06 June 2012

BIS/Caruana: Progress and challenges in financial reform

The current global economic uncertainty makes it all the more important to follow through on strengthening financial reform. BIS General Manager, Jaime Caruana, outlined the key elements of the global financial reform agenda.

Underlying principles

• First, there is the need to have reliable buffers in the system - capital, liquidity, sound infrastructure, strengthened resolution - that will prevent macro-economic surprises, problems in a specific institution or particular market strains from disrupting the broader financial system.
• Second, preserving financial stability involves a wide range of policies.
• Third, a globalised financial system requires consistent global rules.
• Fourth, building a stronger system is not just a job for the public sector. It is in the interest of the private sector to contribute to financial stability and to end the cycle of destabilising crises.

The remaining challenges for financial reform fall into three broad groups:

• First, consistently implementing what has already been agreed.
• Second, completing the regulatory reform agenda, including resolution regimes, over-the-counter (OTC) derivatives and the shadow banking system.
• Third, ensuring adequate oversight, including macroprudential oversight and more proactive prudential supervision.

Consistent implementation of what has been agreed

Basel III enhances the regulatory framework introduced by Basel II at the level of individual institutions, and sets up a macro-prudential overlay to limit systemic risk. But agreeing on Basel III is only a first step; the next phase, implementation, is just as critical.

1. Better and more capital and liquidity

Basel III raises the level and quality of capital in the system. Basel III also addresses systemic risk in both of its dimensions, mitigating procyclicality over time, and reducing interconnection and contagion risk across firms and markets. The second central element of Basel III, complementing capital, is liquidity. The new liquidity standard includes a liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR).

2. Monitoring implementation

Full, consistent and timely implementation by national jurisdictions is now at the top of the Basel Committee's agenda. It has started to conduct peer and thematic reviews to help ensure timely and consistent implementation of all elements of the Basel framework.

Completing the regulatory reform agenda

1. Strengthening resolution

The goal of strengthening resolution frameworks is significantly to reduce the possibility that authorities will find themselves forced to bail out institutions in order to prevent costly market disruption. By reducing the impact of failure, we also lessen the expectation of an official bailout, and thereby reduce moral hazard.

2. OTC derivatives markets

• First, the G20 has agreed that standardised OTC derivatives need to be traded on an exchange and cleared through a central counterparty, or CCP, not bilaterally. This will strengthen the system by making financial institutions less interconnected.
• Second, OTC derivatives trades will need to be reported to a trade repository, which registers electronically all relevant details of an OTC derivatives transaction over its lifetime.
• Third, banking and market supervisors are developing rules to make sure that the risks of derivatives that are not centrally cleared are covered by appropriate capital and margining.

3. Shadow banking

A third critical element of the reform agenda is to monitor and, where appropriate, to address the risks posed by the shadow banking system. Shadow banking can perform valuable functions, such as supplying alternative funding for the real economy, and providing banks and investors with the means to manage credit, liquidity and maturity risks. However, as the financial crisis has shown, systemic risk and regulatory arbitrage can build up in the shadow banking system. Therefore, it is important to monitor the evolution of shadow banking and to address the risks it poses.

Proactive oversight of the financial system

Mr Caruana pointed out that writing rules is not enough. Institutions and processes are needed to ensure that the goals of the new regulatory framework are achieved consistently and effectively.

On the one hand, countries are putting in place macro-prudential oversight frameworks that will support and complement reforms at the micro-prudential level. On the other hand, efforts to implement the new rules need to be supported by enhanced supervision of individual banks, including their asset composition and risk management practices. Supervisors must also be alert to the ongoing evolution of the financial system, in order to address the consequences of financial innovation and regulatory arbitrage.

Full speech

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