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Reshaping the international financial system

Non Paper by the Netherlands

Introduction

Financial stability is a global public good. The financial crisis has
exposed a number of fundamental weaknesses in our international
financial system. Reform is needed. We suggest the following steps.

1.  Gearing the objectives and incentives of financial institutions
towards stability 

The financial sector is not an ordinary sector. It is the backbone of
our economic system. Information failures are pervasive and the risks of
financial strategies are difficult to assess from the outside, and
sometimes even from the inside. Due to the sheer size of the capital
flows, a loss of confidence can cause serious damage to the real economy
almost instantly. Public oversight and public resources cannot be a
substitute for an effective functioning of the market. It is therefore
essential that the incentives and transparency within the financial
sector are improved. To this end we propose an international agreement
on legislative reform covering amongst other things the following
elements:

First, the governance structure of large financial institutions should
be adjusted to reflect the broader economic relevance of these
institutions and to ensure that public interests are adequately
safeguarded. For example, countervailing powers within the financial
institutions against excessive risk taking, such as risk management and
non-executive boards, should be enhanced. Supervisors could monitor
this.

Second, perverse elements (incentive structure, pay for failure) in the
remuneration policy of financial institutions (in the Board as well as
in strategic positions) should be eliminated. Salary structures and
bonuses should be geared towards long term stability and continuity of
the company and should not interfere with the institution’s duty of
care towards its customers. These elements should be made subject to
scrutiny by the prudential supervisor. If this proves to be
insufficient, governments should consider possibilities for corrective
actions. 

Third, credit rating agencies must take measures to ensure that their
rating activities are truly independent and not driven by commercial
considerations. The scope of their activities should be well defined and
there should be more transparency and effective oversight.

Fourth, originators of structured products should bear financial
consequences for their role in credit provision in order to ensure a
proper risk evaluation. Assets transferred to special investment
vehicles that still fall within the realm of the originator should be
included in its risk management framework.

Fifth, financial institutions need to provide real-time complete data to
supervisors about their exposure and financial positions, with special
attention to risk and liquidity management (including excessive
leverage). Supervisors should also pay attention to market abuse. In
addition, we need to take the final steps towards common internationally
accepted valuation standards and their uniform application in practice.

2. Strengthening cross-border supervision and crisis management capacity
in the EU

Financial conglomerates have outgrown their national borders and the
integration of financial markets has progressed at an incredible speed.
Supervisory structures in Europe need to catch up with these economic
realities, particularly with regard to financial infrastructure.
Progress is needed towards a more integrated European approach to
financial sector supervision and crisis management, building on the
recommendations of the FSF, the Ecofin road map and the recent European
experience with crisis management.  

First, member states should treat their arrangements for financial
supervision (both prudential and conduct of business) and crisis
resolution as a matter of common concern. Such arrangements should be
subject to peer review (in a manner comparable to budgetary policies)
and be part of the IMF’s surveillance activities. This would allow
detection of shortcomings in financial supervision at an early stage.
The results of these consultations should be published.

Second, as the lines between the insurance and banking sectors are
becoming more blurred due to growing integration and increasingly
complex structures, supervision in Europe should converge towards an
approach along functional lines (prudential versus conduct) rather than
sectoral lines (banking versus insurance), thereby further stimulating
cross-border cooperation.

Third, colleges of supervisors should be in place for all cross-border
groups (banks, insurance companies, investment firms) and include
legally binding agreements on information sharing and cooperation. In
its decisions, the lead supervisor should take careful consideration of
the interests and input of all other supervisors involved. The
Memorandum of Understanding of June 2008 on cooperation between the
financial supervisory authorities, central banks and finance ministries
needs to be implemented vigorously. In addition, there should be an
institutionalized procedure for arbitration or appeal, preferably with
the help of an independent body which can take into account global
macro-economic and spillover effects. 

Fourth, in the area of prudential supervision, close cooperation with
the competent central banks is an increasing necessity. In their
policies, national supervisors should be mindful of possible negative
spillovers to other member states. To this end and as agreed in the
Ecofin roadmap, the mandates of national supervisors should be broadened
to include a European dimension. To stimulate further progress, an EU
directive could be instrumental.

Fifth, the role of the existing level 3 committees in the institutional
framework should be strengthened. They should be given the authority to
issue binding guidelines and be endowed with instruments to ensure
consistency and a level playing field in international supervisory
practices (including colleges of supervisors with a lead supervisor).
The increased cooperation between the Committee of European Banking
Supervisors and the Banking Supervision Committee is a step in the right
direction. 

Sixth, Europe’s capacity for crisis management should be strengthened,
building on recent experience. Public action should have a catalytic
role in promoting a proper functioning of the market. Crisis management
tools should include flexible arrangements for sharing information,
building on a framework of conditions for public interventions. In times
of stress, a single decision-making responsibility is needed on issues
which are relevant for all EU countries. To this end, the Presidency or
an independent institution (to be determined) could have a leading role
in coordinating public action. If possible, countries should not engage
in individual action without having consulted their European partners.

Seventh, in order to secure effective crisis management and minimize
disturbances to the international financial sector, adequate bankruptcy
legislation needs to be in place to ensure a proper winding down of
insolvent financial institutions.

Eighth, in the longer term we should consider progressing towards a
European system of prudential supervision with a strong central body. 

3. Strengthening the global institutions

Financial markets have become truly global. Financial instability in one
part of the world may rapidly spread to other parts. Whereas financial
crises are of all times. the principal sources of instability seem to
have changed. Traditionally, the focus has been on the negative impacts
of expansionary fiscal and monetary policies. More recently, financial
sector instability has emerged as an additional important source of
macro-economic disturbances. The IMF should adapt to these changing
realities.

First, the IMF should be transformed into the prime organization
responsible for world financial stability. To this end, its mandate
should be broadened to include financial sector stability as an
additional area of responsibility. Its Articles of Agreement should be
amended to reflect its role in capital account crises.

Second, the IMF should assess the stability impact of the work of the
Financial Stability Forum, Bank for International Settlements, Basel
Committee, the International Organization of Securities Commissions and
the International Accounting Standards Board. It should also have the
authority to issue recommendations to countries and relevant fora. The
FSF membership should be enlarged with representatives of systemically
important emerging market economies. The work of the FSF and IASB should
formally be brought under the IMF umbrella.   

Third, the IMF needs to engage in regular discussions with existing
consultation groups within the financial sector, such as the Institute
for International Finance and the Counterparty Risk Management Policy
Group, to discuss policy requirements and stimulate best practices
within the sector. 

Fourth, the IMF should strengthen its financial sector surveillance. In
concrete terms, the Financial Sector Assessment Programs (FSAPs) should
be made obligatory. Assessments of the financial sector should be
integrated in the Article IV consultations, including an assessment of
the implementation of FSF recommendations, an examination of prudential
supervision and the institutional set-up compared to a set of
internationally accepted standards. Obligatory publication of Article IV
consultations will enhance the leverage of the IMF. 

Fifth, the IMF should provide a platform for its members to discuss the
impact of national spill-overs, global standards, and regulations,
incentive systems and supervision standards on global financial
stability. The IMF should assess the impact of regulation and formulate
recommendations at each of these levels. In addition, the IMF Global
Financial Stability Report should present an analysis of the interplay
between national, regional and global financial stability. 

Sixth, the IMF should be able to act at an earlier stage and in response
to a larger spectrum of problems. To prevent financial and macroeconomic
crises from taking place, the IMF should enhance its efforts to support
governments that are adapting their macroeconomic, financial and
exchange rate policies at an earlier, pre-crisis, stage. In addition to
the traditional technical advisory services, the IMF should have
financing available to accompany the policy changes. In this respect,
the IMF should provide assurances – e.g. through a financial stability
line – to countries that have adequate policies, but run the risk of
contagion or rapidly changing market sentiments. 

4. Next steps 

This year, international summit(s) should lead to an agreement on
principles and core issues in the following areas:

Strengthening the responsibility and functioning of the financial sector
to promote long-term stability.  

Strengthening financial oversight of cross-border groups. 

Anchoring global financial sector stability through institutional
reform, with special attention for the role of the IMF and its
relationship with other international fora.

These principles should then be translated into concrete proposals by
the IMF and other relevant fora. During this process, the EU should
maintain its pro-active role and safeguard cooperation with all member
states by means of a separate EU summit. Close cooperation with the
“De Larosière Group” on financial sector reform should also be
maintained. 

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