Who Will Do It?

When the G20 nations assemble in London to repair the financial system, they must not forget implementation. Trying times naturally focus attention on sweeping solutions rather than technical details of implementation. But now, more than “What is to be done?,” we need to ask “Who will do it?”

The growing integration of once segmented financial markets requires a new cadre of well prepared regulators. Comprehensive oversight demands coordination among the financial regulators of many nations with differing laws, cultures, and traditions. Since national regulators cling to their accustomed methods except in moments of domestic pressure, international consensus emerges haltingly (Singer 2006). As the Group of 30 recommends, it is time to “move beyond coordinated rule making and standard setting to the identification and modification of material national differences in the application and enforcement of such standards” (pp. 37-38). To achieve the common purpose, regulators must understand each other better.

Financial sector consolidation adds another challenge. The businesses of banking, insurance, and securities trading evolved to serve different needs, devised different solutions to information problems, and in the process spawned different cultures. As these businesses become increasingly intertwined, their regulators must master each other’s tools, share information confidentially but efficiently, and coordinate their actions to mitigate regulatory arbitrage.

Apart from blurred national boundaries and product line distinctions, the complexity of prudential supervision involves great expertise. Unlike other enterprises, financial firms do not encounter a rising cost of capital when increasing leverage. The depositors and policyholders who supply funds cannot influence the firm’s management decisions nor foresee future changes in the firm’s financial strategy. Thus the market provides little countervailing force to a financial firm’s temptation to enhance profitability by increasing leverage. Prudential supervision is the only constraint on excessive risk taking, and it requires a clear grasp of the risks financial firms are taking.

Although not commonly appreciated, the liberalization of financial markets intensifies the need for prudential supervision. A more competitive market presents more opportunities for financial firms to miscalculate, while increasing the pressure on them to take more risk. As the market players become more sophisticated, so must the market supervisors.

Although we are still in its early stages, some suggest that financial globalization will lead a new wave of economic development and reduction of poverty (Mishkin 2006). Mounting evidence shows that robust financial markets contribute to economic growth (Beck, et al, 2000). Research at the International Insurance Foundation added insurance to the financial services linked to growth (Webb 2006). This research also shows significant synergies: various financial services reinforce one another in promoting faster growth.

But the benefits of an efficient global financial system are not automatic, nor are they free. They depend on the proper institutions being in place. Markets need rules so that all the participants know what to expect. Overly prescriptive rules, however, can discourage innovation and distract market participants into devising ways around the rules.

Rather than verifying mere conformity to easily circumvented specific rules, principles-based supervision employs guiding ideas in quest of good outcomes. Others conversant with the subject acknowledge these outcomes as good even when their roles are reversed. The vision of an efficient financial system puts everyone on the same page. Whereas rules specify minimum expectations, principles identify aspirations. A principles-based approach requires supervisors equipped with a solid understanding of the business and market conditions. Principles-based supervision is also a work in progress, since it requires continuous learning to keep pace with market innovation.

In little more than a single decade, many impressive structures have sprouted. IMF codes of good practice have made monetary and fiscal policies more transparent, helping to stabilize currency markets. International Financial Reporting Standards are becoming the global standard for the preparation of public company financial statements. Banking, insurance, and securities regulators have each formed international standard-setting bodies and agreed upon core principles. The OECD has articulated corporate governance standards, and the Financial Action Task Force has drafted recommendations to prevent money laundering and terrorist financing. The Financial Stability Forum, which brings together all the relevant bodies, has identified 12 key standards for sound financial systems. Thus elements of a strong global framework already exist, even though the links need reinforcement.

A valuable scorecard also exists. The Financial Sector Assessment Program (FSAP), a joint IMF and World Bank effort introduced in May 1999, provides a diagnostic tool to promote the soundness of financial systems in member countries. Assessments seek to identify the strengths and vulnerabilities of a country's financial system; to determine how key sources of risk are being managed; to ascertain developmental and technical assistance needs; and to help prioritize policy responses. Thus in concept the FSAP constitutes a systematic process of continuous improvement.

So where does this process fall short? Implementation. The World Bank’s Independent Evaluation Group found that the FSAP had not attained its full potential and recommended integrating the FSAP into a full reform program. “The Bank should leverage more actively the knowledge gained from this extensive exercise,” including best practices, concerns, and “better sharing of data and insights gained through the program” (IEG, p. 39). It also concurred with the IMF Independent Evaluation Office’s call for “a clearer framework for coordinating follow-up capacity-building technical assistance activities.” (IEO, p. 69).

The knowledge required to supervise financial institutions effectively is not spreading as rapidly as new global standards are emerging. A common lament at the WTO comes from countries that have opened their financial sectors to foreign competition but do not have the necessary supervisory expertise and have not received the technical assistance they expected. National supervisors often fault global standards for relying on concepts of fair value, corporate governance, or risk management that are entirely alien to their experience. And the recent financial meltdown offers abundant examples even in advanced economies of regulators who were not prepared to respond effectively.

The global financial system does not need more regulations as much as it needs more and smarter regulators. To secure the benefits of an open system, there must be an investment in building supervisory capacity. It takes vast knowledge to surmount the challenges posed by differing national regulations, disparate financial services, and increasingly sophisticated risk profiles of financial institutions. Spreading that knowledge is now the key to a healthy and sustainable global financial system.

At its Washington meeting in November 2008 the G20 already recognized this need. The final item in its workplan declared:
“Advanced economies, the IMF, and other international organizations should provide capacity-building programs for emerging market economies and developing countries on the formulation and the implementation of new major regulations, consistent with international standards.”

To implement a consistent, comprehensive, and transparent global financial architecture, we need skilled people. The London Summit should move capacity building from the bottom of its list to the top.

Robert Gibbons
Executive Director and President
International Insurance Foundation

References:

Beck, Thorsten, Ross Levine, and Norman Loayza, “Finance and the Sources of Growth,” Journal of Financial Economics, 58, 261-300

Group of Thirty, Financial Reform: A Framework for Stability (Washington, 2009)

Independent Evaluation Office of the IMF, Report on the Evaluation of the Financial Sector Assessment Program (Washington: IMF, 2006)

Mishkin, Frederic S., The Next Great Globalization (Princeton: Princeton University Press, 2006)

Singer, David Andrew, Regulating Capital: Setting Standards for the International Financial System (Ithaca: Cornell University Press, 2007)

Webb, Ian, Assessment on How Strengthening the Insurance Industry in Developing Countries Contributes to Economic Growth (Washington: USAID, 2006)

World Bank Independent Evaluation Group, Financial Sector Assessment Program: IEG Review of the Joint World Bank and IMF Initiative (Washington: The World Bank, 2006)