By Timothy Geithner
Published: September 3 2009 20:00
A year ago, deep concerns about excessive leverage almost brought down the global financial system. The resulting panic severely damaged economies across the world and wiped out trillions of dollars in savings. Since at least the Great Depression, governments have recognised that financial breakdowns have devastating effects, and have put in place safety nets to limit the fall-out from instability.
These safety nets have a cost, because they insulate financial institutions from the full consequences of their actions and can diminish market discipline. We have sought to contain this moral hazard through regulation. We require financial institutions to maintain reserves and capital buffers in proportion to their risk so that they can absorb losses at their own expense, not at the taxpayer’s.
That regulatory framework failed last year. In the benign atmosphere before the crisis, government supervisors and those in the market underestimated risks building in the system. Major global financial institutions maintained capital levels that were too low, relied too heavily on unstable short-term funding, and their compensation plans rewarded excessive risk-taking. Larger banks often held less capital relative to their risks and used more leverage than smaller banks.
The resulting distortions helped make our global financial system dangerously fragile. As that system grew in size and complexity, it became more interconnected and vulnerable to contagion when trouble occurred.
This weekend, the Group of 20 will gather in London to move forward on reforms to put our global financial system on firmer ground. President Barack Obama has outlined a new regulatory framework that promotes stronger protections for consumers and investors and greater financial stability. Making the system safer requires a comprehensive approach including tougher regulation of derivatives, securitisation markets and credit rating agencies, new executive compensation standards and, critically, more powerful tools for governments to wind down firms that fail. We are working with our partners to ensure similar reforms are put in place around the world.
But at the core of our endeavour must be making capital standards for financial institutions stronger. In a recent paper sent to G20 finance ministers, I laid out my views on the principles that should shape a new international accord on capital standards. The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions. Such an approach requires a broad shift in the way capital and related regulations are designed.
First, capital requirements for banks simply must be higher across the board. Bringing more capital into the banking system is vital. It is equally crucial to hold the largest, most interconnected institutions, whether or not they own banks, to tougher standards than others.
Second, the regulatory framework also should put a greater emphasis on higher-quality forms of capital that best enable financial groups to absorb losses. Consistent with this principle, during good economic times, common equity should constitute a large majority of a bank’s Tier 1 capital.
Third, capital requirements and accounting rules should be more forward-looking and should reduce the system’s pro-cyclicality. The capital regime should require banks to hold a larger buffer over their minimum capital requirements during good times, to be available in bad times.
Fourth, banks should be subject to explicit liquidity standards designed to improve their resilience in the face of runs by creditors and prevent the build-up of liquidity risk in the financial system as a whole.
Finally, we need to improve the rules used to measure risks embedded in banks’ portfolios and the capital required to protect against them, and put greater constraints on banks’ use of leverage to dampen volatility.
Strengthening capital requirements is an essential part of a broader effort to modernise our regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions. That is the most effective way to prevent the world from re-living the events of last autumn. And that is the challenge we must tackle in London, Pittsburgh and beyond.
The writer is US Treasury secretary
Copyright The Financial Times Limited 2009.
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