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Speech by World Bank MD and COO Sri Mulyani Indrawati on Policy Challenges for the Financial Sector: Global Financial Sector Reform, Five Years On

World Bank Managing Director and Chief Operating Officer Sri Mulyani Indrawati

14th Annual International Conference on Policy Challenges for the Financial Sector

Washington, DC, United States

June 6, 2014

As Prepared for Delivery

"Are we treating the symptoms or curing the disease?"

Thank you very much. It’s a great pleasure to be with you here today.

I’d like to thank the IMF, the US Federal Reserve, and my colleagues at the World Bank for organizing this important event.

This conference is debating issues that remain vital, seven years after we suffered the first impact of the global financial crisis and five years after we slowly started to emerge from it.

As you all well know, the G-20 responded to the financial crisis with a broad set of reform proposals. These include measures to strengthen capital and liquidity; policies to deal with the “Too-Big-To-Fail” problem; reforms for Over-the-Counter derivatives; and the expansion and redefinition of the regulatory perimeter.

But the lingering question is: Is the drive for global financial reform addressing the disease? Or have we been dealing merely with the symptoms of systemic financial weakness?

We must ask these questions while we shape the reform agenda - to be better equipped for future financial crises.

So let’s remember what the actual disease was:

By now, we know the many fault lines that the last crisis exposed. Let me mention several of them:

To start with, there was an inadequate quantity and quality of capital held by financial institutions. Leverage was high and the system quickly became illiquid. This made financial institutions vulnerable to losses as well as to shocks in interbank and other wholesale funding markets.

On the other side, regulators and supervisors lacked the capacity and the resources to assess the complex internal models of the very same companies they were supposed to oversee.

The “Too-Big-To-Fail” problem not only exposed our inability to unwind large and complex banks and insurance companies. It created a moral hazard that still haunts us today.

And serious deficiencies in corporate governance standards and practices became evident when excessive risk-taking not only became the norm, but was rewarded and envied for its short-term successes.       

So if we know what’s wrong, why is the cure so complicated?

Instability is part of our dynamic globalized economy. We know that banking and capital market crises tend to recur periodically – and we know that they disregard borders, despite policymakers’ best efforts to anticipate, prevent and contain them.

So we’d better have safeguards in place to dampen the severity and contain the fallout. National and international regulations should address systemic weaknesses, to be better prepared for the next crisis.

But as you know, this is easier said than done. While true, this line of thinking ignores the political and economic realities that create policy dilemmas and roadblocks when trying to do what is right.

Let’s not forget the realities of the policymaker, who has to juggle competing demands in the midst of a crisis – and after.

As the finance minister of Indonesia, I experienced the perfect storm. 10,000 miles from the epicenter of the crisis in the US, my currency was devaluating and our banking system became vulnerable. Combine this with conflicting domestic political priorities, and you are left with limited options and tough trade-offs between taking short-term measures and fixing long-term problems.

Keeping these realities in mind, I would like to highlight three critical points.

First, we should review today’s policy environment and how it imposes additional constraints on the implementation of global financial reforms.

Second, we should consider the unintended consequences for emerging markets and developing economies.

Third and finally,  I’ll like to highlight the role that the World Bank and others can play in helping developing countries to be better prepared.

The post-crisis economic environment is looking good.

After a bumpy start, the US, Europe and Japan are growing simultaneously for the first time in more than 5 years.

But they are not growing at the same pace.

While US growth looks reasonably strong, the global economic momentum is slow and overshadowed by uncertainties in parts of Europe. China’s slowdown poses additional challenges to emerging markets, particularly commodity exporters.

Several economies remain vulnerable to a sudden change in global financial conditions. Countries with large current account deficits, high levels of short-term debt, or significant foreign currency exposures could be at risk. Particularly if financial markets freeze up or if uncertainty builds up over the timing and magnitude of changes in high-income countries’ monetary policy.

Adding to this are the political, ideological, and philosophical differences amongst all of us about the scope, implementation, and impact of financial reforms.

There are some lingering questions and uncertainties. And the answers really depend on who you ask:

What activities and aspects of the financial sector should be regulated and how much regulation is desirable?

This is a divisive question. As you know, some have argued that the proposed regulations are too light; others say they are excessive and could hamper innovation and fragile growth.

My friend and colleague Christine Lagarde feels that bank reforms lack in depth and speed because of too many competing interests.

Will all financial institutions be treated equally or will the large ones continue to enjoy political protection?

This “Too-Big-To-Fail” policy dilemma remains a problem. As a policy maker you want to regulate these institutions, but your options are limited not only in terms of scope, but also in terms of political and economic realities.

 Will the implementation of regulatory reform put my economy at a comparative disadvantage?

Win-win outcomes can only be achieved through coordinated implementation. But what if there are short-term gains for my economy for not playing ball. And why move first and farther than the others?

These challenges and uncertainties diminish the appetite for deep change, regardless of how fresh the memory of the crisis still is. We all know that regulation is so much easier when growth is strong.

It is good news that leaders are now confident that a framework for bank regulation is within reach. In fact, most expect the Financial Stability Board of the G-20 to conclude this framework at their meeting in November.

There will surely be tradeoffs in the short term – for example, between financial sector development and financial stability. But I am confident that building a more resilient financial system today is critical for financial intermediation and economic growth tomorrow.

International regulatory response to the global financial crisis

Nevertheless, we need to pay attention to the impact of international reform measures for emerging and developing countries, and we need to be alert about potential unintended consequences.

Higher capital requirements for banks may lead to limited availability of cross-border funding, as large foreign banks are required to hold more capital.  

Additional capital charges on systemically important institutions may lead to changes in bank business models that could increase the cost of capital.

The new liquidity requirements - for instance, the net stable funding ratio - could lead to limited availability of long-term financing by forcing banks to match the maturities of assets and liabilities. This is likely to have a significant impact on infrastructure financing. Should this happen, the World Bank and other providers of long-term finance could play a greater role.

As we all know, implementation has just started. It will take some time to fully understand the actual impact of the reforms. Meanwhile, I welcome the ongoing efforts by the Financial Stability Board in collaboration with the IMF and the World Bank to monitor the impact of the reforms on our client countries.

The way forward

Implementing the financial reform agenda is clearly the central challenge ahead of us, as we seek to ease the impact of any future financial crisis.

The following priorities are among the most critical elements of implementation as we move forward:

Consistent progress across countries and jurisdictions remains relevant, for instance by making risk weights – which are used to calculate capital - credible and comparable.

We will also need to help developing economies align their supervisory and regulatory reforms to new standards.

This is an area, where I feel confident the World Bank is playing and will continue to play an especially active and constructive role. Last February, for example, we began working with Turkish authorities to help them strengthen their resolution frameworks by aligning current practices with recently agreed international standards. We are also supporting Central Asian countries in their efforts to align their regulatory standards with Basel principles.

Moreover, we will need to enhance policy coordination through such steps as data sharing and vigilant monitoring. This way we hope to mitigate any unintended consequences on emerging markets.

So let me get back to my opening question.

Are we treating symptoms or the root causes of the next possible crisis?

As you may guess from the points I made: It depends.

In my view, we have made clear progress. For example, banks with more capital and liquidity should now be more resilient to shocks. And more effective resolution frameworks for large financial, which apparently are on the table of the G-20 regulators, should help dampen and not amplify the effect of their failure on the financial system.

But I also believe that more needs to be done. We need to ensure that once implemented, the reforms change the incentives and the underlying bank business models that were at the core of the crisis. We also need to ensure coordination between home and host jurisdictions for effective resolution of large financial institutions.  

By taking forthright action – and by promoting a spirit of caution and candor among all market participants – we can soften the impact and mitigate the effects of any future financial crisis that awaits us.

Occasional shocks to the system may be inevitable in a globalized financial system. But by promoting robust and resilient markets – overseen by strong and steady regulation – we can responsibly ease the eventual impact of any future economic blow.

Today’s panel will discuss in detail some of the topics that I’ve touched upon in these remarks.

With that, I will end here and open the floor for questions and comments.

Thank you very much.