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Next steps on the road to financial stability
By Mario Draghi
Published: September 16 2010 14:17 | Last updated: September 16 2010
14:17
Crises always accelerate the process of change. Two years after the
collapse of Lehman Brothers, it is not surprising that the signs of a
deep transformation in the financial landscape are very visible. Two
main driving forces are at work.

The first is a different perception of risk. For many years an
optimistic view that underestimated the level of risk and
overestimated its dispersion across participants had become the
conventional wisdom; that view has been wiped out by the crisis. A re-
pricing of risk of all sorts, higher volatility, reduced valuation of
certain assets, more careful examination of credit quality and greater
attention to the longer-term sustainability of debt positions – as
highlighted by the recent sovereign debt crisis in Europe – are all
manifestations of this changed perception. Business models are being
reassessed according to their ability to manage risk. Complexity and
opacity of financial instruments are no longer rewarded; the demand
for transparent, complete and accurate information has increased.

EDITOR’S CHOICE
FT series: Lehman’s legacy - Nov-26

The second source of change is policy driven. After Lehman, any
remaining doubts on the need profoundly to reform the financial sector
were dispelled. It became clear that a common, internationally co-
ordinated approach, involving both advanced and emerging economies,
was needed.

At the prompting of the Group of 20 leading economies, and under the
co-ordination of the Financial Stability Board, the weaknesses
highlighted by the crisis are being tackled. A fundamental step was
taken last weekend with the agreement reached by the Basel committee’s
governing body on new bank capital and liquidity standards. These
standards will markedly increase the resilience of the banking system,
including by constraining the build-up of excessive leverage and
maturity mismatches that proved the tinder for this crisis.

At the same time, the Lehman case reminds us that other, more deep-
seated problems need to be addressed. Lehman was the first global
systemically important institution that was allowed to fail during the
crisis. It was also the last. The public will not, and should not,
accept more such bail-outs. Addressing the problem of “too big to
fail” is therefore the next central step in the reform programme.

The work under way in this area has several dimensions. First,
systemically important institutions must have loss-absorbing capacity
beyond the minimum standards agreed for the banking system in general
last weekend. This loss-absorbing capacity could include a combination
of equity capital surcharges, contingent convertible capital and
mechanisms to “bail in” creditors. The former would increase the
resilience of such institutions on an ongoing basis, while the latter
instruments would strengthen market discipline.

Second, systemically important institutions will operate with correct
incentives only if an effective resolution framework is in place. Many
countries lack the powers, the tools and the operational capacity
needed in this area. Effective regimes must enable the authorities to
resolve financial crises without systemic disruptions and without
taxpayer losses. They should include powers that facilitate “going
concern” capital and liability restructuring as well as “gone concern”
restructuring and wind-down measures, including the establishment of a
temporary bridge bank to take over and continue operating certain
essential functions. Statutory powers enabling the resolution
authority to bail-in senior debt holders would expand the options for
going concern resolution.

Third, we need to improve cross-border resolution capacity. Global
banks have substantial operations across multiple jurisdictions and
thousands of legal entities. In the absence of a global resolution
regime, we need not only effective regimes at the national level, but
also strong capacity for such regimes to co-ordinate across borders.
Assessments of resolvability are part of the recovery and resolution
plans being developed by and for the largest international financial
institutions. If home and host authorities deem that a bank’s
structure is too complex to be resolved in an orderly way, they should
demand changes to its legal and operational structure.

Fourth, the effectiveness and intensity of supervision needs to be
strengthened both for banks in general, and for systemically important
institutions in particular, given the wider damage their failure would
cause. Countries need to strengthen supervisory mandates,
independence, resources and methods.

Fifth, core financial market infrastructures must be strengthened to
reduce contagion risks and to ensure that critical infrastructure is
not itself a source of systemic risk. A key source of the risk
transmission is the network of major institutions’ exposures to each
other; not least in the over-the-counter derivatives and in funding
and repo markets. Central clearing arrangements can simplify and
greatly reduce the risks associated with this web of counterparty
exposures.

The FSB and its members are developing measures in all the above areas
and will present their recommendations to the November G20 summit in
Seoul.

Last, a central lesson of this crisis was the lack of effective system-
wide oversight. One of the blind spots, and an important contributor
to the crisis, was the regulatory arbitrage that developed in the
shadow banking sector. This sector continues to play an important role
in credit intermediation and liquidity transformation, but outside the
capital and liquidity regulatory framework that applies to banks. As
we strengthen the requirements for banks, we must make sure that we
also capture within the regulatory perimeter the sources of systemic
risk currently outside it. This will be a priority for the FSB’s work
in 2011.


The writer is chairman of the Financial Stability Board and governor
of the Bank of