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Cullen APEC Speech - Financial Sector Reforms

5-6 SEPTEMBER 2002


Financial Sector Reforms

5pm, 7 September, NZ time.

Sound and efficient financial systems are essential to a modern economy, given the pivotal role played by the financial system ¡V including the intermediation of savings, the allocation of resources, and the provision of the means by which individuals and businesses transact with each other.

Financial instability can be extremely costly, both in situations of acute financial crises and more protracted, chronic financial system dysfunction.

In an acute financial crisis, the costs can take many forms, including the cost of recapitalising insolvent financial institutions, the opportunity cost of taxpayers¡¦ funds used to support the financial system, the loss of foreign exchange reserves, and dislocation to the real sectors of the economy. Many of the costs may continue well after the financial crisis has passed, including lack of access to foreign investment and a high risk premium on finance.

In the case of a chronic dysfunction of the financial system, there may be no crisis as such, but the weakness of financial institutions and lack of confidence in the banking system can hinder investment and growth for many years. Financial systems with poor quality risk management capacity can have a harmful effect on the growth rate of the economy, by contributing to poor resource allocation.

Throughout history there have always been episodes of financial distress, but the frequency and severity of distress appear to be worsening. In part, this probably reflects the greater risks associated with more open capital markets, faster-moving capital and the increasingly rapid changes we are seeing in the financial and real sectors of our economies.

In a world where capital markets are growing in size and importance, and where capital can move at the press of a button on a computer keyboard, it is becoming all the more important that policies are implemented to strengthen our financial systems.

There is much that can be done to strengthen financial systems and to make them less vulnerable to economic shocks and less prone to internally-generated instability. The key objective is to strengthen the incentives for, and the capability of, financial institutions to identify, understand, measure, monitor and control their business risks. Effective risk management is the key to reducing the frequency and severity of financial system distress.

The policies needed for effective financial sector reforms will vary depending on each economy¡¦s particular circumstances, but the main ingredients will usually involve:

„« Implementing macroeconomic policies that promote a relatively stable economic environment, with low and stable inflation, sustainable fiscal positions, and sustainable balance of payments and external debt positions.

„« An exchange rate regime that is seen as sound and credible, and which desirably avoids protracted exchange misalignments and strengthens the incentives for prudent exchange rate risk management. There is no single ¡§best¡¨ exchange rate regime. The choice of exchange rate mechanism will much depend on the stage of development and circumstances of an economy and on the depth and sophistication of financial markets. However, it is generally recognised that pegged exchange rates generally weaken the incentives for financial institutions and other market participants to manage their currency risks. In contrast, more flexible exchange rate regimes, supported by the required infrastructure, generally sharpen the incentives for sound currency risk management.

„« Implementing microeconomic policy that encourages sound resource allocation and reduces the risk of financial institutions lending to sectors of the economy on the basis of prices distorted by regulation or subsidy or on the basis of government protection of industry.

„« Careful attention being paid to the process and sequencing of financial and real economy liberalisation. Rapid liberalisation of the economy, financial sector and the capital account of the balance of payments can result in financial instability, particularly where the reforms are not accompanied by measures to strengthen the risk management capacity of the financial sector and the incentives for financial institutions to manage their risks cautiously.

„« A good level of transparency and accountability by policy-makers. Investors do not like uncertainty. They like to understand the objectives and nature of economic policy. And they like to have reliable and regular information on economic performance and on whether particular economic policies are delivering the goods.

„« Policies to encourage sound risk management within financial institutions, including robust corporate governance (especially in respect of director duties and the composition of the board of directors) and high quality financial disclosure (based on sound accounting and auditing standards and practices).

„« Policies to foster effective market disciplines, in order to strengthen the incentives for financial institutions to manage their risks effectively. This suggests the need to move away from heavy government-ownership of financial systems, the adoption of policies to strengthen the contestability and competitiveness of the financial system, a minimisation of government guarantees of financial institutions, the careful design of deposit insurance (to minimise moral hazard risks) and a concerted effort to address the ¡§too big or too complex to fail¡¨ syndrome ¡V ie to have the capacity to respond to episodes of financial distress in ways that seek to avoid taxpayer-funded rescues of financial institutions, where feasible. So long as investors and creditors think it likely that governments (or the IMF) will bail them out in a financial crisis, they will have weak incentives to monitor and exert disciplines on financial institutions.

„« An effective system of financial sector regulation and supervision, with clearly defined supervisory objectives and legal powers. The objectives and nature of supervision will vary depending on the circumstances of each economy and financial system. It could be expected that a financial system with relatively under-developed markets and poor corporate governance would require a more intensive supervisory regime than one with strong market disciplines and corporate governance and a strong culture of risk management. Conversely, the stronger the market disciplines and corporate governance in a financial system, the less intensive the supervisory process needs to be.

„« Getting the balance ¡§right¡¨ between institutional self discipline, market discipline, and regulatory discipline is one of the trickier aspects of successful financial sector reform. It is important that, in strengthening regulation and supervision, we do not weaken the incentives for the directors and managers of financial institutions to take responsibility for managing risks in their institution, and that we do not weaken the incentives for the market to monitor, and impose disciplines on, financial institutions.

„« In the approach to financial sector regulation, it is important to avoid tying up the financial system in knots in an attempt to regulate for lower risks. Such an approach is unlikely to be successful, given the tendency of markets to find ¡§back door¡¨ routes to avoid regulation. And it may in fact create perverse incentives, resulting in higher, rather than lower, risk-taking, to the detriment of financial stability and efficiency.

„« International financial reforms of recent years are likely to assist the financial sector reform process. In particular, the development of international standards and codes and the new Financial Sector Assessment Programme are important and potentially very helpful developments.

„« However, we need to remember that, although these international reforms are helpful, the real work lies at home ¡V ie each government, in liaison with the private sector and community at large, must define the goals of financial reforms and the nature of those reforms. And they must have the commitment to see them through. Financial sector reform is more likely to be successful if the reforms are adopted voluntarily by a government out of a genuine desire to promote a sound and efficient financial system, rather than merely for the sake of complying with international standards and codes.

„« International standards and codes provide helpful guides in the reform process, but should not be applied prescriptively, in a ¡§one size fits all¡¨ approach. Each economy must have the flexibility to tailor their policies according to the policy objectives and particular circumstances of their situation and stage of development.

„« And, while the FSAP process is a desirable and positive development, there is a need to ensure that the surveillance process focuses on the substantive policy outcomes, rather than on a mechanistic approach to assessing compliance with standards and codes.

„« We need to be realistic in what can be achieved. There are no silver bullets. It is not possible ¡V and probably not even desirable ¡V to eliminate occasional financial system distress. To try to do so carries a risk of over-regulating and over-supervising our financial systems, to the detriment of their efficiency in meeting the needs of the real economy, and probably to the detriment of longer-term financial stability. Rather, our aim should be to reduce the frequency and scale of financial system instability, such that when occasional episodes of financial system distress occur ¡V as they inevitably will from time to time ¡V they do not pose a threat to the stability of the system as a whole and are resolved relatively quickly and effectively.


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