General Manager's speech: Three policy challenges for the world economy

Speech delivered by Mr Jaime Caruana, General Manager of the BIS, on the occasion of the Bank's Annual General Meeting, Basel, 28 June 2010.

Policymakers everywhere continue to steer a course across treacherous terrain. Given the difficult situation, the policies followed worldwide over the past two years can claim some success. These exceptional measures prevented a financial system meltdown and helped bring to an end the great contraction in global economic activity. Strong expansion of domestic demand in many emerging market countries helped.

But the policy challenges today are no less daunting than they were a year ago. The room for manoeuvre for macroeconomic policies has narrowed. Most advanced countries are reaching the limits to fiscal expansion. The essential task of reducing leverage and repairing balance sheets is simply not finished. Exceptional policies seek to help an orderly adjustment, but some of them are delaying necessary changes in the financial system and the real economy.

The remaining vulnerabilities in the international banking system continue to weigh on confidence. It is true that many banks have increased their capital buffers above pre-crisis levels and that a number of temporary factors have boosted bank profits. Yet there are considerable challenges ahead for the global financial system. Some banks may find it difficult to earn their way out of the crisis given the prospects of further loan losses, higher funding costs and significant refinancing pressure. The contagion from fiscal difficulties to the banks accentuates these difficulties. The financial system remains vulnerable to adverse turns of sentiment, as recent disruptions in funding markets have shown. Many segments of financial markets are still dependent on official support.   

Steering economic policy in such circumstances requires a delicate balance. A well-articulated medium-term perspective is needed to guide all policies - including those aimed at supporting a still-fragile recovery and keeping the financial system operating. Policies must foster adjustment by encouraging the repair of bank balance sheets, the reduction of leverage and the development of a less credit-dependent growth model.

The specific policy measures that are needed will vary according to the different circumstances in each country. The scale of fiscal problems and the strength of local banking systems differ across countries. There is therefore no single policy prescription for all.

Central banks need to maintain their medium-term focus in setting monetary policy. Although core inflation is low at present in the major advanced economies, and there is little reason to expect a sharp near-term rise, we should remain vigilant about risks a few years ahead. In current circumstances, when public sector debt is rising so rapidly, any expectation that central banks would be prepared to tolerate higher inflation could easily unsettle the markets.

This morning, however, I would like to concentrate on three broader policy challenges.

  • The first and immediate challenge is to make a convincing start to reducing budget deficits in the advanced economies. This should be accompanied by microeconomic reforms to enhance sustainable growth. At the same time, greater exchange rate flexibility could help to strengthen domestic demand in some emerging market countries and thereby support global growth at a critical juncture.
  • The second challenge is to foster the necessary balance sheet adjustments and behavioural changes in the financial industry. Official support was intended to facilitate orderly adjustments, but if it continues too long, it will create moral hazard, undermine private sector financial intermediation and generate new, hidden risks. 
  • The third challenge is to finalise international agreements on financial regulation reform. In doing so, we should ensure that systemic risk awareness is embedded in all aspects of regulation and supervision. In building a broader financial stability framework, we must also make sure that macroprudential and macroeconomic policies complement and reinforce each other to limit the build-up of financial vulnerabilities in a more pre-emptive way. All this is central to our current work in Basel.

Any delay in taking effective action to meet these three challenges would run significant risks.

Fiscal adjustment and better international balance

The first challenge is fiscal adjustment. Global growth can no longer be sustained by fiscal expansion in the advanced world. Structural budget deficits in many countries are just too high: even at today's very low long-term interest rates, public debt-to-GDP ratios are on unsustainable trajectories. In addition, most industrial countries need to reform their pension and health care systems if they are to contain future increases in age-related expenditures. Without substantial fiscal reforms, bouts of volatility in financial markets could well become more intense and interact strongly with the fragilities in the financial system. This could disrupt markets, tighten funding conditions and sharply increase risk aversion. 

Several European countries are introducing front-loaded policies to cut budget deficits. Such measures are never easy, and governments that have grasped this nettle are to be applauded. It is easy for critics to point to the adverse effects such policies could have on income growth and employment in the short term. But in the current unsettled times, the alternative of having to cope with the financial and macroeconomic disruption that a sudden loss in market confidence could cause would be far worse.

Medium-term programmes of fiscal consolidation - in which some measures take immediate effect and the overall aim is to cut deficits by several percentage points of GDP over a number of years - would offer significant benefits. Greater predictability and transparency of fiscal plans would promote lower and more stable long-term real interest rates, help to contain inflation expectations and make the financial system less volatile. Ultimately, the prospects for investment and thus for sustainable growth would improve. These benefits can be enhanced by institutional measures designed to bolster the credibility of fiscal plans. Legislation could be used to strengthen limits on future debt ratios or fiscal deficits. Official budget forecasts could be prepared or verified by independent agencies.

The burden of fiscal consolidation can be further reduced by complementing it with microeconomic reforms to promote sustainable growth. There is plenty of scope in many countries for such reforms. For example, measures could address: social security regimes; labour market and public sector management practices that discourage private job creation and impede wage flexibility; regulations that stifle initiative and business investment; market arrangements that work against competition. And so on. The list could be easily enlarged.

In many advanced economies, fiscal consolidation is essential to reduce domestic saving-investment imbalances and thereby promote sustainable growth. In several countries recovering from the housing market bust, household saving rates have risen and residential construction has declined. With these changes in spending, current account deficits in many countries are likely to fall substantially. We are already beginning to see this: for instance, the US current account deficit has fallen appreciably.

The counterpart of adjustment in deficit countries should be reciprocal moves towards balance in countries with large and persistent current account surpluses. A strong resurgence of domestic demand in China has led to a substantial reduction of its current account surplus. This significantly contributed to stabilising the world economy at a time when the recovery in the advanced economies was very fragile. While the rebalancing of global growth is essential, however, it should not come at the price of new financial vulnerabilities and macroeconomic volatility.

The resurgence of demand in some emerging market economies has been associated with sizeable capital inflows, strong rises in bank credit and higher asset prices. These developments create difficult policy dilemmas for many countries. In some cases, currency appreciation has helped to offset rising inflation pressures. In other cases, however, central banks have attempted to prevent appreciation by heavy intervention in the foreign exchange market. Some central banks may even have held back increases in policy rates, despite rising inflation pressures. If maintained too long, policies to stem currency adjustment will create risks for the domestic economy. They can cause distortions in local financial markets, fuel excessive domestic credit expansion and only aggravate incipient inflation pressures. Such policies would also delay the global adjustment of current account imbalances.

Balance sheet repair and reducing public sector involvement in financial intermediation

The second major challenge is to address decisively the remaining weaknesses in the banking system and to scale back the public sector's involvement in financial intermediation. The pervasive presence of quasi-government institutions and the widespread use of implicit state guarantees, preferential financing and so on undermine market discipline. The public sector has taken an even greater role in the financial system as a direct result of the crisis. Most government support measures for the financial industry were intended to last only long enough for banks and other financial firms to adjust - to absorb the losses from toxic assets, to raise new equity capital, to develop more stable sources of funding and to adopt business models that require less leverage.

Authorities should be proactive in getting banks to make more progress on all these fronts. Some banks have yet to recognise in a transparent way the scale of losses on their balance sheets. Although new equity has been raised, banks still need to position themselves better for the losses and risks that lie ahead. Dividend and remuneration policies must take account of the need to conserve capital in order to help reduce leverage and restore confidence. Some banks remain too dependent on very short-term borrowing, partly because short-term interest rates are so low.

Because these essential adjustments in the financial sector have yet to be made, prolonged government support risks deepening moral hazard. The continued public ownership of financial institutions threatens to delay the necessary reduction of capacity in the industry. Overcapacity may impede the efforts of the more efficient and well managed banks. Governments should take determined measures to promote restructuring. Where business models are no longer viable, resolution needs to be addressed. These steps are essential to strengthen competition, to reduce excess capacity and to restore confidence in the rest of the financial system.

Equally, the direct central bank participation needed to restore normal market functioning also entails significant risks. If continued too long, this would distort private incentives to trade in markets and thus compromise liquidity and market depth. The market's role in pricing risk would be undermined.

In short, adjustment to a more stable financial sector requires a timely winding down of the exceptional central bank and government support measures.

International agreement on regulatory reform within a global financial stability framework

The third major challenge is to put in place a global financial stability framework to ensure a safer, more resilient financial system. Let me emphasise three key elements of this challenge - regulatory reform; a macroprudential policy focus on the systemic dimensions of financial risk; and a recognition of the role that macroeconomic policy should play.

The task of regulatory reform will not be completed overnight. International cooperation in designing such reform is essential. It is therefore very encouraging that the Financial Stability Board has made considerable progress on its reform agenda.

The Basel Committee is well advanced in its proposals to reform the rules governing the core elements of banking system soundness. These reforms have two dimensions. The first is to strengthen individual banks. The main instruments for doing this are well known: raising the quantity, quality and transparency of bank capital; improving the risk coverage of the framework; introducing a leverage ratio; and defining a global minimum liquidity standard. The second, and more novel, dimension is to embody a macroprudential perspective.

These reforms are being prepared in full and detailed consultation with the industry. The measures proposed are undergoing rigorous quantitative testing, including a macroeconomic impact study. According to preliminary results, the reforms will not undermine economic growth. Their short-term impact on demand is likely to be small and temporary. And the long-term benefits of lowering the probability and cost of financial crises are substantial. The reforms will quickly generate significant benefits from enhanced resilience. This is all the more true when - as now - the probability of further shocks is elevated.

Sustainable global recovery requires stable performance from the financial sector through the cycle - not temporary bursts of lending on shaky foundations that ultimately lead to heavy losses. Fundamental changes in bank behaviour, incentive structures and attitudes to risk are needed. Progress in addressing the deficiencies in bank governance and risk management that contributed to the crisis needs to continue. Banks must develop more stable funding sources, lengthen the maturity of their liabilities and properly manage interest rate risk. Investors in banks already understand this. They have become more discriminating, rewarding those firms with more prudent and resilient models. The policy priority now is to reinforce in a durable way this greater prudence in the regulatory framework.

As I have already mentioned, a central element of the new policy framework is its focus on the systemic dimension of financial risk. The term "macroprudential" was first used in BIS meetings more than 30 years ago to capture this dimension. We all now understand that system-wide risks are not simply the aggregation of individual risks. They include issues arising from common exposures, interlinkages and procyclicality. What we need to do now is to translate this insight into practical policies. There are many ways of adapting conventional prudential tools to address systemic risks.

Addressing procyclicality is key to restraining credit and asset price excesses and mitigating the accumulation of systemic financial vulnerabilities. Countercyclical provisions and capital buffers need to be built up when credit growth rises above trend during a boom and released during the downturn. Other prudential measures - for instance, ceilings on loan-to-value ratios for mortgage lending - can act as automatic stabilisers. Reducing the procyclicality of margining practices in secured wholesale lending can also help. 

The reforms also contribute to addressing the too-big-to-fail issue in several ways. Reforms should not only reduce the probability of a systemically important institution failing, but also enhance the resolution capacity of governments in dealing with such firms. And reforms to trading and payment infrastructures should reduce contagion risk from problems with a systemic firm. The Committee on Payment and Settlement Systems is playing a major role in developing strong and resilient central counterparties for the safer settlement of a sizeable portion of over-the-counter derivatives.

The regulatory reform of the financial system must be part of a broader policy framework for financial stability. This framework needs to bring together contributions from regulatory, supervisory and macroeconomic policies. It should be supported by institutional arrangements that foster effective system-wide risk management and by international cooperation.

As part of this financial stability framework, monetary policy frameworks need to be broadened. The prime objective of monetary policy is, and should remain, price stability. But we have learned that monetary and financial stability are closely linked. Central banks need realistic financial stability objectives and a clearly communicated strategy consistent with their monetary policy responsibilities. They need instruments - in addition to the policy interest rate - to meet their financial stability objectives.

A prolonged period of extremely low policy rates - even if justified by weak macroeconomic prospects - can create risks for financial stability. This can in turn threaten longer-term macroeconomic stability. Very low short-term rates can lead borrowers to shorten the duration of their debts, increasing their exposure to rollover risks. They can also encourage greater leverage of risky positions, and delay necessary balance sheet adjustments. While prudential policies are crucial in addressing such risks, monetary policy and interest rates also have an important role to play. The key is to be always forward-looking so that financial developments and risks are fully recognised in the setting of policy rates.


Let me conclude. The lingering structural deficiencies in the financial sector and the longer-term drawbacks of very expansionary macroeconomic policies continue to put enormous demands on our ability to steer the best course through hazardous terrain.

When markets and the public start to lose confidence, it is an illusion to suppose that delaying the adoption of the policies we know are needed would smooth the adjustment process. We cannot wait for the resumption of strong growth to begin the process of policy correction. In particular, delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress. A much better strategy is to set out credible front-loaded actions for meaningful fiscal adjustment and for restructuring the financial system.

International cooperation is particularly important at the current difficult juncture, when confidence is fragile. In particular, finalising international agreements on regulatory reform on schedule will send the right signal - not only to financial markets but also to the public at large. The time has come to agree on major practical reforms to substantially increase the resilience of the financial industry. These reforms, combined with policies of fiscal adjustment and efforts to restructure the financial industry, will go a long way to putting the financial crisis behind us. We must seize this opportunity.