Conference Agenda Proceedings of the Seminar, published in April 2002 Summary of Proceedings For more information on the seminar contact: ojohnson@imf.org IMF Seminars, Conferences and Workshops
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Seminar on Financial Risks, System Stability,
and Economic Globalization June 5–8, 2000 IMF Headquarters, Washington, D.C. Participation by invitation only Agenda
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Seminar on Financial Risks, System Stability, and Economic Globalization The eighth Central Banking Seminar of the IMF was held during the period June 5-8, 2000, organized by the Fund's Monetary and Exchange Affairs Department in collaboration with the IMF Institute. The last seminar in this series took place in January 1997. The theme of this seminar was "Financial Risks, System Stability, and Economic Globalization." Apart from staffs of the IMF and the World Bank, participants were drawn from private financial firms, academia, regulatory and supervisory agencies, and central banks. Officials from over 35 countries were represented. The main proceedings will be published, as a book, by the Fund. The topics covered included: (1) internal rating processes and models in the measurement and management of credit risks; (2) calculating counterparty credit exposure when credit quality is correlated with market prices; (3) assessing the ability of a financial system to withstand financial stress; (4) approaches to regulation and corporate governance in financial firms; (5) welfare costs of systemic risk, financial instability, and financial crises; (6) changes in banking behavior during financial crises; (7) long-run versus short-run effects of too-big-to-fail policymaking; (8) international capital mobility and domestic financial system stability; (9) safety first monetary and financial policies for emerging countries; (10) fiscal support in financial sector restructuring; (11) international cooperation for financial system stability; and (12) the role of the Fund in assessing financial sector soundness. In his opening remarks, Stanley Fischer, First Deputy Managing Director of the IMF, described the changing role of the IMF in the financial sector; indicated the growing importance of international standards in this area; and touched on a number of other issues that the Fund and its members were addressing as understanding of the central role of the financial sector developed. Fischer noted that the crises that swept emerging market nations in recent years left no one in any doubt about the importance of a strong and well-regulated financial sector in dealing with capital flows. But in re-examining the proper role of the Fund in the wake of these crises, he thought it fair to ask how the institution should incorporate structural and other policies into its normal activities without moving too far away from its central mission in macroeconomic policy. He underscored the rationale for the Fund's involvement in financial sector issues; namely, that the effectiveness of the economic policies the Fund supports depends enormously on the state of the financial sector. David Stephen and Michael Fischer, of Credit Suisse/First Boston (CSFB), described internal rating processes and models and discussed the issues that CSFB had faced in designing and implementing its internal ratings process. They noted that the most important objective of the internal models was to provide banks with sound basis to determine the level of risk and the creditworthiness of each counterpart. Internal rating models should, in their view, foster consistency, transparency and objectivity in credit ratings. An appropriate risk management system should comprise both quantitative models as well as processes (building data bases, validation and benchmarking, testing, and maintenance, review and audit). Charles Monet, of J. P. Morgan & Co., presented a technical paper on addressing the problem of wrong way credit exposure--handling trades when there is an adverse relationship between exposure size and counterparty default (exposure increasing at "the wrong time"). In line with recent trends in research on the subject, Monet underscored the need to model market and credit risk in an integrated fashion in order to have better estimates of the amounts exposed to counterparties. Exposure estimation, otherwise straightforward for traditional credit products, becomes fairly complex when the exposure is contingent on market factors, as is the case for derivative products, and even more complex when there is a dependency between counterparty credit quality and the relevant market factors. Monet showed how at J. P. Morgan & Co. they were trying to estimate the expected exposure conditional on counterparty default. Christopher Mahoney of Moody's Investor's Service argued that there were four factors that could help identify vulnerability to stress but which were only necessary and not sufficient to cause financial crisis. These factors were: systemic solvency (the proportion of a system's banks that are insolvent); accounting transparency (opaque or bogus accounting); quality of supervision (lax supervision); and funding stability (excessive reliance upon hot or noncore funding). He argued that those four factors were not sufficient to cause banking crisis. Rather two things were sufficient: (1) the injudicious introduction of market discipline (into a weak financial system), and (2) an external payments crisis. The situation is aggravated when the two things coincide. David Llewellyn, professor at Loughborough University, United Kingdom, argued that there were seven major components of a regulatory regime and that the objective of public policy should be an optimal combination of those components to design and implement an appropriate regulatory strategy. The seven components were: (1) rules established by regulatory agencies; (2) monitoring and supervision by official agencies; (3) the incentive structures faced by regulatory agencies, consumers, and banks; (4) market discipline and monitoring; (5) intervention arrangements in the event of compliance failures; (6) corporate governance arrangements in financial firms; and (7) the disciplining and accountability arrangements applied to regulatory agencies. He stressed the complementarity of the seven components. He argued that the optimum mix would change over time as market conditions and compliance culture change. Koichi Hamada, Professor at Yale University in the United States discussed the welfare costs of systemic risk, financial instability, and financial crises. He demonstrated the immense difficulties in trying to be concrete and precise and the dilemma faced by public policy. He illustrated, under some simplifying assumptions, that the welfare loss (especially in terms of output and employment) from a systemic crisis will depend on the probability of the crisis occurring, the duration of the crisis, the recovery rate of defective claims and other damages, and the availability of facilities to dampen the disruption (such as lender of last resort facilities). He pointed out that the welfare cost of a financial crisis would depend on the monetary regime. He proceeded to give a brief and general description of how to look at the welfare costs of financial crises under different monetary regimes and "situations"--seven in all--currently highly topical, including currency board and dollarized systems. His underlying message was that there were opportunity costs of adopting a particular monetary regime. The implication was that in assessing the welfare costs of financial crises countries should try to isolate those costs traceable to the monetary regime they had chosen. Hiroshi Nakaso, of the Bank of Japan (BOJ), outlined some important features of the financial crisis of Japan, which lasted with various degrees of severity for most of the 1990s, the factors behind the crisis, and the conclusions and lessons that he (and some of his colleagues at BOJ) had drawn for early warning signals of banking crises. He also described the evolution of the resolution strategy in Japan, with special emphasis on the role of the central bank and the government. A central argument of his presentation was that, in addition to general economic and market indicators, bank behavior could provide early clues to the development of problems in the financial sector. For instance, the deposit-taking institutions' funding behavior (and circumstances) clearly changes as a crisis deepens. In Japan, the evidence from the crisis tended to support the hypothesis that the institutions would go through four stages in a developing crisis. In Stage 1, market participants and large depositors would impose risk premiums in dealing with troubled institutions. In Stage 2, as information spreads, troubled deposit-taking institutions would face higher rates and shorter maturities. In addition, providers of funds in the market would avoid making long-term deposits in deposit-taking institutions. In Stage 3, providers of funds would begin to refuse further credit to troubled deposit-taking institutions and even small depositors would begin to lose confidence such that core deposits become depleted. The deposit-taking institutions then would begin recovering or selling loans and securities and the market would begin to ask for additional collateral. In stage 4, the troubled institutions would become unable to obtain negotiable large-lot time deposits and the run on deposits would accelerate. The institutions would then turn to the market even more as selling of assets no longer suffice. Once an institution could no longer raise funds (especially overnight) in the market it would face imminent failure. Edward Kane, Professor at Boston College, in the US, reviewed the costs and benefits that fully informed creditors would consider in deciding whether to recapitalize or liquidate an insolvent corporation. The greater the cost of identifying and contracting with an effective set of managers to take over the firm, and the greater the opportunity cost to creditors of re-optimizing their portfolios to accommodate or eliminate their liquidity claim on the restructured enterprise, the greater the chances that closure and liquidation may be the best option for the creditors. But there are also costs to liquidation. In particular, the greater the transaction costs of liquidating the firm's tangible assets and the greater the intangible going-concern value that would be sacrificed in closing the firm the more likely the chance that the recapitalization option is superior. He went on to identify the additional concerns and conflicts of interest that incompletely informed taxpayers face when government regulators with short horizons manage the insolvency of giant banks. In this context, regulatory decisions may exhibit dynamic inconsistency because opportunistic forbearance offers personal and bureaucratic rewards and officials who confront bank insolvency in a timely way are threatened with substantial reputational and career penalties. In that case, the socially optimal takeover point, which should be the one guiding regulators, would be replaced by the "incentive-conflicted takeover point" that incorporates the influence of regulators' private interests. The model also indicated that dynamically inconsistent capital forbearance could emerge because current taxpayers believe they can shift the costs of resolving bank insolvencies to future taxpayers. Akira Ariyoshi surveyed a number of issues related to the subject of international capital mobility and domestic financial system stability. The basic message was that capital mobility had major implications for financial system stability. It has a positive impact on financial market development; among other things, it improves the menu of investment outlets available to suppliers of funds while users of funds have access to cheaper and more sophisticated financing, and it expands the opportunities for portfolio diversification. At the same, capital mobility complicates risk management for individual financial firms, makes macroeconomic management more challenging, and the financial integration it fosters increases the risk of cross-border contagion. Ariyoshi explained that, in order to address the complications, two fundamental policy responses had been found useful. First, the macroeconomic policy framework (most notably monetary and exchange policies) must be appropriately designed and tailored to meet the circumstances. This framework must be supported by appropriate institutional measures and regimes in other areas. Second, a strong prudential framework should be developed to help ensure a sound financial sector and a high standard of risk management. On the question of capital controls to supplement the above two fundamental responses, Ariyoshi argued, first, that country experiences showed that for those countries with substantially liberalized capital transactions, the ability of selective capital controls to provide monetary independence was limited. Second, reimposition of capital controls also appeared ineffective in preventing large-scale outflows that precipitate financial crises, especially when the reversals reflected unsustainable macroeconomic policies. When comprehensively applied, it might be possible for outflow controls to provide a temporary breathing space in which to address weaknesses and to stabilize expectations. But the controls could encourage delays in implementation of needed corrective policies and dampen investor confidence, with potential costs to the economy in future borrowing or by delaying integration into global markets. As regards capital controls to discourage inflows and to reduce the probability of excessive risk-taking, Ariyoshi argued, first, that as far as external borrowing by banks were concerned, effective prudential supervision should be able to contain risks and capital controls may not be necessary. Second, if because of weak supervision or some other reason capital controls were used, experience indicated that controls need to be broad-based and be adjusted continuously to prevent circumvention. Andrew Powell of the Central Bank of Argentina argued that emerging market economies should pursue safety-first strategies in their monetary and financial policies. He examined three important policy areas to illustrate the implications of a safety-first strategy. The three areas were: exchange rate regimes, liquidity policies, and banking sector policies. As regards exchange regimes, he argued that a way out of controversy between the different regimes would be to attempt to define a set of standards for different exchange rate policies. This would involve establishing a set of guidelines to rule out inconsistencies between the exchange rate system and the monetary rule (or other aspects of policy). In this context, he argued that there may be inconsistency between a purely open capital account and purely floating exchange rate for a typical emerging country, and that at the very least countries that wished to take this route should consider very carefully strategies to manage floating rate volatility. Countries that wished to maintain a fixed exchange rate and an open capital account should consider a hard monetary rule such as currency board or even full dollarization or monetary union. He argued that, because emerging countries faced a tighter trade-off between monetary and financial stability, they should consider establishing a systemic liquidity policy whatever the exchange rate regime. For instance, a liquidity policy could entail a rule that foreign reserves cover (1) public sector debt coming due within one year, (2) one hundred percent of base money, and (3) 20 percent of bank deposits. Of course, since liquidity shocks were not perfectly correlated across countries, efficiency could be enhanced by having multilateral agencies (the IMF especially) complement liquidity policies. The IMF, for instance, could play the role of lender of last resort. As regards banking sector policies, he discussed the BASIC system of banking system oversight pursued in Argentina. BASIC itself stands for Bonds (the obligation of banks to issue bonds as specified by regulation, forcing them to the market and subjecting them to ratings and analysis by investors), (external) Auditing, traditional Supervision, Information, and Credit rating. Jeffrey Davis and Timo Valila surveyed the main analytical issues related to fiscal support in financial sector restructuring and illustrated their analysis by discussing the recent experience of Korea and Thailand. They underscored the fact that a restructuring operation similar in magnitude to those in Korea and Thailand had far-reaching implications for fiscal policy. Most notably, the elimination of the debt stock arising from the restructuring operation could necessitate, other things being equal, a significant fiscal adjustment effort for some time to come. For Korea and Thailand, however, the improvement in economic conditions following the resolution of the crises should contribute significantly to a strengthening of the fiscal position thus lessening the need for active fiscal policy measures to generate primary surpluses. They argued that the main role of fiscal policy in financial sector restructuring was to extend financial support in a cost-effective and efficient, transparent, and equitable way so as to minimize the risk of having to deal with moral hazard problems. Fiscal support could be extended using balance sheet and/or income support instruments, the former being preferable on transparency and efficiency grounds. The use of fiscal instruments should preferably be accompanied by operational and structural reforms aimed at addressing underlying problems. Ydahlia Metzgen summarized the various initiatives at the national and international level being pursued to improve the functioning of national and international financial markets, took stock of progress so far, and offered a view of the challenges that lay ahead. Apart from the IMF, international bodies whose work and cooperation were mentioned included: Financial Stability Forum, Bank for International Settlements, International Organization for Securities Commissions, International Association of Insurance Supervisors, International Accounting Standards Committee, International Federation of Accountants, United Nations Commission of International Trade Law, and the World Bank. Important initiatives in which the IMF had been active, mentioned by Metzgen, included: Financial Sector Assessment Program (FSAP); Basel Committee on Banking Supervision; and the Financial Stability Forum and its working groups on offshore financial centers, capital flows, and highly leveraged institutions. Apart from FSAP and related work, IMF was also doing work on standards. In that context, it had produced two codes on transparency (in fiscal and in monetary and financial policies) and the two two-tiered data standards (the Special Data Dissemination Standard and the General Data Dissemination Standard), and was producing, jointly with the World Bank, Reports on Standards and Codes for individual countries. The IMF's multilateral surveillance of international economic and financial market developments had expanded and was playing an important role in focusing the international community's attention on the key financial market issues. The IMF was also devoting increasing attention to regional surveillance and technical assistance. Metzgen noted the resource-intensive nature and the complexity of the above processes and underscored the need for coordination to prevent duplication and waste of resources. Stefan Ingves, Director of the Monetary and Exchange Affairs Department, discussed the Financial Sector Assessment Program: its purpose, process, and the technical nature of its content. He also discussed the Financial System Stability Assessment (FSSA), which is the paper prepared by the Fund Staff for its Board following the IMF-World Bank FSAP mission and report for the country authorities. The FSAP program was designed to identify and assess financial system strengths and vulnerabilities from the perspective of best practice. The FSAP looks at the macroeconomic environment, financial institutions' structure and soundness, and financial market structure and market liquidity. To this end, it reviews and assesses systemic risks in payment systems and the risk management processes and procedures in place. It also examines the legal framework and the system of official oversight and prudential regulations and supervision. In addition, it looks into the institutional (including legal) arrangements in place for crisis management, the financial safety nets, and the mechanisms for financial and corporate intervention as well as workouts. Based on these assessments FSAP missions can formulate action plans for financial system reforms and propose a sequencing of specific measures to be implemented in the short- to medium-run. Missions also seek to identify sector development and technical assistance needs to support needed reforms. Ingves discussed some of the analytical approaches, including stress testing, used by FSAP missions. Linked to FSAP, there is substantial financial sector analytical work underway in the IMF, particularly to develop macroprudential indicators. Ingves noted that, because of resource constraints, it would not be possible to undertake assessments of every member country on an annual basis. Thus would arise the question of whether coverage should be universal or be confined to only a subgroup of countries. If the logic of IMF surveillance and equal treatment favored universal coverage then the relative infrequency of assessments for any given country would pose a challenge as to how to keep the assessments up to date. Apart from the above presentations and the comments and general discussion that ensued after each presentation, there were also three luncheon speeches. Orio Giarini, editor of the Geneva Papers on Risk and Insurance, underlined the importance of the insurance industry in the financial sector--in risk management and risk transfer. He noted that governments had increasingly come to realize that promoting an efficient private insurance system was important in ensuring a sound financial system. Malcolm Knight, Senior Deputy Governor, Bank of Canada, in his luncheon speech, discussed the role of the central bank in fostering financial system stability and the experience of the Bank of Canada in particular. He differentiated four types of policies for creating the appropriate framework for financial system stability, namely, (1) a policy-making authority that develops and implements the framework of laws and regulations governing the operation of the financial system; (2) a supervisory authority; (3) a system (typically a deposit insurance system) that limits risks to retail depositors without creating generalized guarantees; and (4) a central bank to act as monetary authority and lender of last resort to the financial system. In Canada, the Department of Finance was responsible for policy making; the Office of the Supervisor of Financial Institutions was the supervisory authority at the Federal level; the Canadian Deposit Insurance Corporation managed the deposit insurance system; and the Bank of Canada was responsible for monetary policy, the lender-of-last-resort function, and oversight of systemically important clearing and settlement systems. A panel, comprising André Icard of the Bank for International Settlements, Carl Lindgren of the IMF and Manuel Conthe of the World Bank, discussed the subject of the changing role of the IMF and the World Bank in assessing and promoting financial system soundness in a global setting. The panel members agreed that, in light of their universal membership, the two institutions had a comparative advantage in assessing financial systems and promoting financial system stability worldwide. They underscored the need for cooperation between the two international financial institutions and with other international organizations and institutions working in the financial area. In addition, panelists agreed that standards should not be allowed to proliferate unnecessarily and that the costs of implementation should be taken into account when promoting standards. Eduardo Aninat, Deputy Managing Director of the IMF, in his closing remarks at the seminar highlighted some of the main conclusions of the four days of discussions. |