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Let me address some of the key regulatory issues, beginning with bank capital and liquidity:
Capital and liquidity
Much has been done both on capital rules and liquidity standards as well as setting capital surcharges for globally systemically important banks. We are, however, worried about uneven implementation of these rules, particularly the delay of Basel III in major jurisdictions. Different rates of implementation could contribute to dilution of overall minimum standards. These delays affect longer-term business decisions, straining credit markets and spilling over to the real economy.
Accounting
Progress with accounting standards is also mixed. For example, on this same issue of risk measurement, the two main accounting bodies, the International Accounting Standards Board and US Financial Accounting Standards Board, have not reached agreement on a common approach for asset impairment, that is, whether to base it on expected or incurred losses. This is not just an academic exercise. As you know, it materially affects the assessment of asset quality and valuation, which of course informs investors and regulators about an institution’s financial strength.
Too big to fail and resolution
The IMF estimates the implicit subsidy available to big banks in terms of lower borrowing costs at about 0.8 percentage points. Others have used this to derive a dollar figure for the five largest banks in the US of about $64 billion, roughly equivalent to their typical annual profits — a gift from the taxpayer. While this may be a simplistic approach, it highlights the social dimension of the issue.
Pressure to address the moral hazard from this problem and facilitate resolution has fostered the development of regional initiatives to legislate banking activities or ring-fence operations, such as the Liikanen, Vickers and Volcker proposals, and the soon-to-be legislated German and French reforms. While well-intentioned, these separate plans could undermine common goals of harmonising global standards if they are not well coordinated.
The bottom line is that we have yet to fix “too-big-to-fail”. We need to forge ahead on three fronts to address the root cause of this problem: (1) regulation, like systemic surcharges; (2) intensive supervision; and (3) frameworks for orderly failure and resolution, nationally and across borders.
Over the counter derivatives
Progress on reform of derivative markets is too slow. We all agree that wider use of clearing houses—central counterparties—will raise transparency of over-the-counter markets and make the system safer. However, no authorities have met the deadlines to implement reforms.
First, available data shows that the increase in the value of centrally-cleared contracts has been modest. For example, as of September 2012, only 10 per cent of all credit default swaps were contracted through central counterparties. Second, data is limited, and almost non-existent for commodity, equity and foreign exchange asset classes. This is a problem we need to address.
Shadow banking
Back in 2009, when I was with the G20 Finance Ministers, we made the point that regulation needed to cover “all markets, all products, and all operators”. On shadow banking, however, I am afraid there is not much progress to report. This is worrisome since regulators were largely in the dark before the crisis hit and since then, I suspect that funds have been migrating to new unregulated activities. For example, we have anecdotal evidence—because there is no official data—that trading is moving to unregulated hedge funds.
Impact in Europe
Together with Outright Monetary Transactions and other liquidity support from the ECB, these reforms have helped to calm markets, particularly in Europe. Borrowers, however, particularly small business and households, have not yet felt the impact, and rates of lending to the real economy have not yet incorporated this framework of stronger discipline, nor the path towards banking union.
Balance Sheet Repair: The Missing Link in the Quest for Recovery
We still see fragmentation in funding conditions—a direct result of concerns about the quality of bank assets—which is impairing the credit transmission to the real economy. In addition, peripheral euro area banking systems remain relatively weak, with capital buffers still low relative to impaired assets. These banks are less able to absorb losses, which worsens the drag on new lending. This chokes off credit to viable firms and reinforces weaknesses in corporate sectors, perpetuating “zombie” companies as well as zombie banks.
There is a way out of this adverse spiral: clean up balance sheets and use a common backstop—the European Stability Mechanism (ESM)— for systemic cases. Enhanced disclosure and credible asset quality reviews will help restore confidence and banks should be urged to deleverage by raising equity and cutting business lines that are no longer viable.
Country authorities and the Single Supervisory Mechanism (SSM) should undertake selective asset quality reviews. For direct recapitalisation by the ESM, modalities and governance arrangements should be established as soon as possible.
Banking Union in Europe—Necessary and Worthwhile
This integrated oversight framework is the logical extension of an integrated banking system, but it also plays a central role in the global process of transformation. In many ways it represents a microcosm of the aims of the global regulatory reform agenda. Banking union will move responsibility for supervision and potential financial support to a shared level which would help contain systemic risks and curb moral hazard. This would remove destructive incentives for deposit flight and fragmentation, and weaken the vicious loop of rising sovereign and bank borrowing costs.
The IMF recently released two important papers on these issues, including last week the inaugural Financial System Stability Assessment for the European Union. And I would encourage you to take a look at them.
Let me first recognise the considerable progress on banking union so far: agreement on the Single Supervisory Mechanism; proposals by the EC to harmonize regulations on capital (CRR─the Capital Requirements Regulation, and CRD-IV, the Fourth Capital Requirements Directive), on resolution regimes, and for national deposit insurance schemes; agreement to draw on the ESM to recapitalise banks, with ECB supervision; and finally, commitment to a Single Resolution Mechanism with backstop arrangements to recoup taxpayer support over time.
“To do” list
Policymakers need to plow ahead with their “to do” list. Recent agreements are major steps towards a new landscape, but follow-through will be critical. This means swift adoption of the various Directives, and ensuring that they are in full compliance with global accords, namely Basel III and the FSB “Key Attributes”.
Other priorities include endowing the single supervisor with requisite resources and authority; implementing the common resolution and safety nets with a coherent, credible backstop; and setting up the resolution authority and insurance fund with access to common backstops.
Full embrace of this Union-wide architecture is needed to ensure durable financial stability, but also to sustain the currency union and the single market for financial services in Europe. This includes severing the link between weak sovereigns and future banking sector risks, otherwise the impact of new rules and institutions on economic growth, and on the citizens of Europe, will be limited.