Restoring Confidence and Creating Resilience in the Global Financial System

Charles Dallara is the Managing Director of the Institute of International Finance

oday, as the global financial crisis enters its third year, there is • Development with the official sector of bettera understanding Tevidence of a restoration of financial stability. At the same time, of systemic risk, using this understanding in risk management, there is a need for far-reaching regulatory reforms to reinforce the and working with the official sector on macroprudential means financial services industry’s efforts to strengthen the global financial through which it can be identified, addressed, and mitigated; system. The key is to restore confidence in and stability of the financial system. This is imperative, above all, to secure well functioning • Significantly enhanced risk management, processing, financial markets that are essential for sustaining global economic transparency, and systems and procedures for carrying on growth. Credit Default Swaps (CDS) and other Over-the-Counter (OTC) derivatives business. In the wide-ranging debates in many countries over regulatory reform of the financial system, there has largely been insufficient attention to In addition on compensation, significant reforms of firms’ efforts that firms themselves have made to take the lessons learned compensation practices are taking place to align incentives with from the crisis and implement operational and governance reforms long-term shareholders’ interests and firm-wide profitability, taking that, as I believe is already becoming increasingly apparent, are account of overall risk and cost of capital. The IIF’s members are contributing to healthier institutions. Before discussing the public committed to implementation of the principles on compensation set sector’s approaches to regulatory reform, therefore, I believe it is out in the Market Practices Report and we welcome the new Financial useful to look at what the industry has been doing. Stability Board’s Principles for Sound Compensation Practices published in April. As the crisis started in the second half of 2007, leaders of the world’s largest financial services firms agreed to establish a special commit- Given the progress being made within firms, and the extensive tee on market best practices in the Institute of International Finance developments completed or underway in the official sector, we see (IIF) to understand the weaknesses that the crisis was exposing and to reform of the financial system onto a more stable and sustainable formulate principles and recommendations to guide reforms within path as very much a shared responsibility between the industry banks and other financial services firms. Senior executives from more and the public sector. Our determination to contribute to public than 60 firms participated in this undertaking which resulted in July, understanding and to provide the perspectives of the financial 2008, in the publication of the “Final Report of the IIF Committee on services industry to many of the proposals for reform that have been Market Best Practices: Principles of Conduct and Best Practice Recom- published in recent months, has led our IIF Special Committee on mendations. Financial Services In- Effective Regulation to recently dustry Response to the Market Tur- publish a new report, Restoring moil of 2007-2008.” Confidence, Creating Resilience: An “We believe that the crisis affords a Industry Perspective on the Future of This IIF report has become a International Financial Regulation blueprint for action, the subject unique opportunity to build a more and the Search for Stability. of many management seminars in efficient global financial system” many countries and an important The IIF is the global association of influence on the many changes more than 375 member institutions that we are now seeing in firms. To be sure, much remains to be done and the new report reflects the views of a very wide spectrum of the to strengthen practices in many firms, but significant advances have industry’s leaders. The IIF Special Committee is co-chaired by William already been seen, including the following: T Winters, Co-Chief JP Morgan’s Investment Bank and Member of the JP Morgan Chase’s Operating Committee, and Walter B Kielholz, • Materially improved risk management, including more Chairman of the Board of Directors, Swiss Reinsurance Company Ltd robust risk governance, strengthened capabilities in risk (as of May 2009), former Chairman of the Board of Directors of Credit aggregation, improved stress testing, improvement of market- Suisse Group (2003-2009). The report stresses that financial regulatory risk management and significant investment in risk systems and reforms must better align incentives for sound risk management, data; improve transparency, and enhance resilience over the business cycle. It notes the overarching need to build a strong international financial • Increased and better quality capital compared to the position system reinforced by well-coordinated international regulation and prior to the crisis, in response to market and official demand; credible market discipline. Regulatory measures need to be designed with strong international cooperation to achieve regulatory goals on • Better liquidity risk management, including more robust an effective but also efficient basis. analysis of funding needs and sources, wide application of stress-testing techniques, and substantial liquidity buffers; We believe that the crisis affords a unique opportunity to build a more efficient global financial system. To achieve this, the new regulatory • Substantial reduction of leverage, both on a systemic and framework of the system needs to be well coordinated across borders individual-firm basis, based on the clear recognition of the with an emphasis on consistency and harmonization. It will need to negative effects of excessive leverage; avoid inward-looking measures that may seem to make sense from a national perspective, but can damage the overall system if taken • Reducing procyclicality by analyzing its causes, refining without adequate coordination across national jurisdictions. provisioning practices and making more extensive use of “through-the-cycle” approaches to capital; The fact is that in recent months we have seen how an array of national authorities have responded to the crisis by taking measures • Material improvement on disclosure and transparency with a distinctly domestic orientation without adequate consistency through Pillar 3, together with industry initiatives to reform and coordination with other countries. There is reason to be securitization, working toward more transparent, liquid, and concerned that should this trend continue, it risks the fragmentation standardized markets, and clarifying firms’ off-balance-sheet of the system of international regulation. Regulatory coordination is exposures; absolutely crucial for sustaining an open global system of finance,

14 WCR investment and trade. We suggest in our report, for example, that At the same time, our report underscores that it would be counter- the Financial Stability Board’s (FSB) mandate and resources could be productive to create formal categories of highly systemically relevant expanded to help avoid regulatory fragmentation. firms that should be subject to separate or additional regulation. To do so would invite adverse consequences and could add to instability It is important to understand that the financial services industry fully at a time of market volatility. The report does stress, however, that supports the need for regulation to be enhanced in scope, impact, large and complex institutions may need to be subject to more and quality to minimize systemic risks and as best as possible, prevent intense supervision, depending on the risks inherent in their business. future crises. For example, we accept that levels of capital in many The report stated, “It is essential that all parties recognize that systemic parts of the system leading up to the crisis were insufficient and risk may emerge from the complex interaction of institutions, markets that overall levels in the system may need to be increased within the and products, and that focusing solely on a list of institutions is unlikely framework of a revised Basel II risk-based approach. In this connection to help detect or manage systemic risks more effectively. It would give rise we strongly supports measures to counter cyclicality by building to a mistaken sense that systemic risk had been corralled and controlled resources in good times that can be drawn down in bad times. within such a category of firms; it would incentivize risk migration and opacity; it would give rise to undue reliance on an entity-based prism for Moreover, we do believe that leverage in the system has been too viewing systemic risk; and it would create distortion moral hazard.” high and needs to be kept under control in the future. This requires a regulatory response to reinforce industry efforts and market As we point out in our report, systemic events can be triggered by incentives. Rather than hard-wired ratios, which do not take into firms of many different shapes and sizes or by market developments. account actual portfolio composition and basic risk issues, we are More importantly, such risks do not reside in single entities but in the recommending a less rigid approach. We suggest an approach where interconnectedness of global markets, players and products. Large supervisors can react to individual situations and adopt appropriately institutions play an important role in supporting the global economy. sharp remedial actions, avoiding arbitrary and anomalous results that Artificial restrictions on size could produce materially distorting distort prudent lending patterns. effects and unmanageable risk patterns within the system.

But, as authorities consider remedies to past weaknesses and Noting that successful regulation needs to operate in tandem with new regulatory approaches, so we underscore the need to avoid well-disciplined markets, we have emphasized that there needs to be duplicative or inefficiently burdensome solutions, which inevitably meaningful market discipline over firms. This means that investors would be at the expense of consumers. For example, one could see and creditors (other than ordinary depositors or policy-holders) need some authorities increasing capital and liquidity requirements at the to face a possibility of loss and so it needs to be made feasible for group level, and then others doing so again at the individual country even the largest financial firms to fail. And, in this regard, we suggest level. All reforms should be framed around risk-based principles, that it should be a priority to implement the infrastructural, legal, and decided through strengthened international coordination. process reforms necessary to ensure that all firms can exit the market in an orderly fashion and without causing a systemic crisis regardless What we emphasize is that regulatory reform should be implemented of their size, nature, or range of activities. with an integrated global perspective and an assessment of the cumulative impact of all of the different changes that are being At the same time, while government interventions to secure stability devised – in home country and host country regulations, in have been welcome and important, it is necessary now to develop intensity of supervision, in conduct-of-business regulation, and in strategies for governments to exit their holdings in financial firms and accounting – that are in the works. We are concerned that multiple end debt guarantee programs and extraordinary support for markets official institutions doing hard, often technical work via different and liquidity. We stress that well-formulated, well-coordinated, and workstreams may not have the time to make an integrated judgment well-executed exit plans are essential to avoid competitive distortions of all the changes that have been or will be imposed, especially on an and ensure a level playing field both within and across countries and international level. Yet that impact assessment is absolutely essential to restore an effectively functioning market place. to devising a new system that is efficiently functional as well as safe and sound. The substantial progress being made within firms today to adopt practices that guard against vulnerabilities and that offer strong An issue that is discussed in detail in our new report and that is prospects for stable and sustainable corporate development are likely very much on the stage of public debate today relates to how best to join with important reforms of the regulation and supervision of to make changes in the architecture, objectives, and framework of the financial system. We are hopeful that the opportunity indeed will financial regulation, domestic and international, to reduce systemic be seized to create a more effective and efficient international system. risks. We agree that all market participants whose activities could And, we look forward to a continued and deepened dialogue with materially impact systemic stability should fall within the framework the official sector, at national and international levels, as a reformed of macroprudential oversight regardless of form or license. So also framework takes shape. The combined efforts of the industry and should all financial markets and products with similar potential for the official community can, if properly coordinated, have enormous systemic impact. potential to assist in the reestablishment of financial stability and create a more resilient system for the future. ■

Charles Dallara became the third Managing Director of the Institute of International Finance in 1993. Before joining the Institute, he was a Managing Director at JP Morgan & Company. He was the head of investment and commercial banking business in Eastern Europe and the CIS, the Middle East, South-eastern Europe, Africa, and India. He was also Chairman of Morgan’s Emerging Markets Risk Committee. Mr Dallara was appointed by President George Bush as Assistant Secretary of the US Treasury for International Affairs in 1989, serving until 1991. He was also Assistant Secretary for Policy Development and the Senior Advisor for Policy to the Secretary of the Treasury from 1988 to 1989, US Executive Director of the International Monetary Fund from 1984 to 1989, and Senior Deputy Assistant Secretary of the Treasury for International Economic Policy from 1985 to 1988. Charles H Dallara was born in Spartanburg, South Carolina, and was educated at the University of South Carolina and the Fletcher School of Law and Diplomacy at Tufts University in Medford, Massachusetts. He received an Honorary Doctor of Laws Degree by the University of South Carolina in 1990. The Institute of International Finance (IIF) is the global association of financial institutions. Members include most of the world’s largest financial services firms, including leading commercial and investment banks, insurance companies with global operations, and investment management firms. The Institute, established 25 years ago with its offices in Washington DC, has more than 375 members headquartered in more than 65 countries, including Australia. www.iif.com

WCR 15 15