International cooperation necessary to prevent future financial crisis as capital flows becomes more globalized

The recent financial crisis has exposed critical vulnerabilities in the modern financial system. However, the current reforms proposed by the Financial Stability Bureau and global standard setters, such as the Basel Committee on Banking Supervision, are certainly a step toward building a more resilient global financial system.

Chinese regulators welcome the new capital and liquidity standards approved by the G20 in November (the so-called BASEL III rules), and China's banking regulator, the China Banking Regulatory Commission (CBRC), has already begun the process of revising its own regulations so that BASEL III can be implemented by beginning of 2012.

The recent crisis occurred because the global financial system had become over-leveraged, over-complex, and under-regulated in key areas. These characteristics contributed to the fragility of the system and eventually led to the crisis. To prevent a future crisis, we need a simpler financial system that is less leveraged, and better regulated. That transformation, which the current reforms are leading to, will have costs. Some vested interests will be hurt, and there will be costs and uncertainties in the adjustment process. However, trade-offs are necessary to avoid the disastrous consequences of unmanaged fragility.

I wish to make three points about regulatory reform in the financial sector.

First, the importance of international collaboration and cooperation in financial regulation and supervision. One of the fundamental problems with the modern financial system is the fact that capital flows have become increasingly globalized, while financial regulation prior to the crisis remained largely a domestic concern. Indeed, effective financial regulation today requires intense collaboration amongst national regulators not just in setting standards but also in daily supervision.

We have seen important improvements in this area in recent years. The membership of important international organizations, such as the Basel Committee, has been expanded to include authorities from emerging markets, which are playing an increasingly important role in the global financial system. Supervisory colleges have been formed amongst national regulators in order to effectively supervise global financial institutions. Indeed, the CBRC has hosted a number of college meetings for two of the largest Chinese banks. And important work is under way to establish and harmonize global systemically important financial institutions, the so-called G-SIFIs.

That said, there remain a number of difficulties for international collaboration, including the fact that countries have different legal systems, some are at different stages of development, and many have different financial structures. These differences make it very difficult to have one-size-fits-all rules for all occasions. For example, emerging markets typically have less developed capital markets that may not be suitable for innovative capital instruments. Even developed countries do not have uniform financial structures.

Despite these difficulties, important consensus has emerged from recent discussions amongst regulators in a number of areas. The need for surveillance of systemic risks and the need for macro-prudential tools to reduce cyclicality are now broadly recognized. Regulators around the world are increasingly speaking the same language in terms of prudential standards and best practices in supervision. Regulators also agree that shadow banks, which have grown rapidly in recent years and often serve as a conduit for regulatory arbitrage, should be brought under the purview of financial supervision. And collaboration in rule making and supervision has improved materially, reflecting the consensus that regulators must stand together in a financial system that is increasingly complex and interconnected.

The second point I wish to make regards the continuity of financial reform. The newly proposed regulatory rules have engendered strong debate in the financial community. Debates are essential in policymaking to ensure that policymakers are well-informed of associated risks and trade-offs. However, policymakers should not be swayed from the general direction of financial reform undertaken so far.

However, policymakers must bear in mind that the promulgation of BASEL III rules does not mean the end of financial reforms. There is no magic bullet in financial policymaking, and no single reform will set things right forever. If history is a guide, we know that there will always be new risks to destabilize the financial system in the future, albeit in a different form. Policymakers should therefore always be on their guard, ready to take action. This is particularly important as the painful memory of the global financial crisis begins to fade.

And this brings me to my third point: sufficient attention must be paid to the power, resources and governance of financial regulators and supervisors. After the crisis, many countries have asked financial supervisors to play a greater role in financial governance. The term "macro-prudential supervision" has become the new buzzword within the regulatory community. Supervisors are now responsible for identifying and mitigating systemic risks in their financial systems - a truly enormous task.

If policymakers are serious about this arrangement, then sufficient attention must be devoted to the incentives and resources of regulatory institutions, so that they have the will and ability to take action when necessary. Clear mandates, sufficient powers and resources are essential. Equally important, structures, processes, reward and accountability systems must be established to ensure that regulators have the incentives to take actions that may prove unpopular, and which may be misunderstood at times.

This is especially important, because while the benefit of regulation is often hidden and hard to measure, the costs are immediately apparent. When you take away the punch bowl, everybody at the party will complain about you ruining their fun, very few will offer thanks for the reduced drunken misbehavior that was bound to happen if nothing was done.

The author is director general of the policy research bureau and statistics department, China Banking Regulatory Commission.

(China Daily 02/16/2011 page8)