Emily Vogl, Frank Vogl
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The Financial Industry Calls for Action to Strengthen the Global Financial System and Promote Stability in Financial Markets
New York, July 23, 2009 — Leaders of global financial services firms called today for far-reaching regulatory reforms to reinforce industry efforts to strengthen the global financial system. "Our main challenge now is to restore confidence in and stability of the financial system - this is essential for sound financial markets that can finance growth for the future," said Dr. Josef Ackermann, Chairman of the Institute of International Finance's Board of Directors and Chairman of the Management Board and Group Executive Committee of Deutsche Bank AG.
The IIF, which is the global association of financial services firms with over 370 members across the world, today published a new report Restoring Confidence, Creating Resilience: An Industry Perspective on the Future of International Financial Regulation and the Search for Stability. Dr. Ackermann emphasized that, "We are publishing this report because we recognize that the industry and the public sector have to build a system that can weather storms yet still provide the credit that the global economy depends upon. We are operating in a globally interconnected world where we need to strengthen the system's capacity to minimize the risks and to maximize the benefits of the interconnected global marketplace."
Today's report, reflecting the views of the industry's leaders, emphasized the shared responsibility between the industry and the public sectors for strengthening the global financial system. It stressed that financial regulatory reforms must better align incentives for sound risk management, improve transparency, and enhance resilience over the business cycle. It noted the overarching need to build a strong international financial system where regulation should work with the market, with investors and creditors to bring market discipline to bear and be framed with the costs and benefits of regulatory measures very much in mind.
Dr. Ackermann added, "We recognize that far reaching regulatory and industry reforms are necessary to guard against systemic vulnerabilities. A return to 'business as usual' is not an option for us. We need to establish a more resilient and stable international financial system, which stimulates and encourages innovation and foster competition to provide cost effective services to customers. We believe that international coordination among regulators and supervisors is essential. For our part, financial services firms are committed to strengthening our own practices and to working with the official sector in the design of necessary structural and regulatory changes to minimize the risk in the future of the kind of crisis that we are still wrestling with."
The new report, approved by the IIF's Board of Directors on behalf of the Institute's membership, has been developed with inputs from senior executives across the industry under the auspices of the IIF Special Committee on Effective Regulation. The Committee is co-chaired by Mr. Walter B. Kielholz, Member of the IIF Board of Directors, Chairman of the Board of Directors, Swiss Reinsurance Company Ltd (as of May 2009), former Chairman of the Board of Directors of Credit Suisse Group (2003-2009), and by Mr. William T. Winters, Member of the IIF Board of Directors, Co-Chief Executive Officer of J.P. Morgan Investment Bank and Member of JPMorgan Chase's Operating Committee.
Ensuring an Efficient International Financial System
At a press conference today, Mr. Kielholz said that in responding to proposals for financial reform published in recent months, IIF members recognize that there is now an opportunity to build a more efficient and effective system. However, he said, "The new system that emerges needs to be well coordinated among regulators with an emphasis on effectiveness and harmonization. It will need to avoid protectionist measures taken purely with a national perspective without adequate coordination across national jurisdictions."
Mr. Kielholz added that in responding to the crisis some national authorities have taken measures with a domestic orientation without adequate consistency and coordination with other regulators. He noted that should this trend continue, then it risks the fragmentation of the system of international regulatory coordination that the financial services industry considers essential. He said, "Our concerns not only relate to the potential undermining of today's international system, which has benefited the global economy, but also to the reality that a fragmented system will not be able to respond effectively to future systemic vulnerabilities that might arise in international financial markets. We suggest in our report today, for example, that the Financial Stability Board's (FSB) mandate and resources could be expanded to help avoid regulatory fragmentation."
Mr. Winters stated, "The financial services industry fully supports the need for regulation to be enhanced in scope, impact, and quality. We must develop new and effective ways to assess and minimize systemic risks. We emphasize in our report, however, that the cost of misjudged regulation could be great in terms of jobs, investment and growth. Accordingly, the industry is moving forward with its own efforts to analyze the costs and benefits of various regulatory proposals and it is prepared to work with regulators on this important process."
Mr. Winters underscored that, "We believe it is essential that regulatory reform be implemented with an integrated global perspective and an assessment of the cumulative impact of all the varied changes that are in the works. In addition, such reforms should be framed around the principles of risk-based approaches and ones that strengthen international coordination, and we look forward to participating in that dialogue."
Raising Capital Ratios and Reducing Leverage
Today's report noted that IIF members accept that levels of capital in many parts of the system leading up to the crisis were insufficient and that overall levels in the system may need to be increased within the framework of a revised Basel II risk-based approach. In this connection the IIF strongly supports measures to counter cyclicality by building resources in good times that can be drawn down in bad times.
The report said there is broad agreement that the quality of capital required, in particular Tier 1 capital, needs to be reviewed and that there needs to be international consistency with respect to the components of Tier 1 capital. The report noted that there should be a continuing important role for Tier 2 capital including convertible debt, which has proved an effective source of new Tier 1 capital in a number of cases.
IIF Managing Director Charles Dallara said, "Leverage in the system has been too high and needs to be kept under control in the future. This requires a regulatory response to reinforce industry efforts and market incentives. In our report today we have argued that hard-wired ratios, which do not take into account actual portfolio composition and basic risk issues, are likely to be counterproductive. Instead, we recommend a less rigid approach under which supervisors can react to individual situations and adopt appropriately sharp remedial actions, avoiding arbitrary and anomalous results that distort prudent lending patterns."
The IIF report highlighted support for the need for firms to hold buffers against liquidity risks. But, it stated that in determining a firm's liquidity buffer, overly mechanistic approaches that do not take into account the overall business model, funding profile, and market context of the firm should be avoided. International coordination is essential on defining eligible liquid assets, which should not be defined so narrowly as to cause market distortions.
Avoiding Uncoordinated Accumulation of Regulation
The IIF stressed that it fully recognizes the importance of addressing gaps and weaknesses in regulation that tolerated poor risk management. However, it pointed out that the risk of introducing remedies more than once could lead to inefficiencies and added costs to consumers. It stated, for example, that this could arise by increasing capital and liquidity requirements at the group level, and then again at the individual country level; or by not taking account of the integrated effect of changes in provisioning rules, capital requirements, and new liquidity measures; or by addressing past securitization excesses with overlapping new prudential and market regulatory requirements. The report noted that without careful coordination the burdens on intermediation could be substantial with adverse effects on global economic activity.
Mr. Kielholz said, "It is of central importance that all practical steps be taken to assess the full cumulative impact of proposed measures, to consider their effect on the availability of the costs of credit and other financial resources to the wider economy, and to calibrate the new measures as accurately as possible. We acknowledged that this is not an easy task. Time needs to be allowed for analysis and debate and the IIF's members stand ready to play their role in helping ensure that it is successfully achieved."
Systemically Important Institutions
Mr. Winters noted at the press conference, "We concluded in developing today's report that the international financial system as a whole was poorly equipped to deal with systemic risk and therefore there need to be a significant changes in the architecture, objectives, and framework of financial regulation, domestic and international. We agree that all market participants whose activities could materially impact systemic stability should fall within the framework of macroprudential oversight regardless of form or license. So also should all financial markets and products with similar potential for systemic impact."
At the same time, the report said it would be counter-productive to create formal categories of highly systemically relevant firms that should be subject to separate or additional regulation. To do so would have adverse consequences and could add to instability at a time of market volatility. The report does stress, however, that large and complex institutions may need to be subject to more intense supervision.
The report stated, "It is essential that all parties recognize that systemic risk may emerge from the complex interaction of institutions, markets and products, and that focusing solely on a list of institutions is unlikely to help detect or manage systemic risks more effectively. It would give rise to a mistaken sense that systemic risk had been corralled and controlled within such a category of firms; it would incentivize risk migration and opacity; it would give rise to undue reliance on an entity-based prism for viewing systemic risk; and it would create distortion moral hazard."
Mr. Kielholz added that, "As we point out in our report, systemic events can be triggered by firms of many different shapes and sizes or by market developments. More importantly, such risks do not reside in single entities but in the interconnectedness of global markets, players and products. Large institutions play an important role in supporting the global economy. Artificial restrictions on size could produce materially distorting effects and unmanageable risk patterns within the system."
Market Discipline and Government Exit Strategies
Noting that successful regulation needs to operate in tandem with well-disciplined markets, the IIF emphasized that for markets to operate effectively there needs to be meaningful market discipline. This means that investors and creditors other than depositors or policy-holders need to face a possibility of loss and so it needs to be made feasible for even the largest financial firms to fail. And, in this regard, the IIF noted that it should be a priority to implement the infrastructural, legal, and process reforms necessary to ensure that all firms can exit the market in an orderly fashion and without causing a systemic crisis regardless of their size, nature, or range of activities.
At the same time, the report noted that while government interventions to secure stability have been welcome and important, it is necessary now to develop strategies for governments to exit their holdings in financial firms and end debt guarantee programs and extraordinary support for markets and liquidity. "Well-formulated, well-coordinated, and well-executed exit plans are essential to avoid competitive distortions and ensure a level playing field both within and across countries and to restore an effectively functioning market place," said the IIF.
Firms Reinforce Reforms
IIF Managing Director Charles Dallara said at the press conference that, "The industry recognizes that it has a shared responsibility with the official sector to act to restore confidence and secure stability. The industry's greatest contribution here is going to be in the ways in which it fully recognizes past weaknesses and raises standards in line with the principles and best practices contained in the comprehensive report that we published one year ago, Final Report of the IIF Committee on Market Best Practices. "
Mr. Dallara, noting that today's report highlights extensive measures that the industry is taking towards this end, said, "Central amongst these have been significantly enhanced risk management across the globe, more effective liquidity management, greater transparency, and compensation policies aligned with long-term, risk-adjusted performance. Sustaining and deepening these and related reforms by the industry are a sine qua non for greater systemic stability and an essential underpinning to more effective regulation and supervision."
The IIF report noted that while much work remains to be done, significant advances continue to be made by the industry to act on the lessons learned in critical areas, including the following:
- Materially Improved Risk Management, including more robust risk governance, strengthened capabilities in risk aggregation, improved stress testing, improvement of market-risk management and significant investment in risk systems and data;
- Increased and Better Quality Capital compared to the position prior to the crisis, in response to market and official demand;
- Better Liquidity Risk Management, including more robust analysis of funding needs and sources, wide application of stress-testing techniques, and substantial liquidity buffers;
- Substantial Reduction of Leverage, both on a systemic and individual-firm basis, based on the clear recognition of the negative effects of excessive leverage;
- Reducing Procyclicality by analyzing its causes, refining provisioning practices and making more extensive use of "through-the-cycle" approaches to capital;
- Material Improvement on Disclosure and Transparency through Pillar 3, together with Industry Initiatives to Reform Securitization, working toward more transparent, liquid, and standardized markets, and clarifying firms' Off-Balance-Sheet Exposures;
- Development with the official sector of a Better Understanding of Systemic Risk, using this understanding in risk management, and working with the official sector on macroprudential means through which it can be identified, addressed, and mitigated;
- Significantly enhanced risk management, processing, transparency, and systems and procedures for carrying on Credit Default Swaps (CDS) and Other Over-the-Counter (OTC) Derivatives business.
In addition, the report noted that on compensation, significant reforms of firms' compensation practices are taking place to align incentives with long-term shareholders' interests and firm-wide profitability, taking account of overall risk and cost of capital. The IIF reaffirmed its commitment to implementation of the Principles on compensation set out in the Market Practices Report and welcomed the FSB Principles for Sound Compensation Practices published in April.
Emily Vogl, Frank Vogl