risk tax doesn’t introduce more moral hazard than a Tobin tax. The money coming from a Tobin tax will be used in the same manner for further bailouts.

    Moreover, it wouldn’t create a disincentive to risky trades as most risky trades are done OVER THE COUNTER. People need to understand that most risky institutional trades happen over the counter, not on regulated exchanges. It was the case in 2008. A Tobin tax cannot be applied to OTC trades. Only a tax per institution can achieve this goal.

    When everything is said, it is always better to tax profits than what is used to make those profits. Some trading profits are outrageous. Why not tax them? At least everybody keeps his job.

  8. Per Kurowski January 11, 2010 at 5:48 pm

    You say “It is harder than you think not to succumb to the Tobin tax sales pitch.” No, I know how hard it is because even when I tie myself hard to the mast there are days I succumb to the songs of the Tobin sirens.

    But the purpose of my comment was different. It was to describe the difference between a Tobin tax, applied to all transactions of one category, “a speed bump”, which could be a good or a bad speed bump; and the current capital requirements for banks based on risks which discriminate, “a channel” which diverts the funds, toward what is perceived as low risk and away from where the risks are perceived to be higher. And, between slowing and channeling in the financial markets, I always take the first.

    And I am not talking peanuts here … what is the cost of 8 percent in bank equity that an ordinary citizen has to pay for when taking loans from his bank when compared to the 1.6 percent a AAA rated borrower needs to pay or the zero percent the government pays?

    Then you say “I thought we wanted to tax banks, not Per Kurowski.” No I have not said I want to tax banks… why would I? A bank’s purpose is to be a good financial utility for the society, not a fiscal cash-cow. What I want though is to get rid of all the other inefficiencies that allow the banks too high intermediation margins, as those margins are the ones really taxing the small businesses, the entrepreneurs and the ordinary citizens like Per Kurowski and Miroslav. (I know you will now tell me the Tobin tax is just another new layer of inefficiency and you are right, but at least one can hold that this layer would be more transparent than the others)

    And so here comes my pragmatic recommendation… let us give the world the Tobin tax it seems to want (make it truly minuscule) so that we can stop discussing that issue and proceed to discuss much more important issues, like the elimination of the Basel Committee Risk-Tax.

  9. iMFdirect January 12, 2010 at 7:04 am

    Thanks to all for very interesting comments. I’d also like to draw your attention to my recent interview with IMF Survey magazine on the options we are considering for the financial sector.

  10. […] first deputy managing director, recently argued that no country believes the measures so far are anything other than one-offs and not a “substitute for the more fundamental reforms needed to help avoid future […]

  11. Joanne Thornton January 14, 2010 at 11:03 am

    As Anthony Schippers pointed out, the U.S. government is considering an assessment on the liabilities of large financial institutions rather than a transaction tax. This assessment also would be levied on U.S. subsidiaries of foreign financial firms in addition to domestic institutions. This proposal likely will be viewed favorably by U.S. politicians because it would “level the playing field” between domestic firms and their foreign competitors operating in the U.S. market.
    But overseas affiliates of U.S. financial firms could face a similar tax or fee imposed by foreign governments — in fact the Obama administration has said it will promote this idea via the G-20 and Financial Stability Board.
    Regarding the proper balance between regulation/taxation and effective financial intermediation, the IMF’s study will help to put this in a global context. In addition to considering whether taxes could offset regulation, we should also think about avoiding double taxation of firms that operate in multiple jurisdictions.

  12. Miroslav January 16, 2010 at 10:30 am

    Bailout Insurance Premium? That would be the first attempt to price in the hidden taxpayer’s cost of the ‘government put’ – the (so far) free option embedded in the government-funded bankruptcy protection (the implict bailout guarantee extented to those ‘Too Big To Fail’ or TBTF).

    But the IMF would have to guarantee that governments meet their insurers’ obligations. These institutions which carry ‘genuine’ systemic risk (asset-based tests or similar definitions are needed) and would have to pay the Bailout Insurance Premium, should be treated seriously, i.e. protected unconditionally, ‘Genuine Too Big Too Fail’ (as opposed to: Too Big To Fail, But Then Again I’m Having Second Thoughts, Let’s Not Throw Good Money After Bad, Shall We? Chapter 11 Is Cheaper Here.)

    CIT Group, the newly re-emerged from bankruptcy U.S. bank holding company would most likely qualify to pay such international Bailout Insurance Premium, at least judging from the asset-based test proposed in the U.S. (to be assessed for the Financial Crisis Responsibility Fee, an institution’s consolidated assets must exceed an arbitrary threshold of $50 billion).
    However, despite being initially treated as TBTF and receiving $2.3 billion of government aid (now wiped out together with all other stock), the U.S. Treasury subsequently “rebuffed further bailout requests over the summer, after concluding CIT’s demise wouldn’t threaten the broad financial system,” reflecting the opinion of some bank bailout experts such as Linus Wilson, who think that “the $50 to $100 billion banks pose no systemic risk.” (See Simon Johnson’s blog)

    So, to make the fee viable and accepted as fair by the insured institutions, an explicit, judgement-free contract should be drawn, clearly and unconditionally stating the obligations of the insurer, i.e. the liquidity provision services offered to the premium payer.

    One of the biggest problems with any forward-looking insurance premia is of course its predictive element–these insurance contracts would be, after all, designed to replace the currently used ad-hoc extraordinary measures, creating an expectation that premiums collected are adequate to cover the costs of future bailouts completely.

    However, accurate forecasing of future magnitudes of such one-off events as financial liquidity crises seems unlikely, so these insurance policies would have to be very flexible, still allowing eligible banks to demand more money than will be available in the TARP-equivalent insurance pool(s) (in return the insured would agree to a retroactive surcharge in the premium rate, designed to recoup the additional money provided by the government).

  13. Miroslav January 25, 2010 at 6:56 am

    A recent report “Debt and deleveraging: The global credit bubble and its economic consequences” published by McKinsey Global Institute (McKinsey & Co’s research arm established in 1990) includes several suggestions for regulators seeking to increase financial markets stability (see p. 46-8).

    The report argues in favor of the following stability-enhancing measures, all of which are targeting “excessive” build-up of leverage in the financial system and in the real economy, placing constraints on such build-up to avoid “over-leveraging” and ease the deleveraging process required afterwards:

    1) a high-granularity (sector-level), internationally standardized system for tracking leverage should be maintained by the Financial Stability Board or the IMF, which would facilitate early identification of potentially developing credit bubbles (with sector-level leverage being proxy for such bubbles),

    2) a new regulation should be incorporated in the Basel II framework, requiring banks to adjust their internal risk models to reflect levels of leverage in the relevant sectors (or ideally even narrower borrower groups) they are exposed to; this would effectively force banks to increase capital reserves in anticipation of any increases in default rates, rather than merely reacting to volatility increases when the deleveraging process is already underway (note that this assumes leverage is a leading indicator of volatility, which may be contested by banks forced to implement such models at their own expense),

    3) because it would be “impractical and undesirable” for regulators to intervene at a very micro level of detail, macroprudential policy should be used instead to control leverage levels in specific (overheated) sectors of the real economy; an example of such intervention, albeit still at a national level, is a comprehensive set of “overexuberance” metrics (with readily available datasets) and a systemic risk “surcharge” over the existing microprudential bank capital requirements, recently proposed by the Bank of England (see pages 17-19 of their November 2009 discussion paper “The role of macroprudential policy”),

    4) national regulators should reassess the need for further increases in bank capital ratios, given that the leverage of the US commercial banks has already reached average pre-crisis levels by the third quarter of 2009 (the ratio of risk-weighted assets to Core Tier 1 capital is around 13.3, i.e. below the 15-year average of 13.8) and further regulation-induced compulsory deleveraging would restric credit supply to the real economy or raise the cost of credit; if this long-term leverage level were to be used as a regulatory leverage limit (i.e. if banks were required to maintain at least 7.5% of tangible common equity to secure their risk-weighted assets), then 3/4 of the banks in financial distress would have weathered the recent financial crisis,

    5) central bankers should include leverage in their monetary policy objectives, on top of the traditional inflation targets, thus preventing the development of asset bubbles, not only in financial markets but also in real estate; this can be also achieved with more precisely targeted regulatory tools, such as margin requirements propagated through the broker-dealer industry (already implemented or under discussion, such as the new leverage limits recently proposed by the U.S. regulators) or maximum loan-to-value ratios permitted in mortgage lending (however difficult they may be to implement for political reasons),

    6) policymakers should reconsider the highly preferential tax and capital treatment of residential mortgages, because most bank loans are extended to finance real estate purchases (and asset bubbles), at the cost of small and medium-sized enterprise loans; moreover, equity financing should receive equal treatment with corporate debt issuance (which currently enjoys preferential tax treatment),

    7) regulators should analyze and possibly limit all incentives for households to take on debt (broadly defined, not restricted to tax incentives, because they were not required for overleveraging to develop in countries such as Spain), making it more difficult to access credit, especially for less creditworthy borrowers (this should include limiting loan-to-value ratios on broadly defined household debt).

  14. […] feel under intense political pressure to act on financial sector regulation. A consensus on how to move ahead on a financial sector tax hasn’t emerged yet, but that a process, initiated by the G-20 industrialized and emerging […]

  15. […] autour du monde, ce que j'ai appelé à ces pages, au grand gaspillage. C'est pourquoi il nous indique les pas qui se devraient prendre pour revertir celles-ci politiques par la crise c'est-à-dire pour revertir politiques confondues […]

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