Strengthening financial stability: institutional approach or pragmatic multitherapy?
Speech by André Icard at the Federal Reserve Bank of Chicago, 2 October 1999 and published in 'Global Financial Crises: Lessons from recent events', BIS and Federal Reserve Bank of Chicago.
Financial crises look like becoming a quasi-permanent feature of the international financial system. This feeling clearly emerges from the series of difficulties which have hurt Mexico, a large part of Asia, Russia and Brazil since 1995. Indeed, the last Mexican crisis occurred 10 years or so after the turmoil which touched the sovereign debts in Latin America, central Europe, the Middle East, Africa and some Asian countries in the mid-1980s. However, the decade in-between was not that calm as the international financial community had to absorb the 1987 stock market crash, the 1992-93 foreign exchange crisis in Europe and the 1994 bond market shock.
Global markets and sophisticated financial techniques generate large opportunities as well as big risks, both of them intimately linked. This environment imposes constraints on the international financial institutions, which have to adjust very quickly to changing circumstances and to address a much wider variety of concerns than in the past. For instance, the main problems which surfaced during the recent crises were linked to weaknesses in structures and policies in emerging countries, but not exclusively: the instability of international capital flows, which played a major role in the building of imbalances in the indebted countries and later in the development of crises, gave evidence of international financial markets malfunctioning, with herd behaviour and poor risk management on the part of the lenders.
Crises are a part of market life and it would be an illusion to believe that they could be avoided. It is far from sure, in addition, that this would be a suitable objective as moral hazard concerns would be aggravated. Instead, the international financial community has to deal with the major existing weaknesses which make these events so frequent, so costly to the emerging countries and their populations, and so risky to the international markets and investors.
Which organisation of the international financial system is best suited to address this problem? Is the answer an institutional approach, which concentrates powers in the domain of regulation, supervision of financial intermediaries, monitoring of market trends and macroeconomic surveillance through the creation of new bodies or the redefinition of roles of existing institutions? Or is a kind of "multitherapy", by which the different problems are addressed by the various specialised bodies and authorities already existing, better adapted to the current situation? These are the questions that this contribution will briefly address. However, before entering into this debate, it might be useful to review briefly the main lessons to be drawn from recent crises that must be addressed in order to make the markets more stable and the world financial system more resilient.
An analysis of recent crises clearly reveals big differences in specific content from one situation to another, especially in the nature of economic agents involved as lenders and borrowers. But it also leads to the conclusion that significant generalised weaknesses have contributed to the successive crises. The former calls for adaptability in crisis management, the latter for significant reforms in the system.
The specific content of crises has changed over time and the economic agents involved were different in the mid-1980's sovereign debt crisis in Latin America, the 1995 Mexican difficulties and the 1997-98 Asian events (BIS, 1998). In the first case, creditors were international banks and debtors were governments. In the second case, the debtor was still the government but its debt was securitised and held not only by banks, but also by a large variety of other investors. The crisis in Asia had a new characteristic in the sense that debtors were not mainly governments but rather private agents, banks and corporations.
The growing share of bonds in emerging countries' external debt is the result of a long trend towards disintermediation, similar to that observed on domestic markets. However, this development has also been favoured in the international field by the fact that, until recent decisions taken by the Paris Club, eurobonds had never been subject to inclusion in debt restructuring programmes. The presence of a large variety of bondholders in the Mexican crisis, as well as in the Russian one, makes crisis management more complex in the absence of clauses (majority action, collective action, sharing) which would be necessary for efficient negotiation between the debtor and its numerous creditors.
The Asian crisis was special in comparison with previous experiences in that the debt mainly took the form of international credits granted not to governments but to the private sector. This raised a number of difficulties linked to structural problems of these debtors, their poor management of risks and positions, their insufficient transparency and the weaknesses of their supervision. The rapid collapse of much of the banking sector and large ambiguities about the degree of government protection were major elements of the crisis.
Another significant development is the growing influence of emerging stock markets in the channelling of international financing. Investors in those markets can be very different in nature (BIS, 1998): commercial banks, investment banks, insurance companies, pension funds, mutual funds, hedge funds and so on. Foreign exchange markets also involve a large range of participants. These differ in terms of function, objectives, investment policies, regulation and capital base, and their interest once the crisis is about to start or has already emerged can diverge or even be antagonistic. This makes prevention policies more delicate to implement and crisis management more difficult to define and achieve; in any case, it implies both better consultation procedures with the private sector and a multidisciplinarity in the approach to crisis prevention and management that international institutions are not well suited to provide within their traditional structure.
By contrast to the increasing diversity of actors in the recent financial crises, some features were similar, if not identical, in all countries in difficulty. Rather than entering into a detailed analysis of the sources of financial instability, let us summarise these features.
In the macroeconomic domain, a large majority of "crisis countries" had rigid foreign exchange pegs that they maintained for too long (Radelet and Sachs, 1997). In addition, there were also other macroeconomic disequilibria. In Asia, external competitiveness was weak, owing to the external value of the currency, and excessive liquidity in the banking system had generated a rapid expansion of credit which itself contributed to significant asset price increases. In the case of Mexico, Brazil and Russia, the main problem was an excessive fiscal deficit.
All these problems and imbalances were detectable before the crises, and in fact they were detected. What was lacking was the awareness that these situations were likely to turn into major turmoil and, in parallel, the ability to take preventive measures that were adequate in terms of both time and content.
In Asia, as in Mexico three years earlier, weaknesses in the local financial system exacerbated the crisis. With more resilient banking structures, macroeconomic imbalances would have been more manageable or easier to reduce. This underlines the importance of associating macroeconomic analyses with prudential and structural concerns. In this respect, the recent decision to include in IMF Article IV consultations a monitoring of progress towards implementation of banking standards, as well as the possibility now available of publishing the content of these consultations with the consent of the country concerned, are very significant steps forward.
Improving the banking sector in countries which are just at the start of this process is far from trivial as it touches a host of domains: corporate management, banking skills, accounting principles, risk assessment procedures, transparency rules, banking structures, degree of openness to foreign banks, bank supervision and so on. Besides all this, other standards in such important areas as monetary policy, fiscal policy and payment systems also need to be implemented urgently; progress is also required in many countries as regards the legal environment - in particular as regards bankruptcies. Prioritisation and technical assistance are essential to address all these challenges in an orderly and timely manner. Here again, multidisciplinarity is required.
In addition to macroeconomic and structural concerns, the instability of international capital flows is a domain that requires special attention (Icard, 1999 b). Excess capital inflows to emerging countries, often in the form of short-term interbank credits, have been disruptive in many cases. In countries with large imbalances, they contributed to a false impression of sustainability and to the postponement of unpopular but unavoidable reforms. In countries with an already large saving capacity, as was the case in Asia, they contributed to overinvestment, poor allocation of resources and the creation of a financial bubble. Once the crisis occurred, abrupt withdrawals made the adjustment process deeper, longer and much more painful.
These phenomena, which are disruptive for both the lenders (who often fall victim to a herd instinct) and the borrowers, show that the functioning of international financial markets is defective. They have their roots in weaknesses that are of varied and complex nature: availability of information and statistics, transparency of financial actors both on the borrowing and on the lending side, the sequencing of capital control removal, the type of controls on capital inflows, risk and exposure management in borrowing banks, credit risk assessment and policy in lending institutions, lack of effective burden-sharing arrangements and, last but not least, liquidity and debt maturity management in borrowing countries.
From this rapid "tour d'horizon" one can conclude that, despite a large variety of preoccupations and challenges, four main domains have to be considered when discussing which architecture is best suited to reduce the risk of financial instability:
- the atomisation and diversity of market actors, which make prevention measures and crises management much more complex, with the involvement and coordination of a large range of specialists;
- the exercise in parallel of macroeconomic and prudential surveillance, which is the key to crisis prevention and management;
- the necessary strengthening of financial, administrative and legal structures in emerging countries;
- the need for a more stable flow of capital to developing economies.
The debate on the "architecture" of the international financial system has generated a number of proposals for redefining responsibilities among international institutions and sometimes for creating new bodies. We are not going to discuss here the idea of a large scaling-down of the current institutional framework, with a larger part of the adjustment process left to the market (Edwards, 1998; Schwartz, 1998). This is seldom architecture. The reason for having official institutions, as well as for regulation, is that markets are not that rational and risk-free for the system, and one can suppose that, if the organisers of this conference arranged this session on the "future of official international organisations", it is precisely because they believe that these organisations still have a future. Considering the other proposals, they range from a significant enlargement of the powers of the IMF to the creation of a new World Financial Authority heading up all initiatives aiming at financial stability (Eatwell and Taylor, 1998), with some intermediary variants such as the merger of the two Bretton Woods institutions or the organisation of an international lender-of-last-resort function by the IMF (Calomiries, 1998) or through the BIS (Aglietta and de Boissieu, 1998).
It is not easy, and possibly unfair, to discuss all these proposals under the same headings. However, they all have in common two characteristics: a focus on institutional reforms rather than on less ambitious but more pragmatic and rapid initiatives, and the concentration of powers in one or a limited number of institutions rather than a dispersion of responsibilities, which is the current feature.
Such proposals certainly have some logic:
- the globalisation of markets inevitably opens the debate about the usefulness of a global regulator which would set standards, monitor their implementation, supervise the functioning of international financial markets and take preventive action;
- the growing diversity of financial actors raises the question of harmonisation of standards and regulations and good communication among supervisors;
- in this respect, regrouping responsibilities could generate synergies and favour unity of vision and concept in the regulation and surveillance fields, similarly to the objectives assigned to national FSAs;
- regrouping competencies in the various domains of supervision, financial and market overview and creating a close link with macroeconomic assessment could generate cross-fertilisation, common understanding and appropriate judgements on market practices and techniques which have become increasingly complex and diverse in their impact on the world's economies;
- necessary actions and initiatives could be taken more rapidly, in a comprehensive manner.
The main obstacle is obviously of a political nature: establishing an international consensus on such far-reaching reforms appears extremely ambitious, at least in the short and medium run. Governments and/or national prudential authorities would have to give up a significant part of their current responsibilities: it is far from sure that they - as well as their respective parliaments - would unanimously agree to such a transfer of power. Reaching agreement on changes or adaptations at the international level, where each participant remains sovereign, is feasible (though sometimes only after long and delicate negotiation), but moving these prerogatives at a supranational level will be hard to conceive and even harder to accept.
Another question which surfaces when considering a concentration of powers is whether the advantages which would be expected in terms of synergies, such as common understanding and the circulation of information among various specialists, would not be seriously impaired by the difficulties of managing such large institutions mandated to deal with such complex issues. Big is not automatically beautiful and efficient. Unwieldy procedures are a real risk and internal difficulties or divergences could be more damaging to the international community than a clear debate on competencies between independent institutions. There is also a significant risk that large supranational institutions could progressively lose touch with the reality of markets and financial practices. This risk is less pronounced with working groups gathering specialists from different countries and specialities.
Another risk is that the "superregulator" turns out to be a "mediocre regulator", able to deal only with common denominator problems and to propose nothing but a kind of average regulation, which would not be adapted to and prove insufficient in a number of countries. If, in order to avoid such difficulties, the superregulator takes the form of a federation whose members individually retain the responsibility of adjusting the decisions to their markets' needs, then the new structure would not be very different from the current "committees", such as the Basel Committee on Banking Supervision, and the common regulation would have similarities with the standards developed by these committees. Finally, compared with the existing system, the obvious advantages of such proposals appear too slim and uncertain to justify a complex institutional reform.
The proposal for a possible international lender-of-last-resort raises both theoretical and political questions. In its original meaning, lending at last resort consists of injecting extra liquidity into the market as a whole or into individual financial institutions in order to avoid a transitory funding problem faced by one or a group of financial institutions turning into a failure with systemic implications. Central banks are the only institutions able to create extra liquidity and they of course can do it only in their own currency. It is hard to understand how to create new liquidity at the international level in a certain currency without the participation of the issuing central bank; under these conditions, why not leave this matter in their hands? There is no international money and so there can be no international lender-of-last-resort (Capie, 1998).
If, in a broader concept, the words "international lender-of-last-resort" mean the allocation of pre-existing liquidity, one could argue that the IMF does that already and the debate would have to be shifted to the adequacy of IMF resources and procedures. Similarly, if lending-at-last-resort means organising private sector liquidity support, this is typically what central banks have regularly been doing. The experience of urgent measures taken by the Federal Reserve System in 1987 in the wake of the stock market crash (with injection of liquidity) and in 1999 when LTCM faced collapse (facilitating the setting-up of a private sector support operation, without injection of new liquidity) shows a perfect adaptation of means to needs. It is far from certain that an international institution inevitably more distant from immediate market realities would have been as efficient.
Returning to the problem of institutional reforms, another major obstacle would be practicability: redoing Bretton Woods will obviously take much longer than it took to reach the initial agreement and later to adapt it to evolving realities. By contrast, the international financial scene changes very rapidly under the influence of innovations, of the globalisation process and of the emergence of new actors. There is thus a risk that at the end of a long institutional process the result would not entirely fit the realities of the moment. Small and progressive reforms are therefore better suited to our changing environment than ambitious transformations.
In the same vein, one could argue that, confronted with large risks of financial instability of a potentially systemic nature, what is expected from the public sector is certainly more concrete and rapid measures aiming at strengthening the financial system than a long and uncertain institutional debate. This clearly pleads for acting through institutions that already exist.
In the wake of the Asian crisis, a series of initiatives was taken to diagnose the crisis, define possible courses of action and address the main concerns. Three working groups in which emerging countries played a significant role made recommendations aimed at increasing transparency and accountability, strengthening financial systems and improving the resolution of crises (Willard Group proceedings, 1998). In addition to these initiatives, commonly called the "Willard process", the Bretton Woods institutions and the main groupings involved in financial stability became very active in addressing the more urgent problems: drawing up new standards, promoting greater transparency, revising procedures, assessing major vulnerabilities and defining new forms of official financial support.
This intense process of revision and adaptation had its first result in the way the Brazilian crisis was handled. By contrast to what happened with Mexico and Asia, the Brazilian programme was discussed with the IMF not once the crisis had emerged but in a more preventive manner. The financial package put in place was also proportionally smaller than the Mexican and the Asian ones and was shared not only by the IMF, the World Bank and the IADB, but also by a group of 20 central banks and the BIS; in addition, international banks were requested to maintain their short-term lines.
The process initiated by the Willard Group and carried forward since then is positive and should be continued. It is based on a pragmatic approach to the problems, starting with an identification of weaknesses and aiming for concrete solutions in individual areas. A significant part of the recommendations for change and the establishment of new standards either originated from or have been taken forward by the IMF, the World Bank and the committees of national experts working under the aegis of the G10 and the BIS.
The main risk associated with this pragmatic approach is that it could lead to a lack of consistency among the multiple bodies involved, and to insufficient coordination of their initiatives. In order to prevent these difficulties and to give more visibility and accountability to the process, the G7, following a recommendation made by Bundesbank President Tietmeyer, created the Financial Stability Forum - FSF.
The basis for the creation of the FSF was the feeling, already discussed in Part II of this survey, that an ambitious reform of existing international institutions would be extremely difficult to achieve at sufficiently short notice to address the more urgent needs.
A second important element was the judgement that existing institutions, in their diversity, cover the full range of concerns, have the necessary skills and competencies to address them, and bring the necessary multidisciplinarity requested by modern markets and practices (Icard, 1999 a).
Referring to the four main domains listed at the end of the first part of this survey and considered as being of the greatest relevance for the strengthening of financial stability, one can easily identify areas in which the competencies of the Bretton Woods institutions, the OECD and the international groupings of national authorities come into contact with one another.
The diversity of market actors involves the contribution of all categories of regulators and supervisors in the financial domain. The latter are grouped into three committees: the Basel Committee on Banking Supervision - BCBS (commercial banks), the International Association of Insurance Supervisors - IAIS (whose secretariat is also located in Basel) and IOSCO (made up of the regulators and supervisors of investment banks and other non-banking financial institutions). Preventive measures applicable to the large variety of financial institutions in the form of regulations, recommendations and standards involve the contribution of these committees.
If macroeconomic surveillance is one of the most traditional activities of the IMF, prudential surveillance is more the competence of national supervisors and their international committees. Yet the recent crises have underscored the interdependence of prudential weaknesses and macroeconomic vulnerability. Hence, in the context of its Article IV surveillance activities, the IMF will in future increasingly monitor observance of financial standards established by the international supervisory and prudential groupings.
Strengthening financial, administrative and legal structures is part of the World Bank's responsibilities. In the financial domain, contributions also come from the IMF, central banks and regulators. In addition, in the essential area of payment systems, a committee located at the BIS - the CPSS - is in charge of international cooperation and standardisation.
Lastly, monitoring capital flows involves a large range of contributions due to the diversity of problems involved. The IMF, owing to its general competencies, the BIS and the OECD for statistics, the World Bank for the borrowers' structures, the committees of supervisors for the lenders and the central banks for the surveillance of markets each contribute to this task. In addition, the Committee on the Global Financial System (CGFS), which brings together central bank experts from G10 countries and emerging markets, plays a key role in monitoring market trends, maintaining and analysing international debt statistics and assessing major vulnerabilities.
Due to this large range of contributors to financial stability, engaged in such a variety of initiatives and responsibilities, the route to be followed was less to create new institutions or to radically change the structure of the existing ones than to strengthen the present decentralised framework by improving the cohesion among the various institutions and committees.
In a single grouping devoted to concertation and coordination and supported by a small secretariat, the Forum brings together treasuries, central banks and regulators from the main countries involved (G7 plus four other countries) and representatives of all financial stability bodies (IMF, World Bank, OECD, BIS, BCBS, IAIS, IOSCO, CPSS and CGFS). This diversity in membership is in itself a big strength, as the FSF is a unique grouping where policymakers, macroeconomic specialists, market analysts, regulators and supervisors meet regularly to exchange views on concrete matters and projects. In this respect, this specific structure favours the synergies between macroeconomic assessments and prudential surveillance which were lacking in the past.
The main missions of the Forum are to assess vulnerabilities, detect and fill the gaps in surveillance, give impetus to the implementation of standards, identify and oversee actions to be taken, strengthen coordination and information sharing among members and promote consistency in decentralised decisions (Tietmeyer, 1999). Equally important is the definition of what the Forum should not do: duplicate or overlap its members' activities and develop lengthy surveys not directed to decisions or reforms.
The Forum is by no means a new institution. It is no more than a coordinating group, a process that works through its members. Yet, given the mandates of its member institutions and the status of its participants, it should have the political weight to pursue the necessary changes.
The foremost challenge confronting the FSF is to establish its credibility. Indeed, its prestigious membership raises expectations in this matter, as well as the fact that it constitutes one of the main initiatives taken in the field of international organisation since the 1997-98 crisis. As it was created in February 1999, it is certainly too early to judge the success of its first activities, which have centred mainly on capital flows, highly leveraged institutions, offshore centres and the implementation of financial standards, in addition to ongoing vulnerability assessment (FSF press release, September 1999). However, more than the quality of the work in these different domains, and others which could be developed later, the FSF will have to prove that it can both effectively coordinate decisions on reforms, adjustments and new initiatives and monitor their implementation. Surveys are mainly the preserve of its members, concrete implementation is at the centre of its own responsibilities.
Another delicate matter is the geographical coverage of the FSF. The Forum should not appear as a grouping excluding emerging countries, who also have an influence on financial stability. The preponderance of the G7 in its composition could suggest such an interpretation. This concern was already expressed at the very beginning of the Forum's existence. Rapidly, two measures were taken: inclusion in FSF expert groups of specialists from non-G7 countries and extension of the membership to Australia, Hong Kong, Singapore and the Netherlands, with one representative each. However, these measures do not entirely solve the problem. The authority of the FSF has to be accepted worldwide. This will be hard to achieve unless other countries are admitted; this poses the question of the appropriate balance between representativeness, which tends to enlargement, and efficiency, which pleads in favour of a restricted grouping. Obviously, the FSF will have to expand again, but this process cannot be very large in addition to the existing 40 participants.
Equally important, the Forum will have to avoid the risk of becoming too technocratic, and appropriate contacts will have to be made with practitioners on each main topic discussed. Here again the right balance will have to be struck in order to benefit from outside expertise while avoiding external interference in the decision-making process. Appropriate consultation with the private sector is a challenge faced by the official international community; the FSF should play its part in finding the answer.
The FSF was created without any reorganisation of the institutions and committees which constitute its members. This structure, original and rich, is however complex and not easily understandable other than by a few specialists. One danger could be that a multiplication of internal sub-groups and working parties, short-lived or permanent, would make things even more complex. The FSF will certainly be sensitive to this problem, but similar difficulties could also arise outside its own constituency and it is of prime importance that overlapping of mandates and duplication of work be avoided.
The number of existing international financial institutions is already imposing, as is the number of "G"s. Several of these institutions and groupings were created in the past few years, but one can think of hardly any that have disappeared. The recent creation of the GX (G20) adds a new face to the family picture; its mandate for the time being is undefined but it is important that it does not overlap with existing initiatives and that it does not generate the emergence of a number of new technical groups. In any case, its role should be carefully harmonised with that of the Forum. Developments in the Interim Committee, newly renamed the International Monetary and Financial Committee, should also be contained within the existing structures, which are mainly of a political nature. The creation in early 1999 of a Committee of Deputies was necessary, due to the evolving role of the committee; adding new technical structures and groupings to the current scheme would run the risk of new redundancies.
One should avoid three traps: the dilution of financial stability initiatives among an increasing number of committees and groupings; the dispersal of scarce resources devoted worldwide to these matters; the blurring of the mandate of one group by the activities of the others. Furthermore, it could prove counterproductive if, while asking the private sector for more transparency, the international institutions were setting a bad example by adding complexity to a system already unclear to the public.
The creation of the Financial Stability Forum is a significant contribution to the "pragmatic multitherapy" which is best suited in the current circumstances to improving international financial stability.
Certainly, some will consider that this is not the appropriate answer to a search for a new architecture of the international financial system and that the project lacks ambition by comparison with the expectations. However, one should consider facts and not appearances: this initiative is not "grand" but realistic, it is not mild but well-targeted and the difficulties that the Forum will have to face in order to fulfil its duties will not be trivial. Indeed, improving financial stability through better utilisation of existing forces already constitutes an ambitious programme. In these conditions, would it be necessary to enter into a long and possibly conflictual debate on a fundamental reform of international financial institutions, when pragmatic ad hoc adjustments are sufficient and when so many initiatives should be taken urgently to reduce the risk of new crises? Considering the creation of the Forum as just a temporary initiative, necessary to answer the immediate challenges, while long-term and more ambitious reforms were being prepared would run the risk of a duality of objectives impairing the usefulness of the Forum and its ability to fulfil its mission.
The creation of the Forum is a major initiative which paves the way for more stability through a better use of current resources. Following a worrying series of financial crises, its success is a matter of credibility for the international financial authorities.
"Report of the Working Group on International Financial Crises".