Press Advisories

16. 6. 200916:48

New Financial Architecture - Panacea or Chimera?

Speech of Prime Minister Jan Fischer in London, Chatham House

Mr. Chairman, ladies and gentlemen,

Those of you, who have personal experience of statisticians and Czechs, have a bit of an unfair informational advantage. Because you already know that no panacea will be found today. No chimeras, either. My entire professional background is in statistics, and Czechs—by nature—are fairly skeptical to begin with. And I am both. But do not worry—I can at least promise that I will spare you any statistics.

Having said this, I do share the general line of the fine report of the high-level group led by Jacques de Larosière, released earlier this year, that the near collapse of the global financial system last autumn resulted from an exceedingly complex interaction of market failures, global financial and monetary imbalances, inappropriate regulation, weak supervision and poor macro-prudential oversight.

Add in moral hazard, sheer greed, gullibility and a heavy dose of perverse incentives and you have rich ground for Hollywood to sift through. Expect movies with villains compared to whom Gordon Gecko was a decent fellow.

We have avoided the collapse, but it is clear that repairing the damage done not only to the financial sector’s balance sheets, but also to households and non-financial companies, and restoring confidence in the integrity of financial institutions and the smooth functioning of financial markets will be a costly and time consuming exercise. It is achievable, and it should be done.

The fiscal consequences are enormous, though. Massive rescue packages for the illiquid and decapitalized financial giants are putting a very serious real as well as contingent fiscal burden on a number of countries. Even those countries—such as the Czech Republic—whose financial sector was not directly exposed to toxic waste and did not engage in excessive mortgage and consumer lending, suffer as the knock-on effects of the financial crisis translate into a decline in real demand through a dramatic fall in international trade. There is very little any government can do in a small, open economy to prop it up meaningfully through a fiscal stimulus, as a significant portion of it is “exported away.” Meanwhile, the soaring deficit has to be financed in its entirety at much higher cost than a year ago, amidst increased competition from much larger borrowers who accumulate debt at a staggering speed. This only underlines the need for a coordinated and measured approach across Europe and beyond.

Let me start from relatively straightforward issues, such as a role of the International Monetary Fund. The Fund barely had customers two years ago, and its revenues declined so much that it had to reduce staff. Amazing how times have changed, the Fund certainly got a new lease of life due to circumstances we are all very sorry about. Lesson number one is: whenever you write-off Bretton Wood institutions, you do so at your peril, because the next crisis is waiting just around the corner.

A very significant replenishment of its financial capacity to support member countries in need is a done deal, and a sensible one at that. So is strengthening its surveillance function. More thorough surveillance and the ability to detect a build-up of macroeconomic imbalances and potential asset bubbles is one thing, and I have no doubt that the IMF is well equipped from a technical standpoint to red flag the areas of potential concern. Any missing skills can be filled in fairly quickly. After all, as any participant in Article IV consultations can confirm, the IMF staff always possessed very impressive analytical skills and could discuss the sensitive issues with their member country authorities with remarkable candor. The real issue is the ability to translate advice into policy change and action. The recent spectacular failure to adjust macropolicies and upgrade regulatory frameworks to plug the glaring holes early on to avoid the near breakdown of the global financial system was not born in some “Faroffistan”. Although party poopers are not welcome anywhere, and there is no way to push policymakers to change course when there is no funding need from the IMF, at least the Fund would have had sufficient clout to be listened to seriously. But we are talking about a failure to act by the authorities in the world’s largest economy with the most sophisticated financial system that had ever existed on this planet and with the deepest pool of human capital available. Apart from disclosure and the ability to provide honest and unbiased opinion, the IMF will hardly ever be equipped to deal with this problem when things get going again. Someone may wish to create a global cop, but I am very skeptical that he will ever be given a real gun. Even if he got a real gun, he certainly would not receive real ammunition.

On the other aspect of Bretton Woods system: its governance. It was clear even to occasional observers that emerging and developing countries deserved a bigger voice and participation in the international financial institutions a decade ago, and a correction in this matter is long overdue. Not doing this means risking a lack of “ownership” and a loss of interest in multilateralism by countries who are going to play a steadily increasing role in the global economy, whether we want it or not. Quite frankly, I am afraid that we would do Bretton Woods institutions, and a global economy at large, a great disservice if the next World Bank president were a U.S. citizen, or the next IMF Managing Director just another European in a long line of them. Business as usual simply will not do, and it should not.

Now, let me change the topic to regulatory framework and enhanced supervision. The grave problems we have witnessed cannot be resolved just by smarter, less pro-cyclical regulation or more sophisticated supervision, despite ample evidence that public regulators and supervisors have clearly been caught asleep.

Obviously, self-regulation by market participants and market discipline did not work, either. Banks’ and credit rating agencies’ internal risk models proved inadequate, as they did not incorporate extraordinarily adverse conditions. Moreover, the compensation framework and lack of understanding of complex derivative structures added to the problem. The originate and distribute model, with its perverse incentives, alone will become a matter of case studies for a generation of students of finance, as well as an array of books for the general public to enjoy.

At the same time, I am pretty sure that fingers have been burned badly enough to increase the perception of risk by market players tremendously and that it will take years before anybody will touch anything remotely resembling what was dubbed toxic waste again. Does this imply that the lessons learned the very hard way by market participants, CRAs and all others involved are sufficient and public regulation and supervision do not need to be strengthened? Certainly not, the case for improvements in regulatory and supervisory framework and enhanced international cooperation in this field is very strong and Jacques de Larosière’s report canvassed a number of sensible recommendations.

I like the idea of dynamic provisioning and counter cyclical capital requirements that would help alleviate credit booms and subsequent tightening of credit availability in bad times. This is sensible, and so is much more cautious treatment of risk with respect to exposures to structured investment vehicles and derivatives. The timing and gradual introduction of the new rules is important here because a rush to introduce a plethora of strict new regulations would just prolong the current recession and postpone the much-awaited recovery.

It is a plain necessity to eliminate the conflicts of interest that plagued the credit rating industry, as it did auditors cum strategy consultants in the ENRON era. Who should pay for ratings? Well, whoever, certainly not the issuers themselves, especially when they also received advice on structuring the transactions by the raters; this much we know already.

Forgive me for not repeating all the issues and proposals on new financial architecture, we have all read those and it would be a waste of time. But there is one important issue I would like to dwell upon for a while and this is what should be done in the EU to facilitate better functioning of the single financial market, which we do not have yet. I think there is a consensus that there should be a level playing field without scope for regulatory arbitrage. We do need a sensible set of core rules that are respected everywhere and applied consistently across Europe. We probably do need an institutional infrastructure that would promote and ensure that these rules are truly observed. Do we need EU-wide authorities for banking, insurance and securities? Well, we probably have to move in this direction due to the simple fact that there must be something akin to a dispute resolution mechanism as differences in opinion between national supervisors would definitely occur and they have to be resolved in a legally binding way. We have to admit that the crisis has demonstrated the need for a body that would set sensible supervisory standards and provide a platform for effective coordination, especially in crisis situations.

For instance, we should not allow repetition of the situation when deposit guarantees were expanded amidst panic at widely different levels, thus creating a very uneven competitive environment and launching a chain reaction which could and should have been avoided. The existence of banking groups that have grown well beyond the capacity (and willingness) of the national treasurers to orchestrate a group-wide rescue is a particular source of concern.

In the past decade, we have seen very successful penetration by such groups, especially into new member countries, who presented ample opportunities both through privatization and greenfield investment in unsaturated banking and insurance markets. All this was often very actively encouraged by home country governments, international financial institutions, et cetera. It was all fun while it lasted. Profits have been happily transferred to the home country from a host country, while supervisors in both quietly neglected macro-prudential issues and the risks involved. I do not want to sound too agrarian, but now that the teat—all of a sudden—does not seem so full and the milk has turned a little sour, who is gonna feed the goat? Let us not pretend this did not happen, because it did. Home country taxpayers, host country taxpayers, other EU taxpayers, Brussels or the IMF? There is no lack of “smart” free rider ideas, but if the price tag is several dozen percent of the home country’s GDP, there are not many takers.

The Czechs had a very painful and costly experience with a banking crisis about a decade ago. Yes, macro-prudence was neglected, and macroeconomic imbalances and currency misalignment got way out of hand. Micro-prudential supervision was weak, patchy, inconsistent, inexperienced. Capital market supervision was next to non-existent, abuse a legendary textbook case.

Semi-privatized banks had to be cleaned up by the government owned Asset Management Corporation through asset purchases at prices way above the fair market value, we even tinkered with public-private partnership (been there, done that, Mr Geithner, but , surprise, surprise, in market conditions it did not work), we did a carve out of distressed assets into a bad bank. All this was ugly, politically very divisive, obscenely expensive. Ultimately, it worked, somehow.

Cleaned up banks were sold to foreign investors, and have been very profitable since. Now they provide much appreciated dividends to some of their ailing parents. We have learned our lessons the hard way and that is why we eschew grand ideas, but we are always open to sensible ones.

There is a famous Czech movie by Milos Forman, which he shot in 60s before he left for the States. It is called Hoří, má panenko (The Firemen’s Ball) and is about a firefighters ball in a Czech village. There is a lottery with a lot of prizes. Then the light goes out, and the prizes are gone. They start to look for the stolen prizes and it appears that the favorite prize—head cheese neatly wrapped in a pig’s stomach—was taken by the chief firefighter himself.

You see, we are well equipped not to be surprised. One thing, though, we did not assume. That if you hover high enough above the surface, the Earth rotates and the helium runs out, and you may well descend on Manhattan. When there is a blackout, bad things happen. It is still the same old story, only bigger. It is the Big Apple, after all.

We should do better, and if we try hard enough and do it together, we will. Let there be light.

Thank you for having me, a Czech statistician, here tonight.