NEW YORK – The global financial system of 2008 “was woefully inadequate” and while progress in reform has been made, work “is far from complete,” Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley said Friday.
Without a “stable financial system,” he said, there can be no sustainable economic growth.
The financial system needs to funnel “savings from investors to borrowers even under adverse circumstances,” Dudley told the Bretton Woods Committee International Council meeting, according to prepared text of his remarks, which was released by the Fed.
The private sector as well as government should be involved in the efforts, with regulators responsible for minimizing costs and reacting to “unforeseen consequences of reform,” he said. It is also important that regulators keep costs “commensurate with the financial stability benefits generated by particular reform measures,” especially to the burden “on smaller, less systemically important institutions.”
The private sector needs to offer “smart solutions to achieve essential financial stability objectives and not simply lobby against change.”
“It is clear that the build-up of debt during the years prior to the crisis, as well as the crisis itself, has contributed to an unusually anemic recovery. This has occurred despite the best efforts of policymakers to stimulate demand through aggressive monetary and fiscal easing,” he said. “The extraordinarily poor economic outcomes we see today underscore the importance of building a financial system that is resilient in its ability to provide credit to households and business throughout the business cycle. It also underscores the importance of limiting the types of financial and real imbalances that develop during times of prosperity. When such balances unwind, they can cause significant damage to the financial system and the economy.”
The costs and difficulty of reform shouldn’t block it. “I think that the fundamental point that the financial system needs to be changed in profound ways should be broadly accepted at this point,” he said.
One problem, he said, is the system is “inherently unstable—that it is prone to booms and busts, and that these episodes can destabilize the real economy. As a consequence, at times, we must be willing to intervene to restrain financial booms in order to temper the busts.”
Dudley suggested, “Reform should be undertaken in ways that better align the economic incentives of participants in the financial system with the goal of financial stability.
“We should strive to achieve a degree of transparency in the financial system that would enable market participants to make informed judgments about their financial market risks and exposures.”
Major banks, non-bank financial intermediaries, and financial market infrastructures need to be “more resilient to adverse shocks and less susceptible to runs,” he said. During times of stress, contagion must be limited.
Innovation is one contributing factor to instability, he pointed to the internet as an example. “Innovations that initially create real value generate feedback mechanisms that often fuel the development of excessive expectations – a boom that eventually reverses when the basic belief system that sustained it is contradicted by events.”
Subprime lending and structured finance products also were cited as innovations that caused “changes in fundamental valuations or the creation of new markets and financial products.” Market participant’s response pushes up business activity, which increases profits, sustaining the boom. “The process often comes to an abrupt end, and generally does so when the basic belief system that underpinned the boom is contradicted by events,” Dudley says.
Innovation is not bad, in fact, it can generate “significant benefits for the macro-economy.”
Reform should strengthen “the quality of information and the system of incentives governing risk-taking by both institutions and individuals. And on those occasions when regulators judge that a systematic understatement and mispricing of risk may be occurring, we need to find better and more effective ways to actively lean against those dynamics. This includes using the bully pulpit to point out why a particular boom is likely to prove unsustainable.”
Also, regulation should set standards “that will be appropriate” during the boom and bust.
Even with reform, it will be difficult to identify booms that are sustainable from those that aren’t, he said. Therefore, regulation needs to create incentives that work over long periods of time, so the boom and bust are included.
“As part of our financial stability effort, we also need to build in short-circuit mechanisms that help to dampen shocks and increase resilience,” he said. “This is reflected in work underway in implementing the Basel III agreements relating to the capital conservation buffer and also on capital planning in our supervisory process. This includes requirements for financial intermediaries to cease paying dividends when economic circumstances deteriorate. It also includes developing a systematic framework so that banks can be required to raise capital to ensure that they have adequate resources to deal with adverse economic scenarios—even if those scenarios have a low probability of being realized.”
One problem with forging a solution is that is needs to be global.
He praised Basel III and Dodd-Frank. “But a major challenge remains in implementing resolution effectively on a cross-border basis. The legal rules and regulatory regimes differ across legal jurisdictions,” he said. “So, when a multinational banking organization becomes insolvent, each subsidiary and affiliate must be resolved in multiple bankruptcy proceedings, with the prospect of inconsistent treatment and larger than necessary losses in aggregate. Although the Financial Stability Board has taken up this issue, the legal impediments to progress here are significant despite the best efforts and intentions of regulators. The difficulty in implementing an efficient cross-border resolution is one of the reasons why the largest globally active firms are being asked to hold additional capital.”
