Speech delivered by Jaime 
, 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. …
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.
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. …
3. 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.
