PROMOTING STABILITY AND MAINTAINING EFFICIENCY

FINANCIAL STABILITY

I turn now to the principles that should underlie reforms to deal with the weaknesses exposed by the crisis, while preserving, and if possible enhancing, the unique contribution that finance can make to material well-being. These principles should apply not only to the current environment, but to the financial and economic landscape as it may evolve over time. Inparticular, they should be consistent with an increasingly integrated world economy, in which national borders play a smaller and smaller role in the organisation of economic activity. They should also be consistent with a world in which reconciling the financing needs of governments with the availability of credit to the market economy is almost certain, unfortunately, to be a continuing challenge. I will group my remarks under six headings: 
(i) the problem of “too big to fail”;

(ii) capital and liquidity standards at financial institutions;

(iii) systemic instability and pro-cyclicality; 

(iv) improving efficiency of capital markets; 

(v) infrastructure; and 

(vi) the role of public sector intervention


The existence of institutions that are perceived as too big (or too important) to be allowed to fail can enhance the incentives to socially undesirable risk-taking. As a result, economic distortions are created while such institutions are active, and a potential charge on taxpayers arises when they run into difficulties. Prudently managed and successful enterprises are penalised by comparison. It should not be difficult to agree on the principle that all institutions in a competitive market economy should face the threat of failure as a result of bad business judgment. Indeed it will not be possible to say that a financial system is fit for its 21st century purpose until the anomaly of “too big to fail” is removed. To make the threat of failure credible, however, it must be possible for all financial institutions, no matter how large or complex, to be sold, merged or wound down without creating unacceptable risk to the broader economy. This is not the case at the moment. Standard bankruptcy procedures are not well-suited for financial institutions. A financial institution cannot function in bankruptcy in the same way as a commercial enterprise. It cannot obtain temporary protection from its creditors, because access by creditors is its raison d’être. Moreover, large financial institutions play such a pivotal role in their respective economies, that governments may be reluctant to accept the consequences of their failure. There are, in my view, four key prerequisites of an acceptable regime that maintains market discipline while permitting the orderly winding down of a failing institution: 

(i) imposing losses on stakeholders that are predictable and consistent with the avoidance of moral hazard; 

(ii) avoiding significant damage to “innocent bystanders”, especially when this would provoke a loss of confidence in otherwise sound financial institutions; 

(iii) minimising the ultimate costs borne by taxpayers; and 

(iv) sharing equitably across countries the residual burden of resolving troubled institutions that have international operations. To meet these prerequisites, a specialised resolution regime for large financial institutions needs to be developed. What is important in this connection is not only that there is a regime