Backstopping global banking

Speaking notes of Mr Jaime Caruana, General Manager of the BIS, prepared for a high-level policy panel at the conference: "Financial integration and stability: the legacy of the crisis", jointly sponsored and organised by the ECB and the European Commission, Frankfurt am Main, 12 April 2010.


The financial crisis has led some to suggest that the decades-long process of financial integration could and possibly should reverse. However, we tend to underestimate the enormous benefits of financial integration, benefits which can be diffuse and hard to identify, but which are substantial nonetheless. What is needed is a new framework for global financial stability, one that addresses the challenges of system-wide risks head-on. Such a framework needs to be global in the sense of being both worldwide and comprehensive, with contributions from monetary, fiscal, and macro- and microprudential policies. Regulatory reform is under way, but this is just one of a number of building blocks. We also need adequate tools for systemic risk monitoring, and this means that we need better and more timely data. Uncertainty about the scale of losses on banks’ assets was the proximate cause of the crisis, but it was the dislocations in banks’ funding markets that turned the subprime crisis into a global financial crisis. Regardless of the methods used to manage systemic risks, a first step must thus be to monitor these funding pressures.

Full speech

Thank you for the opportunity to speak on global aspects of financial integration today.

Financial integration brings important benefits. It supports economic growth and complements full monetary integration, which is very relevant from the euro zone perspective. However, during the critical phases of this financial crisis, we saw a sharp decline in international banking activity and witnessed tensions between global banking and national frameworks. Globally, cross-border lending has contracted by more than $5 trillion since early 2008. That is a decline of roughly 15% from the peak of $36 trillion.

Some observers have even suggested that, as a consequence of the crisis, the decades-long process of financial integration could and possibly should reverse. That is, the system is going to deglobalise. And this brings me to the first of three points I want to make today.

1. Encourage financial integration, and manage risks in a global framework

In my view, we should be very careful about this notion of deglobalisation. We tend to underestimate the enormous benefits of financial integration. This is because they are often diffuse, providing small gains for large numbers of people, and hard to identify, scattered in distant places and embedded deep inside economic processes. But the benefits of global integration are large, and it would be tragic to lose them.

That said, it is important to acknowledge that financial integration has risks. The crisis has reminded us that increased integration also means increased complexity. Transactions are more complex, counterparty relationships are more complex, and market dynamics are more complex. And, unsurprisingly, when something becomes more complex, the inherent systemic risks become more difficult to manage. But the response to the increased risk of a globalised financial system must not be a retreat to national finance. Instead, it must be a move to better management of systemic risks. And this, in turn, requires that we put in place a global framework for financial stability. That is, a framework that addresses the challenges of system-wide risks head-on.

Let me emphasise two key aspects of this strategy: global and framework. Today, financial stability is a global concern, even though the instability confronts policymakers nationally. The need to act promptly during a crisis tends to encourage national, and often unilateral, solutions. To be sure, there will always be a national component to any global solution, but responses that contribute to economic welfare broadly – both nationally and internationally – and to a level playing field should be part of a global framework, based on timely international cooperation. Only with a global framework will it be possible to both preserve the benefits of financial integration and manage the associated risks in a consistent way.

2. Development of a global financial stability framework is under way, and regulation is just one of the building blocks

We are in the process of building just such a global framework to secure financial stability. With that in mind, national authorities are in the midst of quantifying and finalising key elements of regulatory reform - calibrating the details and agreeing on a calendar for implementation. This task is being taken on by a broad array of international standard-setting bodies, including the Basel Committee on Banking Supervision and national authorities, under the coordination of the Financial Stability Board (FSB). Their work is proceeding according to a tight agreed schedule, and this tight schedule is essential for the elimination of regulatory uncertainty. This year, as scheduled, the strengthened regulatory framework needs to be concluded and made precise on the basis of the quantitative impact studies.

The transition phase must be designed so that measures are introduced to raise the resilience of the financial sector over the long term while avoiding any impairment of the ongoing economic recovery.

In addition to being global, the framework needs to be comprehensive. I mean this in the sense that regulatory reform - in a broad sense including crisis prevention and resolution - is just one of a number of building blocks. With regard to those other building blocks, specifically:

  • we need a new consensus on how macroeconomic policies will be used to mitigate the build-up of financial imbalances, including credit booms and asset price bubbles. We also need to secure international cooperation so that national authorities can act together both to reduce global imbalances as they arise and to manage the necessary global response to shocks; and
  • we need to improve the monitoring of systemic risks. The crisis revealed blind spots in our understanding and monitoring of the structure of markets and their interaction with the real economy.

3. Better systemic risk monitoring requires better data

And it is to these blind spots in the monitoring of the financial system that I want to turn in my third and final point. I want to come back to the contraction of cross-border banking to analyse the fault lines in funding markets. A recent report of the BIS-sponsored Committee on the Global Financial System (CGFS) concluded that the build-up of maturity mismatches, within and across currencies, of internationally active banks was a major systemic vulnerability and requires better monitoring and better management. Uncertainty about the scale of losses on banks’ assets was the proximate cause of the crisis. However, it was the dislocations in banks’ funding markets that turned the subprime crisis into a global financial crisis.

But as we set up a comprehensive framework, it is essential that we recognise that the principal threat to stability was not cross-border activity itself. Rather, it was the inadequate recognition and management of the risks related to that activity. Specifically, the risks arose from international banks’ reliance on short-term funding to finance what turned out to be illiquid long-term assets. Risk-taking and maturity transformation are an integral part of banks’ role, but they need to be properly managed. In fact, there was a failure to appreciate and monitor the vulnerability in what turned out to be a system-wide maturity mismatch, especially in banks’ dollar positions. Some of this was a consequence of the mistaken belief in the liquidity of certain dollar assets. And some of it arose from the ease with which euros, pounds and Swiss francs could be swapped into dollars. All in all, the mismatch was perpetuated by complacency that it would always be easy to borrow dollars in this manner.

As you all know, beginning in August 2007, the system unravelled. The dislocations in dollar funding markets meant that the effective maturity of banks’ dollar funding shortened just as that of their dollar assets lengthened, since many assets became difficult to sell in illiquid markets. At the global level, and what posed risk to the system, was that many large institutions had similar funding strategies. In the parlance of the markets, this was a crowded trade, albeit on the liabilities side of the balance sheet. Importantly, this was a vulnerability that no one saw at the time because such maturity and currency mismatch is not observable in public data, at any level of aggregation.

The immediate national and international policy responses in the form of central bank swap lines and the use of own foreign exchange reserves were effective and appropriate in addressing the recent crisis. But, looking forward, we now need to explore additional policy alternatives that will allow flexible responses to systemic cross-border funding pressures should they arise again.

My conclusion is that, among other things, the crisis also exposed gaps in the technology for monitoring these systemic risks. Regardless of the methods used to manage them, the first step must be to monitor these funding pressures. And to do this, we need better data. That means collecting information on the liabilities side of international banks’ balance sheets. Financial integration means that we live in a world where the balance sheets of financial firms span the globe. But, as the globalisation of financial markets and institutions has progressed, the design and collection of statistics have not kept pace. And as a result, the tools needed to track balance sheet stresses at the systemic, macro, level need to be improved.

In closing, let me reiterate that I believe there is no turning back from globalisation in finance. But in order to make the system safe, ensuring that finance does not recede behind national boundaries, we need to create a global framework that includes better regulation, better macroeconomic policy, better international cooperation and coordination, and better data.

Thank you for your time.