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Important work has been accomplished to strengthen the global financial system since the onset of the financial crisis in 2008, but the system remains fragile. The International Monetary Fund (IMF) warned in September 2011 that the global financial system was more vulnerable than at any time since the 2008 financial crisis. Much of the concern focused on continued troubles in the Eurozone. While the liquidity provided by the European Central Bank helped avert a dramatic credit squeeze and bought policy-makers additional time, efforts to improve Eurozone fiscal solidarity and decrease fiscal imbalances will be a long-term project. As the world’s leaders struggled to form a response to deal with the crisis and avert future crises, the Global Agenda Council on Systemic Financial Resilience met to focus on systemic risks that continue to threaten the stability of the global financial system and to attempt to identify ways to build resilience to future risks.

 Issue Overview

The main backdrop for the work of the Council this term has been the ongoing crisis in the Eurozone, as addressing the imbalances and governance failures at the heart of the Eurozone crisis – but also in the global system – is essential to mitigating the propagation of future financial crises. Despite recent successful efforts to avert a global economic depression, the fiscal positions of many countries, particularly in the southern and western periphery of the European Union, deteriorated dramatically during this Council’s term. Numerous causes contributed to the ongoing crisis. The excessive pre-crisis expansion of private-sector credit, much of it mispriced, generated a level of economic growth and fiscal expectation that proved unsustainable. The fiscal implications broadened the financial crisis into one embracing sovereign debt. This in turn caused additional damage to the balance sheets of banks holding such debt. Concern over sovereign credit ratings and further damage to the banking system forced policy-makers to provide additional official assistance to several economies and to radically increase banks’ capital requirements.

More broadly, the financial crisis has also unveiled serious weaknesses in global, regional and national regulatory frameworks – as well as in risk-management practices and business models in the financial services industry. Additionally, approaches that continue to drive the development of national regulatory frameworks have so far, often unintentionally, departed from international regulatory harmonization. While some progress has been made in addressing these issues, significant gaps remain in the global regulatory architecture. The Financial Stability Board (FSB) has been charged at the international level with coordinating the work of G20 national financial authorities and international standard-setting bodies to promote the implementation of effective regulatory and supervisory policies that will address these vulnerabilities and promote more effective international coordination. The year 2012 will be critical to the FSB’s efforts to achieve these goals – an ambitious work plan is currently being carried out based on clear principles and timetables for implementation with the goal of ultimately strengthening global financial regulation and stability.

Given the composition of the Council on Systemic Financial Resilience and its potential for impact, this Council has seen as its role to assist the FSB in its work. FSB Chairman Mark Carney serves on the Council and one of his stated objectives is to improve the dialogue between the FSB and practitioners. The Council’s composition – bringing together representatives from the public and private sectors, academia, and a broad range of advanced and emerging economies – provides a unique perspective to these efforts. Reflecting both the FSB agenda for 2012 and the Council’s areas of expertise, it was decided to focus this report on the structural reforms of banks and, in particular, the cross-border aspects of banks’ activities. A number of national initiatives have informed the Council’s work.

 Cross-Border Resolution

Ongoing fragility in the global financial system has underscored the need for effective resolution systems to ensure that the failure of an institution cannot threaten financial stability, particularly institutions with activities linked across various jurisdictions. By the end of 2012, the FSB will have finalized a work plan to address systemically important financial institutions (SIFIs). This work plan will contain the implementation of “Key Attributes to Effective Resolution Regimes”, which includes the preparation of resolvability assessments, recovery and resolution plans, and cross-border cooperation agreements between home and host authorities for each SIFI by the end of the year. Because of the importance of this issue – which continues to pose significant challenges to global regulatory authorities – the Council has developed specific recommendations in this area.

While Council Members recognize that cross-border banking can be very different across the world, certain principles need to be established that will govern efforts globally:

  • The free mobility of capital must be ensured, but with the recognition that financial stability concerns warrant close coordination between home and host authorities.
  • The extent and depth of cross-border banking must be matched by the regulatory and supervisory framework.
  • Arrangements for cross-border resolution must inform the design of the regulatory and supervisory framework.
  • Home and host authorities should not discriminate and systemic concerns must be reflected in their decisions.

Additionally, to ensure the cross-border resolution regime can better function, the Council recommends:

  • As there are limits to legal harmonization, “home” legal systems must be recognized in resolutions to discourage other domestic systems from “grabbing assets” when problems emerge.
  • Mechanisms must be developed to improve trust across supervisors and supervisory jurisdictions. One example would be to grant explicit permission to share information on supervised institutions, including a promise of confidentiality on the part of jurisdictions with which it is shared.
  • Agreed planning processes within colleges of supervisors are also needed so banks do not have to deal with each supervisor’s concerns sequentially, such that the demands of one supervisor contradict another.

This Council also feels that the framework needs to reflect the underlying differences of business models between different financial institutions. Because different business models present different risks, the equal treatment of unequal problems should be avoided. For example, the orderly resolution of failing insurance groups – unless they massively engage in banking activities – may require different mechanisms and regulatory tools from banks.

The Council also calls attention to a gap in the current architecture, i.e., what happens as banks in emerging markets are increasingly encouraged to operate through subsidiaries rather than branches. It is necessary to ensure that while attempting to make the system safer overall, the incentives for foreign banks to invest abroad must not be weakened. A current issue is how far the parent of an international group will stand behind the debts of its branches and subsidiaries in other countries. This, in turn, determines the extent to which these subsidiaries are viable and capitalized to stand alone, without expectations that the home authorities will support the whole group rather than just their home operations. A good example of this problem is the case of the Icelandic Landsbanki collapse, where, against a background of insufficient capital to support branches and subsidiaries, domestic depositors were clearly prioritized over those in overseas entities.

Strengthening the Banking System

The Council identified a set of principles that should guide efforts to strengthen the overall banking system, as well as some areas where Council Members feel work still needs to be accomplished:

  • Limits on government guarantees for financial institutions are needed.
  • A distinction should be made between the activities of banks covered by these guarantees, but these “fences” should be determined flexibly according to the specifics of individual institutions.

Like for other measures, the approach to structural issues should be globally coordinated with regulatory consistency ensured. Recent initiatives (e.g. the “Volcker Rule” in the United States, the Independent Commission on Banking in the United Kingdom and the measures recently announced by the European Commission) have been developed without sufficient coordination. The Volcker Rule is a good example of the potential impact of national regulatory reforms on other countries – among others the government of Japan has been particularly critical of the effect this rule will have on the Japanese bond market, arguing it will lead to a softening in the markets for Japanese sovereign bonds that could potentially hurt the ability of the Japanese government to raise funds in the future. The Council feels that the costs, benefits and unintended consequences are important in the analysis of alternative regulatory proposals and should be a central principle guiding their development.

Whereas in the past a “race to the bottom” was problematic in regulatory development, today many countries face the challenge of “super-equivalence”, i.e. the application of higher or additional requirements beyond the agreed international minima in a country’s own jurisdiction and on their own banks. Council Members see this as another area with the potential for damaging knock-on effects without greater coordination. The Council believes it is important for international as well as national interests to be taken into account in the development of any new regulatory requirements, particularly in respect of those economies in which a high proportion of bank assets are held by the branches and subsidiaries of foreign banks.

Additionally, new standards should take account of the macro impact in developing and advanced economies so as not to damage recovery. Where central banks evolve separate committees with responsibility for monetary and macroprudential policy, as in the case of the United Kingdom, or in the European Union where monetary policy is determined centrally but where, because of asynchronous economic cycles, macroprudential policy by necessity is determined nationally, the methodology, skills and targets of each committee should be distinct and clear, to avoid conflicts. At the same time, each committee should operate transparently and in full recognition of the macro impact of their decisions and the implications for their respective governments’ fiscal policy.

Finally, the Council feels that regulatory consistency should not be confused with the need for sector-specific regulation. To ensure that regulations are adequately tailored to sector-specific features of business models, it is important that sector-specific expertise be well represented at the level of the FSB. Furthermore, a multiplication of supervisory layers should be avoided – the supervisors should trust the lead supervisor, particularly in the case of international financial companies, which are subject to many different regulations.

Other Important Issues Warranting Further Discussion

In addition to the issues described above, the Council identified other themes and issues that are directly relevant to work focusing on the resilience of the global financial system, but where the Council either did not develop specific recommendations or did not have sufficient time to take a unified position:

  • The openness of international financial markets: All of the Council’s discussions were animated by the principle that global and national efforts to strengthen financial stability must not interfere with the ability of capital to flow freely, or restrict the openness of global financial markets. Efforts at the FSB and G20 level must reinforce this important principle, and regulatory regime development at the national level should not be motivated by protectionism in financial services or any short-term political concerns. The lack of coordination efforts at the international level can have unintended consequences for other markets or contribute to creating additional gaps in the emerging global financial architecture.
  • The role of macroprudential policy in strengthening systemic financial resilience: While the Council did not have sufficient time to explore this issue and take a unified position, effective macroprudential policy in building systemic resilience to future crises – and the failure so far to develop a dynamic framework for microprudential response to systemic stresses identified at the macroprudential level – was identified as an important issue warranting further discussion. The Council acknowledges that omitting this issue from this term’s recommendations represents a gap in the current report, and Council Members will revisit the issue during the course of the next term.

 Impact

This Council set out to bring together the perspectives of its unique mix of constituent groups from around the world into a shared set of principles and recommendations for implementation. To ensure the Council’s perspective will be integrated directly into FSB discussions, the Council will submit its recommendations in May 2012 to Council Member Mark Carney, the FSB Chairman. Additionally, many Council Members are working on FSB-related tasks and initiatives though their organizations. By highlighting some of the key areas which the FSB should address on the cross-border regulation issue, this work will also influence policy formation – Council Members will hold the property rights to these recommendations and will be allowed to distribute them accordingly through their own channels when necessary.

Looking ahead, the Council will continue dialogue with the FSB throughout 2012 and will continue to engage Chairman Mark Carney directly in its work into the next term. To build on these efforts, however, the Council has also discussed hosting a high-level workshop later in 2012 to further dialogue on the issues identified in this report. The desire to host a workshop that would unite multiple constituencies was also raised during a cross-Council meeting at the World Economic Forum Annual Meeting in Davos-Klosters with the Council on Banking & Capital Markets. The Council will continue to engage Members of that Council to coordinate efforts and to ensure follow-up efforts, where appropriate, are discussed in the public arena.

Regional and national initiatives that align with the Council’s core focus will also be leveraged to further disseminate the Council’s work. One example is the “Vienna 2.0 Initiative”, a dialogue focusing on improving coordination between banks and their home and host-country supervisers, primarily in the countries in the periphery of Europe. This initiative builds on the initial Vienna Initiative originated by the European Bank for Reconstruction and Development (EBRD), the World Bank and the European Investment Bank in early 2009 to help prevent a disorderly unwinding of financial exposures by commercial banks in the countries of emerging Europe subject to IMF/EU financial programmes. During this Council term, the Vienna 2.0 Initiative reached an agreement that aims to better coordinate banking-sector regulation and supervision and to contain negative spill-overs between the euro area and emerging Europe. As the financial crisis continues to threaten global financial stability, the Council will seek to provide input into additional initiatives through the participation of the diverse constituent groups that make up its membership.

Disclaimer

The opinions expressed here are those of the individual members of the Council and not of the World Economic Forum or any institutions to which they are affiliated.