Financial Reform: A Framework for Financial Stability
Market economies require robust and competitive financial systems, national and international,to intermediate between those with financial resources and those with productive and innovative uses for those resources. That intermediation necessarily poses risks—risk with respect to bridging maturity preferences of savers and borrowers and risk with respect to creditworthiness. The process, to be effective, depends on mutual trust—trust based on confidence in the integrity of institutions and the continuity of markets. That confidence, taken for granted in well-functioning financial systems, has been lost in the present crisis, in substantial part due to its recent complexity and opacity.
The costs and economic implications of the present crisis cannot be fully known at this point, but we know they are severe, whether measured in trillions of dollars, in the length and depth of the worldwide recession, or in the simple human terms of unemployment and shattered personal finances. We also know that there is a need for comprehensive reform that addresses the major institutional, market, regulatory, policy, and infrastructure weaknesses that have been exposed.
These include weak credit appraisal and underwriting standards; extreme and sometimes unrealized credit concentrations; misjudged maturity mismatches; wildly excessive use of leverage on and off balance sheets, often imbedded in little-understood financial products; and unwarranted and unsustainable confidence in uninterrupted market liquidity. Gaps in regulatory oversight, accounting, and risk management practices that exaggerated cycles, a flawed system of credit ratings, and weakness in governance also need attention.
To some degree, these factors have been evident in other, less damaging periods of financial crises. Two unique features have worked together to help account for the extent of the current market breakdown. Highly aggressive and unbalanced compensation practices have strongly encouraged risk taking over prudence. At the same time, highly engineered financial instruments, in their complexity, obscured the risk and uncertainties inherent in those instruments, giving rise to false confidence and heavy use of leverage to enhance profits, as asset prices rose. As those asset prices began declining, the risks became apparent, triggering sales of assets. A downward spiral of deleveraging has undermined the stability of even the largest financial institutions at the core of the system, contributing to an economic contraction of global proportions. Authorities in most countries have been stretched to and even beyond the limits of their capacity to restore liquidity and contain the instability.
This Report is organized as follows. Part 1 lays out an overview of a program of reform, the Group of Thirty guiding principles, and core recommendations. Part 2 through Part 5 lay out the reasoning behind and content of 18 specific policy recommendations. Specifically, Part 2 reviews the policy issues related to redefining the boundaries of prudential regulation; Part 3 reviews issues related to the strengthening of prudential regulation, including the role of central banks, and international coordination; Part 4 addresses matters related to improving governance, risk management, regulatory policies, and accounting policies; Part 5 concerns needed improvements in transparency and financial infrastructure, including arrangements for clearing and settling over-the-counter transactions; Part 6 provides a concluding comment; and a full list of the recommendations provided throughout the Report can be found in the Appendix.
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