Financial Regulation Reform and Financial Stability
By Zhao Xijun
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How important is financial regulation to financial stability?
The G20 has played an important role in linking financial regulation and stability.
The origin and the development of the G20 is closely related to addressing the financial crisis through global governance. The mechanism of the G20 Finance Ministers and Central Bank Governors Meeting was initially set up to prevent the recurrence and spread of a crisis similar to the Asian financial crisis in 1997, then the mechanism of G20 was upgraded to a leaders summit in 2008 under the suggestion of French President Nicolas Sarkozy and British Prime Minister Gordon Brown due to the subprime mortgage crisis in the United States, and the then-U.S. President George W. Bush agreed to organize the first summit.
As we know, the nature of a financial crisis is an unstable financial market and an unstable economy. What people can do is to bring them back into a normal and stable situation. But how can this be achieved? The first and most important thing is to understand what has caused the crisis and how the crisis has developed. Based on this analysis, appropriate measures can be taken, and then implemented.
The 2008 Washington Summit analyzed the root causes of the crisis as following: “Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.”1 The 2009 London Summit also concluded: “Major failures in the financial sector and in financial regulation and supervision were fundamental causes of the crisis.”2
Although numerous factors contributed to the crisis, inadequate regulation was the first and most cited reason. The G20 then proposed the “Common Principles for Reform of Financial Markets” and the improvement or enhancement of financial regulation was placed as a core position.3
As the first G20 summit suggested: “we will implement reforms that will strengthen financial markets and regulatory regimes so as to avoid future crises. Regulation is first and foremost the responsibility of national regulators who constitute the first line of defense against market instability.” The action was called “Enhancing Sound Regulation,” which touched upon areas such as regulatory regimes, prudential oversight, risk management, promoting integrity in financial markets, strengthening transparency and accountability.4 And from then on, financial regulation and stability have been linked closely together by G20.
What have we done since the global financial crisis?
Apart from the first G20 summit, seven summits have been organized since then and every summit has discussed financial regulation without exception.
The 2009 London Summit emphasized that: “We will take action to build a stronger, more globally consistent, supervisory and regulatory framework for the future financial sector.” The action was called “Strengthening financial supervision and regulation” and aimed to reshape regulatory systems so that authorities could identify and take account of macro-prudential risks; extended regulation and oversight to all systemically important financial institutions, instruments, and markets, including hedge funds; and established a new Financial Stability Board (FSB) with a strengthened mandate to provide early warning of macroeconomic and financial risks and the actions needed to address them.5
The 2009 Pittsburgh Summit took the action called “Strengthening the International Financial Regulatory System,” and enhanced and expanded the scope of regulation and oversight, with tougher regulation of over-the-counter (OTC) derivatives, securitization markets, credit rating agencies, and hedge funds.6 The scope of regulation was extended to protect consumers, depositors, and investors against abusive market practices.
The 2010 Toronto Summit proposed a four-pillar regulation reform plan that addressed capital and liquidity, more intensive supervision, resolution of financial institutions, addressing systemically important financial institutions, financial sector responsibility, financial market infrastructure and scope of regulation, and accounting standards.7
The 2010 Seoul Summit proposed some core elements of a new financial regulatory framework, and to strengthen global financial safety nets to overcome sudden reversals of international capital flows.8
The 2011 Cannes Summit proposed to reform the financial sector and to enhance market integrity to reinvigorate economic growth, create jobs, ensure financial stability. Comprehensive regulation measures were considered to be taken on global systemically important financial institutions (G-SIFIs), on shadow banking, and on compensation practices.9
The 2012 Los Cabos Summit emphasized the implementation of the structural and regulatory reform agenda to enhance medium-term growth prospects and job creation, to build more resilient financial systems, and to foster financial inclusion. The reform priorities were granted to areas such as: the Basel Committee capital and liquidity framework; the framework for G-SIFIs, resolution regimes, over-the-counter (OTC) derivatives reforms, shadow banking, and compensation practices.10
The 2013 St. Petersburg Summit concluded the achievements of financial regulation to date as follows: (1) implementation of new global capital standards (Basel III); (2) completion of the necessary frameworks for OTC derivatives to be traded on exchanges or electronic trading platforms, centrally cleared, and reported; (3) identification of global systemically important banks and insurers, and agreement to subject them to heightened prudential standards to mitigate the risks they pose; (4) implementation of agreed tools and procedures for the orderly resolution of large, complex financial institutions without taxpayer loss; and (5) progress in addressing potential systemic risks to financial stability emanating from the shadow-banking system.11 It stated that “coordinated action by the G20 has been critical to tackling the financial crisis and putting the world economy on a path to recovery.”12
What’s going on and the road ahead
Too many things are still in progress, for example, tackling systemic risk, building more resilient financial institutions and ending too-big-to-fail, increasing transparency and market integrity, filling regulatory gaps and addressing the risks from shadow banking, promoting continuously functioning financial markets, strengthening market infrastructure and reforming credit rating agencies, tackling money laundering and terrorist financing, enhancing financial inclusion, financial education, consumer protection, and internet finance.
As long as these are not completed, a stable financial market should not be expected. The ultimate objective of promoting financial regulatory reforms is to reduce moral hazard and systemic risk, and to foster a stable financial system that supports sustainable and balanced economic growth. From my point of view, a stable financial system requires not only adequate regulation, but also appropriate macroeconomic policies, and sustainable and balanced economic growth requires much more, for example, we need finance for innovation, we need finance for infrastructure investment, and we need finance for environmental protection.