Since October 2009, the health of the global financial system has improved and the economic recovery has taken hold. So far, so good. But despite some positive numbers here and there, the present is not looking rosy. Stability risks remain high and the recovery is still fragile as balance sheets are repaired.

What could undermine stability is advanced country sovereign risks such as we have seen in Greece or Spain. This could bring the credit crisis into a new phase, with a so-called spill-over effect threatening the transmission of sovereign risks to banking systems.

Still worrying is the poor capitalisation of some banking systems that are facing high risk. The International Monetary Fund (IMF), an international organisation that oversees the global financial system, sees this as a major problem and in its Global Financial Stability Report, says: ‘The failure to deal decisively with weak institutions could act as a deadweight on growth. Banks must reassess business models, raise further capital, de-risk balance sheets and stabilise funding.’

The IMF is currently reviewing its options for ways to devise financial reforms that address systemic risks. There are two major questions that the Fund has to respond to. One, whether systemic risk would be reduced by placing all regulatory functions under the review of one entity – be that a single agency or an overseeing council. And two, if capital surcharges were to be used on financial institutions to try to limit the systemic risk associated with domino-like failures, how would these surcharges be constructed?

What went wrong and how can it be fixed?
The IMF is suggesting that to maintain the momentum in the reduction of systemic risks, further action is required of policymakers in several key areas. The Fund is calling on governments to design credible medium-term fiscal consolidation plans in order to curb rising debt burdens and push the credit crisis into the next phase. 

Clarity is also desperately needed in defining the new financial system framework to give banks more certainty over their future business models. The health of the banking system is generally improving alongside the economic recovery. However, banks still face considerable challenges. A large amount of short-term funding will need to be refinanced this year and next.

New regulations will require banks to rethink their business strategies more carefully. But this is very likely going to put downward pressure on profitability. And medium-sized businesses are feeling the burden of the reduced credit available.

Dealing with cross-border risk
There has been an outcry for regulators to explicitly monitor systemic risks. This is defined as the potential for distress in one institution as it may then adversely affect others.

The problem encountered with monitoring financial institutions that have systemic risk connections is that regulators might have the tendency to be more lenient with systemic institutions in distress that are deemed ‘more important’ than others. A flood of regulatory reform proposals has taken place, but there is considerable uncertainty about how they can be practically applied. For example, where or in which existing regulatory body should a systemic risk regulator be placed?

In April, Laura Kodres, Chief of the Global Financial Stability Division, said: ‘The first round of regulatory reforms are well under way. The first steps have been put into place and they are typically regulations that build up capital and liquidity buffers in financial institutions, mainly in banks. The next steps are much more difficult. The crisis showed that the safety and soundness of individual institutions is not enough to prevent a breakdown. The whole may be greater than the sum of the parts. That is, there are risks to the financial system that result from the interaction of institutions, in particular, what we are now coining systemic interconnectedness.’

One of the proposals in discussion to deal with this is to construct a systemic risk-based capital surcharge.

Charging on risk
Whichever institution will be responsible to execute plans for a risk-based capital surcharge, great care will be needed to ensure that the combination of measures strikes the right balance between the safety of the financial system and its innovativeness and efficiency.

Two proposals made were to, on the one hand, allocate regulatory powers to monitor and lessen systemic risk, and, on the other hand, introduce systemic risk-based capital surcharges, i.e. higher capital requirements for systemic institutions.

How will it work? It will act as a buffer in so far that the money stays with the institution as opposed to what happens in a tax, where it is transferred to the government. The difference is that the capital charge increases the resiliency of the institution to sustain different shocks.

Juan Solé, one of the authors of the Systemic Risk and Financial Regulation report by the IMF, said at a press briefing in April: ‘It is very important to bear in mind also the cross-border or international connections that most large financial institutions have nowadays. To accomplish this goal, it is important that national regulators collaborate and share information on these cross-border connections because if instead the capital surcharges are implemented from a purely domestic point of view, then we’re bound to underestimate or even miss altogether some important sources of contagion [of risk]. So if it’s decided that these charges should be implemented, getting the timing right is also a key element.’

The time is ripe
In a statement in early June, the IMF persisted that the financial sector reform remains a key priority and that it must be coordinated, both within Europe and globally. This is with regard to ‘new capital and liquidity requirements, surcharges on systemic institutions, as well as targeted macro-prudential measures that address rapid credit growth and liquidity mismatches. For the euro area, a robust calibration in all areas is required to increase the banking system’s resilience to any future shocks.’

Kodres of the Global Financial Stability Division warned that ‘several countries of course are anxious to move ahead and we would caution that we need to move ahead as one global community so that such regulatory arbitrages do not in fact inhibit the types of progress we’re trying to make to eliminate the systemic risk in the system.’ This means that, unless everyone is ready, no progress can be made on the new regulations.

The financial regulatory reform agenda is still a work in progress, but will need to move forward with at least the main ingredients soon. As the IMF said in its Global Financial Stability report in June: ‘The window of opportunity for dealing with too-important-to-fail institutions may be closing and should not be squandered, all the more so because some of these institutions have become bigger and more dominant than before the crisis erupted. Policymakers need to give serious thought about what makes these institutions systemically important and how their risks to the financial system can be mitigated.’

For more information:
To read the Global Financial Stability Report from the IMF, visit: http://www.imf.org/external/pubs/ft/gfsr/2010/01/index.htm