Is the global regulatory system fit for purpose in the 21st century?
Monetary Authority of Singapore Lecture Speech
By Howard Davies, Chairman, Financial Services Authority, UK
19 May 2003

I am greatly honoured to have been invited by the Monetary Authority of Singapore to deliver their 2003 Lecture.

Over the eight years for which I have had responsibility for banking supervision in the UK I have come greatly to respect the Authority's skill and dedication, through some difficult times in the region. Your Chairman, Deputy Prime Minister Lee, and your Managing Director Koh Yong Guan, have both been wise advisers to me over the years, and we have shared many useful discussions here and in London.

In 1995, when I was still at the Bank of England, we were handling the aftermath of the Baring's collapse. Since then, we have worked on many issues together in many places, particularly in the informed international group of integrated regulators, which is proving to be a valuable forum for the exchange of ideas and experience.

I shall be leaving the FSA at the end of September to move to the London School of Economics. But that will not break my links with Singapore : there are very many LSE alumni in the MAS, and in Singapore more generally, so I will continue to have a sound excuse to visit.

You were kind enough to give me the freedom to choose my subject today. In doing so I have posed a question. Is the Global Regulatory System fit for purpose in the 21st century?

We could all save time if I answered 'yes' or 'no' and sat down. But I will indulge myself with a few reflections, based on eight years as a regulator, before I give you my considered response.

The Asian crisis and its aftermath

In the immediate aftermath of the Asian financial crises of 1997-98, there were widespread calls for a fundamental reform of the international financial architecture. It was argued that the traumas of Korea, Indonesia and Thailand, pointed to fundamental weaknesses in the international financial system. These were countries with relatively sound fiscal positions, enjoying rapid economic growth, yet when a crisis of confidence hit, their financial systems collapsed with alarming speed. This experience, which took the international financial institutions by surprise, appeared to demonstrate both that the IMF's financial surveillance was inadequate, and that its crisis management tools were similarly lacking. Though it is also appropriate to point out that the markets did not see the crisis coming either.

There are those like Jeffrey Sachs and, from a different perspective, Joe Stiglitz, who have used this failure to mount a major assault on the policies and practices of the Fund over many years. These disputes rumble on, as Stigiltz's ill-tempered ad hominem attack on Stanley Fischer (in Globalization and Its Discontents) demonstrated. Personality-driven disputes are entertaining for the press. But the more important question
remains whether the institutional framework for overseeing financial markets, seeking to prevent crises and, when prevention fails, to manage them, is adequate. Open financial markets will always be prone to bouts of irrational exuberance, but do we do enough to contain the collateral damage which excessive volatility can cause?

Some academics, notably John Eatwell at Cambridge, argue that we need a fundamental recasting of the international financial institutions. He favours the creation of World Financial Authority charged with setting the regulatory framework for financial markets across the globe, and endowed with powers of intervention when crisis threatens. His arguments are persuasive, but it seems unlikely that countries will be prepared to cede
sovereignty to such an authority on a scale which would be necessary to make it work effectively.

There have been many other less ambitious proposals, both from within the IMF and the World Bank, and from individual countries. For a time it seemed as though the creative departments of every Finance Ministry in the world ? if that is not an oxymoron ? were engaged in a kind of architectural competition to draw up a new set of relationships between the international financial institutions, their member countries, and the key
regulatory organisations in the financial sector.

On the face of it, the changes made as a result of this frenzy of creativity have been very modest. No major new institutions have been set up.

But one potentially significant development was the establishment of the Financial Stability Forum, in a response to a report commissioned by G7 Finance Ministers from Hans Tietmeyer, the retiring President of the Bundesbank. The Forum includes Finance Ministries, Central Banks and the main financial regulators from each of the G7 countries, together with the representatives of the various "Trade Unions" of regulators such as the Basel Committee of Banking Supervisors, the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). Singapore, along with Hong Kong, Australia and the Netherlands, are also present as representatives of other major financial centres while the Chair of IOSCO's Emerging Market Committee currently participates to ensure some emerging market input, though only from a securities perspective. With the establishment of the FSF, for the first time financial regulators were brought into the surveillance game, reflecting the lessons of 97-98.

The Forum, as its name suggests, is charged with monitoring financial stability, and acting as a venue for exchange of information and the common assessment of vulnerabilities in the international financial system. It does not, however, hold any authority over member countries, or indeed over the regulators. It would therefore be hard to describe it as even one step in the direction of a world financial authority. The Forum also has no role in the management of any crises that may still occur.

In addition to the FSF, there was some tinkering with other committee memberships. For example, the Group of 22, which in fact had grown to have 33 members, was scaled back to become the Group of 20 ? though actually it includes 19 countries and the European Union, which makes 34! That momentous change, in 1999, has not obviously made the world a safer place.

The founding of the G20 did, however, represent a recognition by the international community that solutions to global financial pressures had to reach well beyond the G7. Singapore is not represented at the G20. Nor are regulators like the FSA. Nonetheless, the group, composed of finance ministers and central bankers from both developed and emerging markets, has been useful in obtaining emerging market high-level political buy-in to initiatives arising from elsewhere in the financial system. The G20 have all agreed, in principle, to undergo IMF Financial Sector Assessment Program (FSAP) evaluations and, under the current chairmanship of Mexico, they are looking at economic growth and the role of institution - building in the financial sector along with crisis management, transparency, combating terrorist financing and development issues more broadly.

These institutional adjustments do not look fundamental. But there has been more change below the surface than they might suggest. Perhaps most importantly, a broad, albeit not universal, international consensus has developed that soft currency pegs, or other fixed exchange rate regimes, are, in combination with an adverse policy mix, highly likely to contribute to financial crises, and highly unlikely to protect countries from the
financial market implications of poor economic fundamentals, or unstable financial systems.

The second important development, less widely discussed, yet which may be of equal significance, is a radical change in the focus of the IMF's surveillance work. In institutional terms this change in focus is highlighted by the creation of a new Capital Markets Division in the Fund, which prepares a regular Global Financial Stability Report. That document, which has attracted too little international attention so far, is a brave
attempt by the Fund's staff, reinforced by new recruits from the financial markets under Gerd Hausler, late of Dresdner Bank, to focus attention on potential sources of financial instability in institutions and markets. That means, at times, drawing attention to weaknesses in the banking and insurance systems even of G7 countries, which has hitherto been difficult territory for the IMF.

Yet it is important for it to do so, not wholly because of the potential benefit for G7 countries themselves, but also to show that developed countries are taking the medicine which they now impose on others. This is because the second major change at the IMF has been the rapid expansion of its work on financial regulation. The Fund is now committed to preparing financial sector assessments (FSAPs) of member countries, and indeed of some non-members too, such as the significant offshore financial centres.
These assessments review the effectiveness of regulatory structures, financial regulation and adherence to internationally accepted financial sector core standards and codes.

What is the rationale for this activity, which is now consuming a significant proportion of the Fund's resources?

The Asian crisis demonstrated that poorly regulated financial systems, particularly banking systems, could themselves be a cause of crisis, even where the macro-economic position might look relatively stable. In the case of countries like Indonesia, Korea and Thailand it became clear after the event that their banks were heavily exposed to currency risk through unhedged dollar borrowings. Furthermore, that the regulators in those countries had paid little attention to this mismatch, and indeed little
attention to credit quality. In many cases banks were far too close to the companies to which they lent. There had been a rapid expansion of connected lending and little policing of large exposures, so banks were highly vulnerable to individual corporate collapses. That, in turn, precipitated the crisis in the banking system which turned an economic adjustment into a full blown systemic collapse.

Certainly, it will take some time for this IMF assessment programme to bear fruit and it will be crucial to turn initial assessments into effective long-term mitigation and implementation strategies. This will require both political commitment and, where appropriate, technical assistance. But there are signs that more developing countries now appreciate the importance of independent systems of financial regulation, and that the Finance Minister's best friend may not necessarily be the right choice as head of banking supervision, particularly not if his family owns a large slice of the banking system.

Next >>>