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Completing the Task: Financial Sector Reform for Stability and Growth

Address to the Annual Leaders’ Dialogue Hosted by Süddeutsche Zeitung and Atlantic Council

By Christine Lagarde, Managing Director of the International Monetary Fund

New York, Friday June 8, 2012

Good evening. It is a great pleasure to be here. I would like to thank our hosts for the evening, Süddeutsche Zeitung, the Atlantic Council and Roland Berger Consultancy. I would also like to extend my special thanks to Wolfgang Krach and Martin Wittig for their generous opening remarks, and to Fred Kempe, our moderator for this evening.

We had hoped to have this occasion earlier in the year, as Wolfgang indicated in referring to the previously advertised title for tonight’s speech. Yet our hosts graciously made alternative arrangements for us to be here this evening. For that, I am also extremely grateful.

It is, perhaps, fortuitous timing. Today, the spirit behind the Leaders’ Dialogue—the need for Trans-Atlantic and broader policy discussion and cooperation—is more critical than ever.

Five or so years into the crisis, our end goal to restore stability and growth, and our policy resolve are being tested again. Yet, the more we are tested, the more clarity we have around what remains to be done. In the words of Martin Luther King Jr., “Only in the darkness can you see the stars.”

From where we each sit, we may each view a different constellation of stars. But, no matter what your vantage point, the financial sector constellation should be there to brighten the sky. So, to lift the dark of the crisis, we need to fix financial intermediation. To pave the way for a brighter future, we need a financial sector that helps the real economy.

So, tonight, I want to talk about three things:

  • First, where we stand with the global economy;
  • Second, the need to break the damaging cycles that keep holding us back; and
  • Third, the central role of the financial sector in restoring stability and securing growth.

I. Global Economic Developments

Let me begin with a short overview of global economic developments. Unfortunately, the news is not so good. The global economy is still struggling to regain its footing in very difficult circumstances. Bold policy actions, including by the ECB and key partners in Europe, provided some respite earlier in the year, helping to avoid a deeper banking crisis.

That progress is now being severely tested. The gains we have made are very fragile and dependent on continued policy action. More worryingly, there are signs that we are losing ground again, reminiscent of the stresses we saw late last year.

Recent events underline this point. The uncertainty and tense mood ahead of the Greek election. Spain and other countries in Europe are coming under renewed market pressure. And, here in the United States, the latest growth estimates and jobs numbers were disappointing.

There is no mistaking that global risks are on the rise again.

The euro area crisis continues to be the most immediate and most pressing threat, and there is the risk that conditions could get worse.

Here, in the United States, the “fiscal cliff” looms dangerously near, with expiring tax cuts and automatic spending reductions set to begin next year under current law. Slamming on the fiscal brakes too hard would jeopardize the recovery.

At the same time, lack of progress toward credible and ambitious medium-term plans to gradually bring down the ratio between public debt and GDP in the United States and Japan could erode confidence.

Beyond these concerns, I would mention two other growing dangers: oil prices could spike up; and past credit booms in some emerging markets threaten to burst.

These risks are even more troubling when I look around the globe and see the mounting social strains—from high unemployment, rising inequality, and the perceived unfairness in the distribution of adjustment.

Why are strains on the rise again? The lack of clarity and confidence in both the direction and effectiveness of policies is a major factor. Yes, the responses to date have been bold, but they have been usually reactive, rarely proactive; more partial than complete.

We know from history that, at times of deep uncertainty, policymakers need to lead markets with their actions, rather than allowing market fears to lead policies. We must act upon this lesson now.

II. Breaking the cycles of the crisis

This brings me to my second point—the need to break the dangerous cycles that are keeping us stuck in crisis mode.

One is an economic cycle. The feedback loop between weak sovereigns, weak banks and weak growth that continually undermine each other.

Tonight, I also have another cycle on my mind: the political economy. It is a cycle that has become too familiar since the start of the crisis, like a movie we have watched one too many times.

It looks something like this. Tensions escalate and, out of necessity, policymakers take action. But, just enough for the danger to subside. Then the urgency is lost, momentum wanes, and the policy discourse begins to fracture, too focused on their own backyards and not enough on the big picture. And so tensions start to rise again.

But, with the passing of each cycle, we reach a higher and higher level of uncertainty, and the stakes rise. At this point, stability is a stake. Growth is at stake. In the case of Europe, the cycles are now threatening the very existence of the European project.

We must break both of these cycles if we are to break the back of this crisis. And one cannot happen without the other.

To achieve this, the policy debate needs to move beyond the false dichotomies of growth versus austerity, stability versus opportunity, national versus international interests.

We need to agree on a comprehensive strategy that is good for stability and good for growth. We need coordinated action to support that strategy. And we need it now.

Let me outline the main pillars of such a strategy.

First, macroeconomic policies should help support the recovery and also tackle the underlying causes of the crisis.

  • Monetary policy should continue to be very supportive. Central banks, in particular the ECB, should further loosen monetary conditions, and remain ready to use unconventional tools to ease tensions and provide funding to address liquidity constraints.
  • Public debt remains too high and countries need credible and ambitious roadmaps to bring it down over the medium term. For the most part, that adjustment should be gradual and steady, unless countries are forced by markets to move more aggressively—which is, of course, the case for several countries in the Eurozone. If growth becomes weaker than expected, countries should stick to announced fiscal measures, rather than announced fiscal targets—as economists say, they should let the automatic stabilizers to operate.

Second, more effective crisis management. This is very urgent and mainly an issue for the euro area. But, a broader element is the collective effort to reinforce the global financial safety net. In this context, I welcome the increase in the IMF’s resources by $430 billion.

Third, we need more determined progress on structural reforms. For example, labor market and product market reforms that can carry the torch of growth beyond the immediate support from macroeconomic policies.

In many respects, the financial sector is at the heart of these latter two issues. The global crisis may have moved beyond a purely financial phenomenon, but our next steps in the financial sector will be critical to breaking the damaging cycles of the crisis.

III. Shaping the financial system to support stability and growth

So, shaping the financial sector to build a better foundation for stability and growth is my third issue. Let me elaborate on that now.

We all knew a thriving financial sector was behind the pre-crisis boom. But we may not all have recognized how important it was to the boom and the causes of the bust. Now, we are more acutely aware—painfully aware of how the financial system can be a source of instability that works against, rather than for, the real economy.

In large part, this reflects the system’s growing size, its complexity and—perhaps above all—the degree of interconnections, all of which act to magnify any missteps.

The IMF’s analysis of a dozen or so crisis cases reveals that the assets of the top five financial institutions in each country exceeded 300 percent of GDP before the crisis. This is a striking number by any measure—and it has continued to grow.

Remember: what is our ultimate goal for the financial system? It is to build a system that serves growth, but is not wild. A system that brings borrowers and lenders together safely, not recklessly. A system where there is profitability—certainly—but that does not come at the expense of stability.

Five years into the crisis, where are we in terms of our goal? Unfortunately, I have to be blunt. We are still a great distance from our final destination. And, with the stakes rising by the day, we stand at a crossroads. Policymakers need to lay out and follow a clear roadmap of how to finish the job—not just looking to the next five or ten years, but looking to the next weeks and months ahead.

Two important dimensions are essential and urgent: (a) strengthening our crisis management tools; and (b) strengthening the overall architecture of the system.

A. Stronger crisis management tools

The immediate focus should be on repairing the health of financial system. Without repair, weak banks will continue to strangle growth.

European banks are at the epicenter of our current worries and naturally should be the priority for repair. But, this does not mean we should overlook the broader implications of today’s interconnected world.

Banks in the United States may be in better shape at this stage of the crisis and their ties to European banks less pronounced than before the crisis, but those ties still exist. The same can be said of banks in Asia, in Latin America. So, the message I have been repeating over the past number of months is this: we all have a stake in restoring the health of European banks.

Let me be clear: the heart of European bank repair lies in Europe. That means more Europe, not less. Less Europe will be bad for the continent and bad for the world. So, policymakers in Europe need to take further action now to put the monetary union on a sounder footing.

Amidst all this uncertainty you might ask why doubling down on Europe is a good bet.

The main answer is that a single European financial market cannot rely on legal and institutional frameworks that operate on a national basis. To break the vicious cycle of financial-sovereign risks, there simply must be more risk-sharing across borders in the banking system.

What does that mean? In the near term, this should include a pan-euro area facility that has the capacity to take direct stakes in banks. Looking a little further ahead, monetary union needs to be supported by building a true financial union that includes unified supervision; a single bank resolution authority with a common backstop; and a single deposit insurance fund.

Moves toward deeper fiscal integration should go hand-in-hand with these efforts. In particular, the area needs to take the further step of some form of fiscal risk-sharing. Options here include some form of common bonds or a debt redemption fund. This would allow for common support before economic dislocation in one country develops into a costly crisis for the entire euro area.

And, on the upside, breaking the shackles of the sovereign-financial nexus will allow financial institutions to deliver credit and, in turn, create growth and jobs.

B. Better financial system architecture

This brings me to the second half of the financial sector roadmap. How do we create a better financial system architecture?

Like so much in life, we must strike a balance. Certainly, we need regulatory guardrails that will stop the financial system from driving off cliffs. But, at the same time, the road needs to be wide enough for innovation and for markets to drive the economy forward. Although it may not be such a bad thing if the road were a little less crowded with luxury sports cars!

I know this is not a happy topic for many in the industry. Some have voiced concerns about the cost of regulatory change and how this might impinge growth at a time when we can least afford it.

Again, it is a question of balance. Smart regulation need not be punitive. Some estimates have suggested regulatory reforms could cut growth by as much as 3 percent. Official estimates imply something much smaller.

The IMF is also looking at this issue. Our preliminary results point to a relatively small impact on growth, especially when compared to the painful and lingering damage of the crisis—and especially when compared with the potential damage of another crisis. You might argue about the numbers, but what we can say with certainty is that the benefits of stability outweigh the costs of crisis.

So, if we ask ourselves the big question: is the system substantially safer today than it was pre-Lehman? My answer is, no, not yet.

Here, the words of Mark Twain are quite fitting: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

There are still many questions surrounding JP Morgan’s trading loss. Yet, they should be seen as a warning shot over the bow. It is a reminder that what we think “just ain’t so.” It dispels the notion that the system has become less complicated. It dispels the notion that the system is substantially safer. It reveals the complexities and lack of transparency that remain. It reveals that too much risk remains.

Take the derivatives market. In 2011, the total amount of outstanding OTC derivatives was $648 trillion, not much short of its pre-crisis peak of $673 trillion. Again, this is a striking number.

In short, the agenda facing the financial system is not a case of mission accomplished. It is a case of mission yet to be accomplished.

So, what must be done? Three imperatives: regulation; supervision; and incentives.

Better regulation

On regulation, to be fair, we have made good progress on rules for banks.

The Basel III agreement to strengthen both the quality and quantity of capital, the implementation of which is now at our doorstep, is a major achievement. The internationally agreed liquidity requirements, with their emphasis on more liquidity and less maturity mismatch, are also a move in the right direction.

I am also following with interest plans for so-called ‘living wills’ for large financial institutions in the spirit of the Dodd-Frank Act. This could be an important backstop to the potential costs and ripple effects of “too important to fail” institutions.

Now, we must implement what has been agreed—and make more progress on what has not. With tighter regulation of banks, activity is migrating into the more murky corners of the financial sector. So we need to monitor, and potentially regulate, a larger perimeter that encompasses shadow banking.

We also need to shine a light on the derivatives market, by moving transactions to central clearing houses. Collecting better information about who owes whom and how much will help regulators do their job better. This is exactly the information that was lacking after Lehman failed.

The risk, of course, is that too many central clearing houses are being set up, fragmenting and diluting the value of the information they collect. Hence, we must do this on a global basis and in a coordinated way, building a few bulletproof clearing houses to help lower the overall risk in these markets.

Stronger supervision

Better regulation can only ever be part of the solution. You can have the best rules in the world, but if they are not properly implemented, they are not worth much. A safer financial system requires the capacity and the willingness to enforce those rules.

When you think about it, the role of the financial supervisor is pretty unique. The supervisor acts as a midwife, parent, mentor, cop, judge, and undertaker—all rolled into one! These are hefty responsibilities.

To do their job effectively, supervisors need proper legal authority and adequate resources. Frankly, we need capable and qualified people who can go toe-to-toe with the armies of lobbyists! Supervisors need a clear mandate and operational independence that is free from political or industry interference. Ultimately, they need to have the autonomy and prestige of central bankers!

Private sector incentives

Of course, we also need the right incentives, a framework for accountability for the private sector.

Policymakers, regulators and supervisors cannot, and should not, have sole responsibility for the solutions. The social value of the financial system at large carries with it an important social responsibility.

Financial institutions themselves also have an important role to play. This means putting in place top-quality internal governance systems. It means better risk management practices and risk managers empowered to report directly to the top. It also means a more prudent approach to compensation—making sure incentives are aligned with long-term sustainability more than instant gratification. I am thinking again of those luxury sports cars!

I believe that the tax system needs to do more to help deter excess risk-taking in the financial sector, as well as to ensure that it makes an appropriate contribution to public revenues. Some progress has been made in the last couple of years, for example with the introduction in some countries of bank levies. Yet, two years after the IMF’s report to the G-20, much remains to be done in the area of financial sector taxation.

Together, these pillars—regulation, supervision, private sector incentives—make up a three-legged stool. For it to be sturdy and stable, we need all three legs in place.

But, let’s say a really big bank sits on the stool and breaks one of the legs, then what?

What we need is an effective mechanism for the resolution of financial institutions with cross-border operations. This should have at least two things: arrangements between financial institutions to cooperate in the event of a failure; and national laws that allow regulators in different countries to act collectively.

This would make failure a less disruptive and less costly endeavor. For instance, an important dimension would be to allow systemically important financial institutions to continue to operate while they are being unwound.

The first steps in this direction have been taken. Many countries have signed on to the Financial Stability Board’s proposed standards for effective resolution regimes. Yet, as standards, they remain aspirational. And, like so much of what I have talked about tonight, what remains to be done is agree on the rules and implement them.

I would add one other imperative: speed.


What is the essence of this financial sector roadmap in a nutshell? Given the size, complexity and interconnections of the system, we need consistency, coordination and cooperation that should span institutions, markets and borders.

If we do not have consistency, we have a gap. If information is not shared across jurisdictions, we have a gap. The system in its entirety can only be as strong as its weakest link.

So, my main message for tonight: we must finish the job.


Before wrapping up, let me say a word about the role of the IMF in this area. Over the past several years, we have worked to strengthen our work on the financial sector and we will continue to strive to raise our game.

Assessments of financial sector health are part of our core business, for individual countries through the Financial Sector Assessment Program and at a cross-country level in our Global Financial Stability Report. We are also engaged in a broader, collaborative effort—with the G-20 and the Financial Stability Board—to help keep regulatory and supervisory policies moving toward our ultimate goal.

Concluding thoughts

On that note, let me wrap up. Today’s climate of escalating risks is unmistakable. And, in an interconnected world, we all have a responsibility to act in the wider interest. Only then can we move from today’s risks to the reward of sustained growth and stability.

While this is true across the policy spectrum, the financial sector has a special role and responsibility.

In the words of Albert Camus: “Real generosity toward the future lies in giving all to the present.”

In this spirit, we must work together now to transform and rebalance the financial system, so that it is no longer a source of instability. So that it is a source of stability and growth. So that it meets the objectives we all share—and that the world so badly needs.

Thank you.