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.