Modernisation of the Global Fina

Modernisation of the Global Financial Architecture:

Global Financial Stability

Remarks of Mario Draghi

Chairman of the Financial Stability Board

to the

Committee on Economic and Monetary Affairs

European Parliament

17 March 2010

Thank you very much for having invited me to take part in this important debate

between European and national parliaments. International and regional

cooperation and national political leadership are essential complements for

achieving global financial reforms; and the debate in this Committee is really

helpful for that purpose. It is ultimately national and regional legislatures,

accountable to their voters, that must decide and implement reforms.

The strains in the global financial system have eased considerably in the last

twelve months: the banks are once again raising funds, asset write-downs have

diminished. Nevertheless, elements of fragility are still present in various parts of

the financial system and risks, mainly related to the deterioration of traditional

loan books, the bunching of refinancing needs in the next few years, and to new

sources of risk such as sovereign risk. It is essential that we can count, in the

years to come, on a fully restored ability of the banking sector to perform its

essential tasks in the economy.

We have come a long way towards strengthening the financial system since this

crisis began. But we have hard work ahead of us to finish up. In my remarks, I

will focus mainly on these forward challenges. But let me start by taking stock of

where we have gotten to.

Three things have been important in getting us to where we are now:

- First, the recognition that, in a closely integrated system, we all sit in the

same boat;

- Second, the leadership of the G20 process, in which the EU has played an

important role, in agreeing objectives and timelines for substantial reform;

and

- Third, the establishment of mechanisms, such as the FSB, to hasten and

coordinate the policy development needed to meet these objectives.

When I say we have gotten far, I am speaking to an unprecedented amount of

international dialogue and co-operation on important financial system issues, and

the resulting substantive changes that either have or are about to come into

place. While many issues remain to be resolved, in Europe, in the US and

elsewhere, we are, collectively, fundamentally reshaping the framework for

systemic financial oversight:

- First, top-down, system-wide oversight arrangements are being put in

place at the national, regional and international level. These include more

encompassing surveillance, with broadened macro-prudential

perspectives, as well as mechanisms for triggering action on identified

risks. Examples are the European Systemic Risk Board and related

arrangements, the US Financial Services Oversight Council, the IMF-FSB

Early Warning Exercise, and the establishment of the FSB itself.

- Second, as part of this, major jurisdictions and regions are overhauling

their regulatory and supervisory structures to strengthen responsiveness

to systemic risks, improve coordination and close gaps. The FSB is in

many ways the international manifestation of these efforts;

- Third, the regulatory perimeter is being expanded. Major jurisdictions are

finalizing legislation that for the first time establishes formal oversight over

the OTC derivatives markets and its major dealers, hedge funds and credit

rating agencies. In each of these areas, principles for what regulation

should achieve have been internationally agreed;

- Fourth, we have put in place cross-border oversight and crisis

management contingency planning for the largest and most complex

global financial institutions, each of which now have functioning core

supervisory colleges and crisis management groups.

At the level of the essential regulatory policies to buttress financial stability, let

me recall:

- that we are in the process of calibrating a fundamentally revised global

bank capital framework which will establish stronger protection through

improved risk coverage, more and higher quality capital, a counter-cyclical

buffer and a constraint on the build-up of banking sector leverage;

- Second, we have developed and will implement a global liquidity standard

for banks that will promote higher liquidity buffers and constrain the

maturity mismatching that created the condition for this crisis;

- Third, we are making progress in developing a policy framework and tools

to roll back the moral hazard risks posed by institutions that are

systemically important;

- Fourth, we have eliminated the perverse incentives that pervaded

securitization, including the scope for leverage to develop in opaque offbalance

sheet vehicles through changes to accounting standards and

regulatory and prudential rules;

- Fifth, we have developed a series of supervisory tools to raise standards

of governance, risk management and capital conservation at core financial

institutions. In this context, let me note that:

o we are making strong progress towards a forward looking expected

loss provisioning regime for credit losses which will dampen

procyclicality and align accounting and prudential objectives in this

key area; and

o we are making good headway towards establishing compensation

regimes that are better aligned with risks taken in significant

financial institutions.

I have been selective in my enumeration. But the point I want to make is that we

should not underestimate what has been accomplished. Each of the above areas

are difficult in their own right. That we have been able to progress global policy

development and in cases implementation on such a broad front, while fighting a

very serious financial crisis, is something that has never happened before.

So, the direction in which we are moving internationally is encouraging. But as

we hit the homestretch in the above areas, your political leadership will determine

whether we accomplish credible and robust global reforms that deliver the

protections that our citizens rightly demand, yet preserve the enormous

advantages of an internationally integrated financial system. We must not only

reaffirm our commitment to global solutions, but demonstrate our willingness to

reach agreement on the issues that stand in their way. We cannot all have it our

own way.

In the process, we must guard against pressures to water down the stringency of

global reforms. That such pressures originate within a financial industry

concerned to preserve competitive advantages is not a surprise. But such

pressures are also evident in hesitation by some countries about the impact of

reforms on their own financial institutions. This hesitation is stronger where the

starting point is weaker. However, it would be a very serious and unfortunate

mistake to allow these different starting points to result in weaker standards than

we need for the future.

Given the economic and social costs of this crisis, we simply cannot afford substandard

outcomes. And were we to fail, the risks is that countries and regions

will go their own way and that the system will fragment, with very significant

global costs. Hence, we must keep our focus on achieving global standards that

are credible, and as part of this, agree transition and phase-in arrangements that

enable all of us to move there. I will come back to this point.

Let me speak to the key areas where we need to make headway in the months

ahead.

First and foremost, we must complete the revamp of the Basel capital framework

and the liquidity standard, along with the complementary changes, including

provisioning, that address the problems of procyclicality that we have seen in this

crisis. We made a major step forward on this issue in December, when the Basel

Committee released - on schedule – the full package of reform proposals.

Comprehensive impact assessments are now underway to assess the

consequences of the December capital and liquidity proposals on the banking

sector. This is complemented by a top down assessment to calibrate the new

minimum requirements, taking account of, among other things, loss experience

over this crisis, and the impact on banks’ role in the financial system and the

benefits and costs of the new requirements in the steady state.

As I mentioned earlier, it will be critical that we do not let current strained

conditions shape the standards, but instead keep our focus on the rigorous

framework needed to ensure balanced, sustainable banking in the years ahead.

While the banking sector has already made significant progress to raise the level

and quality of its capital and liquidity, immediately implementing in full the more

stringent minimum requirements could have negative effects. We will design

appropriate transition and grandfathering arrangements that rule this out. We

have set in train jointly with the Basel Committee, and with the IMF as a key

partner, a thorough macroeconomic impact assessment to inform these phase-in

and implementation arrangements. Preliminary results on all assessment

streams will be available in June/July. Calibration work will continue into the fall,

and the broad features of the framework, along with the transition arrangements,

will be ready by the G20 Summit in November. Countries will need to pass any

necessary legislation to implement the reform according to the agreed timetable,

and the EU is at the forefront of this.

Second, this year we must agree on measures to credibly reduce the moral

hazard and systemic risk caused by firms that are “too big to fail”. TBTF is first

and foremost a national problem – at worst when institutions are too big to save.

But we are all affected by the moral hazard consequences of the problem going

unresolved. There is no silver bullet or one-size-fits-all solution here. One focus

of our work is therefore to provide supervisors with tools that enable them to take

action in national contexts under existing authority – governance, intensity of

supervision, structural simplification, capital surcharges, etc. Systemically

important financial institutions have to be resilient even in periods of broad

financial system stress events. Capital, liquidity and leverage expectations

should reflect that. But we will never be able to fully eliminate the potential for

failures, therefore a key requirement across all jurisdictions is the establishment

of effective resolution frameworks that allow all types and size of institutions to

fail, and adequate co-ordination of these frameworks across borders. This is a

tall order, as we all know. However, should effective cross-border resolution

prove out of reach, it will strengthen the case for alternative solutions: to place

restrictions on activities/size/structure that make all institutions resolvable, or to

raise capital and other requirements on systemic institutions to a point where the

likelihood and impact of default is reduced to a very low level. This will come at a

cost to intermediation and global financial integration.

Given the diversity of institutions and financial systems involved, a key challenge

will be to avoid inconsistencies in what results. We must achieve consistent

design and implementation of new measures to ensure a level playing field and

to address potential concerns about market fragmentation. Our aim is to reduce

systemic risks globally by having standards for TBTF firms that set a common

floor, and actions across countries that are sufficiently coordinated to avoid

regulatory arbitrage. We will provide an interim report on these issues to the G20

Summit in June, and final recommendations to the November Summit.

Third, we must finalise reforms to regulate, make transparent and centrally clear

a substantial portion of the OTC derivatives markets, and so reduce their scope

to act as channels of contagion. Legislation is advancing in the US and EU to

establish the requisite frameworks for this. Among critical questions to resolve

are:

 which derivatives products can and should be standardised, and ought to be

subject to a mandatory central clearing requirement;

 whether, and if so how to define which type of, commercial end-users should

be exempted from these requirements;

We must be careful to avoid inconsistencies here, because this will drive

regulatory arbitrage in this global market. To accomplish meaningful systemic

risk reduction, we need robust globally agreed standards of soundness for all

central counterparties. And governments should ensure that the determination of

which derivatives should subject be to central clearing is not left to central

counterparties alone. We also need harmonised definitions of standardised

derivatives, and are setting in train work across the US and EU to this effect. It is

also imperative that regulators have the information available to them to police

the market for potential manipulative abuses. This is why there must be

mandatory trade reporting of all OTC derivatives transactions, regardless of

whether they are centrally cleared or bilaterally negotiated.

Fourth, we must firmly embed reforms to compensation practices at financial

institutions. As you know, the FSB set out Principles and Implementation

Standards for Sound Compensation arrangements last year. In December, we

launched a detailed assessment of implementation of these standards. This is a

very important task not just because this is the FSB’s first peer review, but also

because of the importance and political dimension of this topic. We are on

schedule to conclude this review later this month. The review points to a key

message – that a lot has been done by national authorities and that change is

taking place in the major firms. However, differences remain in the approach to

and pace of implementation. Greater progress has been achieved in the areas of

governance, supervisory oversight and disclosure of compensation, while much

more work needs to be done on pay structures and risk-alignment. We will be

setting out additional recommendations in this area later in March.

Concluding remarks

At the outset, I noted that international cooperation and national/regional political

leadership are complementary drivers for achieving global financial reform.

Together, we have come a long way. But 2010 will be a critical year as we press

ahead with global financial reforms. To maintain the momentum, we are critically

dependent on your support. Indeed, internationally coordinated reforms cannot

be agreed nor implemented without the support of national political leaders and

those who are in a position to make final decisions. Your decisions, and those or

your colleagues in other jurisdictions, will determine whether we are able to build

a more robust and consistent global financial order necessary to preserve the

advantages of an integrated financial system.

Beyond the policy development work, full and consistent implementation will take

time and perseverance. As I said, we must keep our eyes on the end objective,

and we will develop transition paths to take us there. As we work to improve

international cooperation and to further financial reforms, I hope we can count on

the political support and leadership of all of you in this room.

Thank you very much.