Fabrizio Saccomanni: Managing international financial stability
Edited text of remarks by Mr Fabrizio Saccomanni, Director General of the Bank of Italy, at a meeting at the Peterson Institute for International Economics, Washington DC, 11 December 2008.
Instability in the age of globalization
"...International financial instability is a subject that has fascinated and intrigued me since when I was a young economist at the IMF and witnessed with considerable anxiety the collapse of the Bretton Woods system on August 15, 1971. The ensuing decade of instability was mostly attributable to the shock of the downward floating of the dollar and the resulting two oil-shocks of 1974 and 1979. After some unsuccessful attempts to rebuild Bretton Woods, the negotiations for the reform of the international monetary system ended in 1976 with the legalization of freely floating exchange rates and that seemed sufficient to fix the problem. A tired US Treasury Secretary, William Simon, commented: “All is well that ends”.
At the beginning of the 1980s, following the process of liberalization, deregulation and privatisation set in motion by Margaret Thatcher and Ronald Reagan, it was widely expected that full international capital mobility would interact with floating exchange rates to ensure adjustment of balance of payments disequilibria and a stable financial environment. Instead, these new conditions paved the way for the emergence of a global financial system in which financial innovation and the ICT revolution combined to produce an extraordinary expansion of financial sectors and markets compared with the real sector in both industrialized and emerging countries. The seeds of instability were thus planted on fertile soil. Indeed since the 1980s financial disturbances have occurred with increased frequency and intensity and have entailed major international repercussions..."
"So, given that the situation has not improved since 2001, what is different and disturbing about the age of globalization? Here are some features that I regard as crucial.
What is different
• The world economy operates under a “market-led international monetary system” in which market forces determine exchange rates and the international allocation of capital. This is the key point of a paper Tommaso Padoa-Schioppa and I wrote for a conference organized by Fred Bergsten and Peter Kenen at this Institute to celebrate the 50th Anniversary of the Bretton Woods System in 1994.3 In the paper we underlined the risk that the increased globalization of financial markets could lead to “disturbances that may have an impact on the stability of the financial system”.
• Global financial intermediaries operate in a highly competitive environment, but with essentially uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events.
• Financial innovation (mainly through securitization and derivatives) has greatly enhanced the ability of global players to manage market and credit risks.
What is disturbing
• There is no stability-oriented anchor for the macroeconomic policies pursued by systemically relevant countries.
• Monetary policies targeted exclusively to consumer price inflation are not likely to prevent unsustainable trends in credit flows and in asset prices (equity, real estate, bonds, foreign exchange).
• The procyclicality of the financial system has been enhanced by factors leading to excessive credit creation followed by sharp credit contraction. These factors are related to both market dynamics (underpricing of risk, overestimation of market liquidity, uniformity of financial strategies and of risk management models, information asymmetries, herd behaviour) and to financial regulation (capital requirement, fair value accounting).
• Perverse incentives and loopholes in the regulatory system have made it possible for financial innovation to transfer credit risks to unregulated entities.
• Widespread conflict of interest, between originators of financial products, credit rating agencies and law firms, has facilitated the dissemination of highly complex, risky and opaque instruments among investors with inadequate risk management culture.
"...In reviewing the response to the current crisis, I will not address the unprecedented array of immediate crisis management measures undertaken by central banks and national Governments in the major countries to underpin banking and financial systems and to support economic activity. I will rather concentrate on the longer-term work being undertaken in the IMF context, in the G20 and in the Financial Stability Forum (FSF) to reform the international monetary and financial system in order to make it less crisis-prone than the present one and more resilient to shocks. On this more systemic issue, a lively debate has developed involving politicians, academic economists and financial analysts. A recurrent theme in the debate is the call for a “new Bretton Woods” and the recent meeting of the Heads of State and Government of the G20 here in Washington last November was seen by many observers as the starting point of a process that could lead to a fundamental reform of the world’s monetary and financial system..."
"...If by a “new Bretton Woods” one means a system built upon the foundations of the “old” one, it may be appropriate to recall how this was shaped. In essence, the Bretton Woods system was based on three main pillars: (i) a stability-oriented anchor for macroeconomic policies, operating through the par-value regime for member currencies in terms of gold and the US dollar; (ii) an obligation to maintain freedom from restrictions for trade and other current international transactions; (iii) the possibility of introducing restrictions on capital movements for restoring equilibrium in the balance of payments. Obviously, in any reform project, these pillars would have to be adapted to the new reality of financial globalization. Leaving aside for a moment the “anchor” question of the first pillar, it must be noted that in the G20 Summit Declaration of November 15, 2008 one can find encouraging language on the issues covered by the two other pillars..."
"...The G20 further outlined the need to strengthen transparency and accountability, to promote integrity in financial markets and to reinforce international cooperation in the regulatory field, broadly endorsing the program and the division of labour agreed upon in this field by the Managing Director of the IMF and the Chairman of the FSF. The FSF, in the words of Chairman Draghi, is working in particular to ensure that financial systems would have more capital, less leverage and would be subject to more effective regulation..."