ASCENT AFTER DECLINE: RE-GROWING ECONOMIC GROWTH Observations on Financial Sector: Constraints and Reform Agenda

1. ASCENT AFTER DECLINE: RE-GROWING ECONOMIC GROWTHObservations on Financial Sector: Constraints and Reform Agenda • Stijn Claessens • Assistant Director, Research Department, IMF • WORKSHOP,  November 19, 2010, World Bank

2. Outline • State of financial sectors and reforms • Finance as constraint on growth and risks • Due to crisis & because of ongoing reforms, or lack thereof • Issues in the session • Links to financial sector, possibilities to accelerate financial restructuring? • General observations, and qualifications

3. State of financial sectors, in advanced countries • Financial sector still weak • Weakly/undercapitalized/reduced profitability • Large overhang (households) to be resolved • Sector facing new regulations, risk averse • More/stricter capital adequacy, etc. requirements • Higher general risk aversion • Yet (systemic) risks not necessarily lowered • Migration of risks to outside banking system • Limited fundamental reforms

4. State of financial regulatory agenda • Progress on some, but “easier” elements • Higher/better capital adequacy, some buffers • Limits on leverage • Better coverage of risks • Some progress on derivatives/CCPs/OTC • At the same time, because of interventions • Moral hazard increased • Market structures largely similar (same top SIFIs) • Concentration greater

5. Ongoing agenda, in various stages • Market discipline • Accounting (note MtM waived): underway • Rules on rating agencies, role of CoCos: TBD • Better corporate governance of FIS: TBD • Regulatory governance • So far, some moving around of boxes (FSA/BOE) • Or more new agencies (US 7 new, only 1 out) • Little progress on independence (less perhaps), accountability, integrity, and transparency

6. U.S.: 1 less, 7 (?) more agencies • Gone (?): Office of Thrift Supervision • New: Consumer Financial Protection Bureau, Financial Stability Oversight Council, Office of Financial Research, Federal Insurance Office, Investor Advisory Committee, Office of Housing Counseling, Office of Minority and Women Inclusion

7. Problems still to be addressed • Limited progress in fixing deeper “causes” • Resolution: few countries fixed so far • Liquidity: requirements still TBD • Cross-border: little so far (some in EU) • Procyclicality: hard, but much to be done • Only some limits on activities • Little on incentives/compensation • Dynamic provisioning, through the cycle TBD

8. Long-standing issues (still or even more so) to be addressed • Shadow banking system • Perimeter: remains TBD • Macro-prudential policy • Concepts and operations: TBD • Surveillance (national, regional, global) • Mandates, powers, institutional structures: TBD • e.g., ESRB, FSOC, IMF/FSB • Data, analyses: to be set up/done • e.g., OFR, BIS, G-SIFIs, data on interconnections

9. Surveillance in EU: quite complex

10. Costs have risen for provision,while risks may remain • Financial services industries facing higher (compliance) costs, reflected in prices and quantity • Spreads up/higher, access less (good to a degree) • Drag on growth (MAG: 0.3% GDP loss in medium) • Emerging /developing markets affected in medium term • Costs of cross-border/capital flows up (like for Basel II) • Foreign banks: less eager to expand in local markets • Short-run, because deeper causes of crisis not addressed, advanced countries’ 2nd best policies create externalities • QE2, low interest rate → capital flows ↑ • Asset prices bubbles, credit booms (and busts?)

11. Issues in the session • Fiscal • Infrastructure • Labor

12. Fiscal policies relate to financial sector: see outcomes to date Source: Laeven and Valencia (2008 and 2010).

13. Macro policies provided much more support than in the past

14. Which helps explains why NPL’s rose more gradually this time

15. Public recapitalization implemented sooner, with less triage (assets/institutions)

16. Combination made direct fiscal costs generally less than in earlier crises

17. Still, weak financial sector hinders growth: more direct fiscal? • Can direct fiscal support helpgrowth? • Tradeoff between fiscal stimulus and recapitalization/household debt restructuring: what are the relative multipliers? • Scope for more direct financial sector support? Or not for incentives, political economy, other? • Other fiscal policies • No disagreements with paper. There is also a financial sector link with taxation (VAT, levies)

18. Other issues in the session • Infrastructure • As noted, largely Keynesian, less long-term • While big part of discretionary, small part of overall fiscal deficits (in advanced countries at least) • Infrastructure financing to be more public, but: • Tradeoffs with already large fiscal debt/exposures • Efficiency arguments to go other way, so stuck? • Labor • Agree on the impacts of financial crisis on empl’ment • Not sure on the channels, though

19. 10 Current Recession 9 8 7 Previous Recessions 6 5 4 3 2 1 0 -12 -8 -4 0 4 8 12 Current Unemployment Rate (US) Higher than in Normal Recessions(Year over Year Change; x-axis in quarters, in percent)

20. But Recessions Associated with Crunches and House Prices Busts are Generally Deeper (percent drop)

21. And Such Recessions Have Much Greater Cumulative Output Losses

22. And Unemployment Picks Up More After Crises(percentage point change four quarters after trough)

23. What is driving current unemployment? • Agree: Housing was leveraged sector, and construction is labor intensive, with low substitutability. And yes, mortgage overhang is holding back mobility. • Yet economic situation is similar across US states, even though housing mess localized in few states • Suggests that supply of financing has been hit, in part due to the housing crisis, which is holding back growth, needed for jobs • So: “Could save jobs by restructuring finance”?