By Don Alexander, MBA,
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
While financial reform is underway around the world, this communique argues that more needs to be done. The reform agenda aims to make the financial system safer while allowing it to provide the intermediation services needed to promote stable economic growth. The intentions of policymakers are clear with 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.
Laura Kodres, of the IMF, in a recent VOXEU communique Not making the grade: Report card on global financial reform (15th Oct.) discussed these issues. Progress was defined by: (1.) Compared to the pre-crisis period, the financial system should be more transparent with better governance. (2.) Both regulators and investors should be able to understand the location of risks, and be able to price them properly. (3.) The system should have less leverage and be made less prone to booms and busts.
This can be accomplished with stronger financial institutions that are better equipped to withstand the distress of downturns by holding more loss-absorbing capital and higher liquidity buffers. The reformed system should allow risks to be diversified – reaping the benefits of interconnectedness and globalization, but without the risk of contagion. Resolution of unviable financial institutions should occur in a timely manner and minimum cost.
The research on reforms focuses on the features of financial systems related to the crisis that need to be addressed to achieve the goal of a stable and effective system. These include: 1) large, dominant, and highly interconnected institutions 2) the heavy role of non-banks, and 3) the development of, for instance, complex financial products.
While the results should be interpreted as very preliminary, the results are in line with the priors. Progress on Basel capital rules are driving banks to alter their liability structures to economize on regulatory costs. Progress is also muting the severe drop in securitization – a result tied closely to the fact that the countries that have made the most progress on Basel 2 and 2.5 are in Europe, where securitization is being used to produce postable collateral at the ECB.
The reforms are moving the structures in the right direction, but progress is slow. Some regions are still in a crisis. There are built-in, long implementations for the agreed reform agenda. However, the basic financial structures that are problematic before the crisis are still present: (1.) financial systems are still overly complex. (2.) Banking assets are highly concentrated, with strong domestic interlinkages. (3.) The too-important-to-fail issues are unresolved. (4.) Banking systems are still over-reliant on wholesale funding.
Going forward, the following issues need to be addressed: (1.) 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. (2.) We need further progress on recovery and resolution planning for large institutions, especially cross-border resolution. (3.) Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector. (4.) Careful thought about how to encourage simpler financial products and simpler organizational 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 at a faster pace to avoid another accident.
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