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Why FRSN? An illustrative reasoning

In 2014 the IMF came up with two valuable publications which are explaining the underlying motiviation of Financial Risk and Stability Network quite well. They give a good background and are presented here with a short remark.

The April 2014 Global Financial Stability Report tackled the too-important-to-fail-problem (TITF) and says that considerable implicit funding subsidies received by systemically important banks (SIB) even rose during the crisis. The authors write that “the implicit government protection of these banks distorts prices and resource allocation. Because creditors of SIBs do not bear the full cost of failure, they are willing to provide funding at a lower cost than warranted by the institutions’ risk profiles. They also have little incentive to monitor and punish excessive risk-taking. SIBs then may take advantage of the lower funding costs to increase their leverage and engage in riskier activities. Banks may also seek to grow faster and larger than justified by economies of scale…”.

Further they say that “countries emerged from the financial crisis with an even bigger problem: many banks were even larger than before and so were the implicit government guarantees. In addition, it became clear that these guarantees were not limited to large institutions. In some countries, smaller institutions with a high degree of interconnectedness, complexity, or political importance were also considered too important to fail, and sometimes they were too many to fail…”.

They conclude that “additional efforts are necessary to deal with the TITF issue and move toward a situation in which the funding cost advantage associated with TITF no longer exists. Besides full implementation of Basel III, international coordination on both regulation and resolution regimes should be enhanced. Moreover, additional capital buffers, loss provisioning, or bank levies may be required to lower the probability that the TITF institutions become distressed and to reduce the burden on taxpayers…”.

So, this problem is not solved. Merger and acquisation activities in the course of a consolidation of the European banking sector could in addition aggrevate the TITF problem. The reluctance by governments and political elites against winding down national banks is likely to advance such concentrations. Although progress has been made we still find ourselves in an uncomfortable situation. Banking Union is still missing in practice and we do not know how future crisis would be managed.

The second publication is an IMF paper from March 2014 asking some uncomforetable questions on regulatory responses to the crisis. The authors Stijn Claessens (speaker at our conference 2015) and Laura Kodres identify current challenges for creating stable, yet efficient financial systems using lessons from recent and past crises. Their findings are of considerably significant importance as regards regulatory capture and financial reforms agenda.

Their analysis finds: “One of the difficulties in making overall progress on financial reforms is that crises tend to instill forward momentum on obvious failings, but often ignore the underlying, deeper causes. Moreover reform processes take significant time for construction, debate, refinement, and implementation during which the public cries for reform diminish and financial sector lobbyists regroup to water down the reforms. The energy for reforms wanes and the perception of the benefits become distant memories…”

They contiunue saying: “Several years beyond the height of the crisis, the financial reform agenda is still only half-baked at best. Some reforms gesture in the right direction, but don’t go far enough or have not been implemented fully. Others are either in conflict with one another or appear to have unintended consequences. Policy makers continue to face severe constraints including complicated governance frameworks, unfavorable structures of political economy, limited knowledge, and stiff political opposition to implementation of reforms…”

The authors describe widespread requests that “the financial sector paradigm that emerged over the past quarter century is due for changes… and both governance strategies and the fashioning of incentives have to be rethinked. … Representation and governance is largely an political economy question, but economists can nevertheless raise questions. How can relevant parties, including the general public, be better mobilized to demand a bigger say in discussions? How can one better harness the power of nongovernmental organizations…”, they ask.

This is of utmost importance in rebalancing risks and benefits, reorient the financial sector toward activities that benefit society at large as well as to better align financial regulation with societies’ goals. That is what FRSN is heading at.