The meeting of the OECD Committee on Financial Markets on 14-15 April endorsed the recent Financial Stability Forum and G7 recommendations to address the crisis. But the OECD is also addressing issues related to the basic framework for financial sector regulation. This includes development of a more modern and dynamic approach to financial regulation. The OECD believes that fundamental reform of the financial system and its regulation has to be a key focus of the policy debate going forward. As stated by Adrian Blundell-Wignall, deputy director at the Directorate for Financial and Entreprise Affairs, “It will no longer be possible to assert the view that we have the best of all possible financial systems”.
The Committee held an extra-plenary session with private market participants to discuss the financial turbulence. There was a widespread view among private market participants that the outlook for financial markets and stability remained uncertain, and they estimated that the time for financial markets to recover would take 12 to 18 months. This estimate reflects the “fear factor” that pervades markets at present and the likelihood that long-term investors may not return to markets within a short time frame. There are private sector initiatives to speed up the process by removing uncertainties related to asset valuations and many private sector representatives acknowledge the need for a role for public regulatory initiatives, but called for an enhanced dialogue to ensure that measures taken are both effective and efficient and do not constrain innovation.
The chair of the CMF, Mr Thomas Wieser, Director General at the Austrian Ministry of Finance considers that the “regulatory framework reflects the “simple” world before globalisation; the new division of labour has partially led to global imbalances. We need to ensure a cooperative framework for financial markets that takes account of new realities, and enhances stability, whilst retaining efficiency. OECD is uniquely placed to provide in-depth analysis and recommendation on reforms needed to adapt the regulatory framework to the new financial landscape”.
(At the meeting, participants also discussed a new OECD report, “The subprime crisis: size, deleveraging and some policy options”) Most loss estimates confirm the seriousness of the crisis and the need for timely, but carefully considered, actions. In 2007, the OECD estimated that losses from the crisis would amount to approximately $300 billion, the highest, but correct, official estimate at that time. Since then, estimates based on market prices have become unreliable, so now, using a different methodology, the OECD estimates that first round losses (not write-downs) could reach some $422 billion, of which about $90bn would rest with US banks. If losses reach this level, the recapitalisation of banks would be essential to avoid the harsher economic impacts of deleveraging, including a pronounced drop-off in credit extension. It could take 6 to 12 months for banks to grow themselves out of losses of this size, and longer if capital for actual expansion were required. Limited credit availability over such a period would have severe economic consequences. The injection of private capital is preferred, but the OECD provides an interesting example of what could be done with an approach similar to the Resolution Trust Corporation model, including the issuance of zero coupon government bonds.
The OECD also notes that the world is moving to a situation in which individuals bear more and more risks, without being necessarily able to cope with them. This concerns not only credit, including sub-prime mortgages, but also insurance or pensions. This situation calls for a new culture of risk awareness and financial education mechanisms that the OECD promotes.
On a specific issue, the importance of the design of explicit deposit insurance schemes was highlighted. For example, as regards the maximum coverage provided, schemes with low levels of coverage and/or partial insurance may not be effective in preventing bank runs. But the higher the guarantee the greater is the risk of moral hazard, that co-insurance and risk based premiums can help to address. Awareness on the part of depositors of the extent of and limits to guarantees and the speed of reimbursement were among the other actions considered by the Committee in this context.
The Committee noted that there are a number of potential amplifiers of downward pressures in financial markets, including downgrades of large financial guarantors (or bond insurers). In this context, it noted that the ratings of insured bonds depend on the quality of the guarantee provided by the bond insurer, which is a function of the insurer’s own rating. A credit rating demotion of a monoline insurer would not only severely affect its own business outlook, but would also lead to downgrades of a significant part of the bonds that such companies guarantee.
