A strategy for sustainable reform

A strong capital base is the single most important reform needed to focus bank owners and management on the need for a prudent balance between risk and the search for return. Capital rules will only be effective in controlling excess risk-taking if they are combined with reforms to the structure of financial conglomerates and their corporate governance. It is more important to get these things right rather than focusing on symptoms such as remuneration.

This is the conclusion of a report by Adrian Blundell-Wignall, deputy director of Finance and Enterprise Affairs of the Organisation for Economic Co-operation and Development.
The report looks at how and when governments can safely wind down their emergency measures and how financial markets should be reformed.

On Basel II, he says, some redesign is needed because it works to bias capital requirements down in the benign part of the cycle and conversely in the downswing. Ideally, capital requirements should encourage the opposite: a build-up of capital in good times to provide a large buffer in bad times.
Capital requirements should relate to the overall portfolio, rather than to any specific assets. Therefore, management decisions about allocating capital to risky activities would take account of the full market cost of capital, and the potential risks and rewards of investing in the asset, but would not be influenced by regulatory rules specific to that asset.

Backdrop

The crisis that struck in 2008 forced governments to take
unprecedented action to shore up financial systems. As economic recovery takes hold, governments will want to withdraw from these extraordinary measures to support financial markets and institutions.

This will be a complex task. Correct timing is crucial. Stepping back too soon could risk undoing gains in financial stabilisation and economic recovery. It is also important to have structural reforms in place so that markets and institutions operate in a renewed environment with better incentives.

From the start, OECD has said: "Exit? Yes. But exit to what?" It is obvious that financial markets cannot return to business as usual. But the incentives and failures that led nstitutions to this perilous situation were many: remuneration structures, risk management, corporate board performance, changes in capital requirements, among others; and they interacted in unexpected ways with tax rules and even the structure of institutions themselves. Sorting through all these issues will take time, but some are urgent. There can be no question that the effort is necessary. Financial markets cannot again be allowed to expose the global economy to damage as has been suffered over the past year.

Two questions, then, are at the core of this report: How and when can governments safely wind down their emergency measures? And how can we sensibly reform financial markets? The purpose is to draw together and demonstrate the nterconnections among a wide range of issues, and in so doing contribute to global efforts to address these challenges.  

Summary of Main Themes

Reform principles

It is necessary to address many issues in order to restore
public confidence in financial markets and put in place incentives to encourage a prudent balance between risk and the search for return in banking. While there is considerable scope for flexibility at specific levels, a few strategic priorities for policy reform stand out:  

• Streamline the regulatory framework, emphasise prudential and business conduct rules, and strengthen incentives for the enforcement thereof.
• Stress integrity and transparency of markets; priorities should include disclosure and protection against fraud.
• Reform capital regulations to ensure much more capital at risk (and less leverage) in the system than has been customary. Regulations should have a countercyclical bias
and encourage better liquidity management in financial institutions.
• Avoid impediments to international investment flows; this will be instrumental in attracting sufficient amounts of new capital.  
• Strengthen governance of financial institutions and ensure accountability to owners and creditors with capital at risk. Non-Operating Holding Company (NOHC) structures should be encouraged for complex financial firms.  
• Once the crisis has passed, allow people with capital at risk, including large creditors, to lose money when they make mistakes. This will help to reduce moral hazard issues arising from the exceptional emergency measures taken and guarantees provided.
• Strengthen understanding of how tax policies affect the soundness of financial markets.
• Respond to the increased complexity of financial products and the transfer of risk (including longevity risk) to households with improved education and consumer
protection programmes.

Exit strategy principles

Reforms along these lines should be put in place as quickly as
feasible. Stabilising the economic and financial situation will take time. But once this happens, governments will need to begin the process of exiting from the unusual support measures that have accumulated in the course of containing the crisis.

As the situation will be fragile, recovery should not be jeopardised by a precipitous withdrawal of the various support measures. Getting the exit process right will be more important than doing it quickly.

While there is great scope for pragmatism, clear principles guiding the process should be established early on. These should be:

• The timeline for exit (including a full sell-down in government voting shares) will be conditional in part on progress with regulatory and other reforms consistent with the above principles.
• Level competitive playing fields will eventually be re- established and support will be withdrawn.
• Viable firms will be restored to health and expected to operate on a commercial basis in the marketplace.
• Support will not be withdrawn precipitously, but will be priced on an increasingly realistic basis.
• If beneficiaries do not find ways to wean themselves off support, then such pricing will increasingly contain a penalty element.
• As adequate pools of equity capital become available, state- owned or controlled financial firms will be privatised andexpected to operate without recourse to any implicit guarantees that state-ownership usually implies.  
• The bad assets and associated collateral that remain in governments’ hands should be managed with a view toward recovering as much for the taxpayer as is feasible over the
medium term.
• Reinforce public confidence in, and the financial soundness of, private pension systems and promote hybrid arrangements to reduce risk.

(A full copy of the 99-page document can be downloaded from http://www.oecd.org/dataoecd/55/47/43091457.pdf)

Note:
The OECD is a unique forum where the governments of 30 democracies work together to address the economic, social and environmental challenges of globalisation. The OECD is also at the forefront of efforts to understand and to help governments respond to new developments and concerns, such as corporate governance, the information economy and the challenges of an
ageing population. The organisation provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies.
The OECD member countries are: Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Commission of the European Communities takes part in the work of the OECD.
South Africa is not a member of the OECD, but is one of five countries offered 'enhanced engagement' with it. The others are Brazil, China, India and Indonesia.