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Thoughts on Regulation and the Future Shape of the Financial System – An IMF View

Written by Richard Reid

17th August 2010

As the summer holiday season draws to a close, the gearing up begins for the autumn conference trail and summit meetings. In the world of financial regulation, Korea has assumed the presidency of the G20, and there will be much discussion of not just the state of the global regulatory response, but also the role that the developing countries are likely to be playing in shaping global financial structure and capital flows over the coming years. The fact that many developing countries have had a “good” financial crisis has not been lost on policy makers there. Hence, while keen to be part of the G20, many are also keen that their own requirements by way of financial services and regulation are given sufficient attention. They are also looking at the competitive position of their own financial services industry. At the same time, there’s  a growing suspicion  that waning economic momentum and worries about restricting the ability of  financial systems  to re-cycle public  debt, may in some quarters, be dampening the enthusiasm for further radical overhaul of financial regulation.

It is against this background that IMF staff have published a broad-brush position paper on the shape of the financial system of the future (see link below). The paper takes an obligatory view of what went wrong but perhaps of more interest now are the thoughts on the choices open for policy makers and what the overall size and shape of the financial system is likely to be.

In view of this paper there are two possible paths ahead for financial regulation: the first, having got over the immediate emergency and recovery phases, in the face of strong resistance from the private sector and a pickup in profitability (perhaps temporary?), allows or even encourages the authorities to take the foot off the regulatory change pedal and  complacency to set in. This is redolent of the observation made by JK Galbraith writing about the 1930’s, to the effect that after a certain period, regulators either become an arm of the industry they are regulating or senile*. The second path is that as bad has this crisis been, and so vigorous the public backlash, there is a risk of over-regulation, thus inhibiting essential financial intermediation and innovation. In the IMF staff’s view, neither of these outcomes is desirable.

As a result of the crisis, the IMF notes that regulatory philosophy effectively changed with many policy makers forced to recognise the need for prudential regulation to encompass systemic risk. It is probably fair to say however, that a number of developing economies had already developed such an approach in the wake of financial crises experienced in their economies in the previous 20 years. Hence, much of the regulatory response has been aimed either at reducing the likelihood of repeating such a crisis, or at the means of developing better tools for dealing with them when they do happen. As this study notes, much work has been done, partly under the auspices of the FSB and the BIS, but also by individual authorities, to identify the problems and means for dealing with them. But the IMF confirms that much still needs to be done, amongst which are:

a. How to collect information from unregulated businesses and sectors in order to have comprehensive risk assessment
b. How to adapt (and harmonise?) different regulatory and supervisory approaches. How will the new structures work in practice both domestically and internationally.
c. How to select institutions  to be regulated (some countries preferring to specify those institutions clearly identified as systemically risky, too-big-to-fail)
d. Should public policy be aimed specifically at preventing institutions from becoming too big to fail? (including size and scope of banking activity as well as preventative measure such as capital and liquidity requirement)
e.  Failure and cross-border resolution mechanisms – making them work.

One of the tests of the months ahead will be to see how well the international community is able to handle the aims of the G20 process with the sometimes apparently conflicting and more pressing economic demands of individual countries and their own domestic political agendas.

What thoughts does this IMF paper offer on the future of the financial system? At least for a while, the financial system is likely to be less volatile, safer and simpler. This may, again in the short term, dampen the amplitude of economic growth once it has returned to its “steady state”. On the thornier question of whether or not this leads to higher or lower growth in the long term, the IMF leaves the door open:

Whether this leads to a higher or lower growth path will depend on whether stability encourages more use of the financial system to intermediate between savers and investors, or whether the regulations have slowed innovation inhibiting efficient intermediation. It may be, however, that some of the previous increase in the growth potential (of the real economy) that was attributed to financial intermediation was illusory and some financial innovations were counter-productive – producing products that did not benefit society at large. If so, then these resources could be redeployed and better used in other nonfinancial activities, thereby supplementing growth.” IMF, pages 11-12

Sometimes in the debate about the size and role of the financial system, the terms banking sector and financial system are used synonymously. This can be very misleading and the IMF here too considers not just the size of the financial sector but also its composition. Clearly the new regulatory requirements on banks suggests their overall weight in financial intermediation may be dampened  (although of course there is also an ongoing change of competitive position within the banking system and this may not be the case either in some developing economies). The IMF reckons a likely outcome for banks is a more “bifurcated” banking system, with some institutions retreating from non-core businesses, perhaps allowing a resurgence of intermediation by institutions less beholding to shareholders, such as mutual or credit cooperative banks. On the other hand, there could be incentives for some institutions to grow bigger. One, oft cited reason for this, apart from a funding motive, is the necessity to provide a full service institution to cater the needs of their clients who themselves have complex, global businesses.

Another point to note, and one that is likely to have increasing resonance with developing countries, is that if financial institutions are likely to be inhibited by regulatory strictures, what happens with other methods of financial intermediation, such as capital and money markets? The more financial intermediation goes through these markets, the more governance and transparency issues surrounding these markets will come to the fore. Indeed, improving governance here may be a precursor to further developing these markets. This involves not just openness and information but also clearing and settlements mechanisms.

Perhaps a key factor for the vigour with which regulatory change will be pursued over the balance of this year might be the development of economic conditions. A deterioration could lead to less desire to upset the apple cart or it could so increase public discontent that it would tend to a further round of more intrusive state intervention. The most likely scenario however, is that the global economy settles back into a “muddling through” growth path with regulators and policy makers trying to support the overall G20 agenda. However with sufficient wiggle room in the detail to accommodate individual needs. Behind all of this of course, is the observation that this crisis has served to highlight just how important the changing balance of power is between the developing and developed countries. While some countries in the G7 are agonising over the size and role of their financial systems and the incidence of “unsocial” financial intermediation, some of the developing countries are considering how best to build and diversify their financial systems and financial centres.

*JK Galbraith, “The Great Crash 1929”