Not making the grade: Report card on global financial reform
While financial reform is underway around the world, this column argues that much more needs to be done.
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The global reform agenda aims to make the financial system safer while allowing it to provide the intermediation services needed to fuel strong and stable economic growth. The reform is well underway, but there is still a long way to go (Bush and Farrant 2011, Campos and Nugent 2011).
The intentions of policymakers are clear and positive, and there have been a host of reforms in the right direction. The system, however, remains vulnerable; the pre-crisis financial structures have not changed much, and they will need to change if the goal is to be reached (IMF 2012).How we measure progress
IMF (2012 Chapter 3) is an interim report on the progress made towards a safer financial system. It begins by setting out some ideals.
In part, this could be accomplished with stronger financial institutions that are better equipped to withstand the distress of downturns by holding more and better loss-absorbing capital and higher liquidity buffers.
The research focuses on the features of financial systems related to the crisis, especially those features that need to be addressed to achieve the goal of a stable and effective system: These include: 1) large, dominant, and highly interconnected institutions 2) the heavy role of non-banks, and 3) the development of, for instance, complex financial products. The focus is on three intermediation features:
The next thing the study does is try to tie the reform agenda to how it could reasonably be expected to alter the various financial structures. Using both quantitative and qualitative information and a dose of judgement, a list of ‘priors’ were set out concerning how reforms could affect financial structures1. The expected outcomes – including intended as well as unintended consequences – are presented in Table 3.3 of the report.How are changes tied to regulatory reforms?
In an effort to quantify ‘progress’, we examine empirically the effects of progress on implementation of the Basel capital reforms on the various elements of financial structures and test our priors. We use the difference-in-differences method, as this technique allows us to estimate the impact of a policy by comparing the policy-induced outcome to what would have happened without it (Ashenfelter and Card 1985; Annex 3.3 in the report). Since Basel 3 has yet to be implemented fully, our results rely primarily on progress on Basel 2 and 2.5, where there is sufficient variation across economies to be able to discern differences statistically (Basel Committee on Banking Supervision 2012).
While the results should be interpreted as very preliminary, it finds that results are in line with the priors (see Table 3.5 in the report)2. Progress on Basel capital rules are driving banks to alter their liability structures to economise on regulatory costs. We also witness this trend in the raw data (Figure 1).
Progress is also muting the severe drop in securitisation – a result we believe is tied closely to the fact that the countries that have made the most progress on Basel 2 and 2.5 are in Europe, where securitisation is being used to produce postable collateral at the ECB. Lastly, progress is linked to lower globalisation. This is suggestive of greater home bias among those countries further along in implementation – a worrisome result (though perhaps again driven by the heavy weight of European countries in the sample). Such a trend should be watched carefully lest the benefits to cross-border risk sharing become impaired.
Figure 1. Non-traditional banking (Average of two ratios: non-loan assets in % of total assets and non-deposit interest-bearing liabilities in % of total liabilities)
Source: IMF staff estimates.
Note: The relative size of nontraditional to total banking activities is constructed as average of the following three ratios: banks' non-interest income over total income, banks' other earning assets over total assets, and banks' other interest bearing liabilities over total liabilities. Data for individual countries (LHS) and cross country averages (RHS) are shown. See Annex 3.1. for the data sources and definitions.Good effort, but requires follow through
So, overall, are the reforms moving the structures in the right direction – to a safer financial system? Our answer so far is: ‘somewhat, but not enough.'
There are a couple of good reasons for the lack of progress.
Measures aimed at preventing deeper financial system distress, and bolstering nascent economic growth, remain in place, and tend to slow the adjustment process.
Nonetheless, there are elements, such as the Basel 2.5 international banking rules and the market’s anticipation of the Basel 3 implementation, that are promising: many banks hold more and better loss-absorbing capital and have begun to divest themselves of activities they view as less profitable.
Figure 2. G20 regulatory reform agenda: Key elements and progress
Overall, however, the basic financial structures that we found problematic before the crisis are still with us:
As some activities become costly, some banks will get out of those businesses, but others with enough scale economies will stay in, making these activities even more concentrated – the fixed income, currency, and commodities trading business line is one such activity.
The good news is that, overall, globalisation has not been seriously harmed, with the exception of crisis-hit economies in Europe. But this also means that the potential for contagion – with bad outcomes from one country affecting the financial system in another – is still present. Moreover, the fragmentation currently underway in the EZ is a reminder that globalisation has a downside that needs to be offset with, at a minimum, appropriate risk management techniques, good governance within institutions, and effective cross-border resolution schemes.
Figure 3. Three-bank asset-concentration ratio
Source: IMF staff estimates.
Note: Data for individual countries (LHS) and cross country averages (RHS) are shown. See Annex 3.1. for the data sources and definitions.
Figure 4. Wholesale funding ratios (non-deposit liabilities in % of total liabilities)
Source: IMF staff estimates.
Note: Data for individual countries (LHS) and cross country averages (RHS) are shown. See Annex 3.1. for the data sources and definitions.What to do?
Given the still-vulnerable financial system, what should be done? By taking stock of all the regulatory reforms to date we can see some areas that still need to be addressed. These areas include:
Even with new rules on the books, their success depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer. Policymakers need to press ahead. We are not encouraging a sprint, but simply a brisk, purposeful walk towards the goal of a safer financial system.
Editor’s note: This column is based on the IMF’s latest Global Financial Stability Report, Chapter 3, written by IMF staff, whose contributions are the basis of this material. Helpful comments on this column were received from Jan Brockmeier, Jacqueline Deslauriers, and Srobona Mitra.References
Ashenfelter, Orley, and David Card (1985), “Using the Longitudinal Structure of Earnings to Estimate the Effect of Training Programs”, The Review of Economics and Statistics, 67(3):648-660.
Basel Committee on Banking Supervision (2011a), “Basel III: A global regulatory framework for more resilient banks and banking systems”, 1 June.
Basel Committee on Banking Supervision (2011b), “Basel III: International framework for liquidity risk measurement, standards and monitoring”, December.
Basel Committee on Banking Supervision (2012), “Progress report on Basel III implementation” (update published in April 2012).
Bush, Oliver and Katie Farrant (2011), “Reform of the international monetary and financial system”, VoxEU.org 21 December.
Campos, Nauro F and Jeffrey B Nugent (2011), “Why has this one been such a disappointing crisis?”, VoxEU.org, 10 July.
European Commission (2012), Report of the High-Level Expert Group, “Liikanen Report”.
Independent Commission on Banking (ICB) 2011, Final Report: Recommendations, “Vickers Report”.
International Monetary Fund (2012), “The Reform Agenda: An Interim Report on Progress toward a Safer Financial System”, Chapter 3, Global Financial Stability Report, World Economic and Financial Survey.
1 Note this exercise is not about the reforms’ effect on institution’s profitability, nor on the economy through, say, their effect on credit or GDP.
2 There are a number of reasons we may not be capturing the 'true' relationship, including the imprecision of the proxy variables to measure the types of financial structures under investigation.