As prepared for delivery

Good evening. Let me begin by thanking the CFA society of Washington for having invited me to their annual dinner, and the organizers for making this a pleasant evening in such wonderful surroundings.

It is apt that we come together here in this splendid Hall of the Americas ballroom, a place built for ballroom dances like the Viennese Waltz. Like the Viennese Waltz, the work of CFAs requires strong technical skills, innate talent, and an elegant touch.

As we all know, CFA accreditation is tough to attain, and rightly so. Financial system stakeholders, including investors, policymakers, and tax payers, expect high standards of probity and rigor of those managing other people’s money and dispensing financial advice.

The IMF also shares a concern for smooth functioning of markets and sound financial institutions. Safe and robust banks operating in a resilient, well-regulated financial system play a key role in the economy and society, intermediating funds between savers and investors, and supporting investment, trade, employment and prosperity.

One of the key lessons of the recent global financial crisis is that banks must improve their ability to manage risk, so they do not wreck the economy instead of helping it thrive. The present uncertain economic outlook makes this even more important. To do so calls for both a stronger risk management culture in individual firms as well tighter regulation and supervision. Current regulatory reforms are designed to encourage a fundamental shift towards lower-risk bank business models that support economic growth. This means that banks and other financial institutions will need to reassess their involvement in overly complex, opaque activities and transactions. It does not imply the end of financial innovation; rather, it is a way to ensure that innovation does not lead to financial instability and future crises, crises where the taxpayer has to pick up the tab.

We have learned the hard way that when the music is playing, bankers want to dance. The next time we hear the Viennese Waltz, we all need the regulators and supervisors to lead not follow. Tonight, I would like to give you my views on the state of the regulatory reform process and the environment in which it is unfolding. Both have profound implications for the asset management business.

Global Outlook

There has been some good news lately. Global financial market conditions have improved in the past six months, prompting a rally in risk assets and a broad reduction in financial stability risks. These favorable conditions reflect a combination of deeper global policy commitments, renewed monetary stimulus, and continued liquidity support for banks. Together, these actions have enhanced confidence, reduced tail risks, and bolstered the economic outlook.¹

Nevertheless, global economic conditions have remained subdued. It is clear that policymakers need to take further actions to address underlying stability risks and promote continued improvement in the economic outlook. This will require further balance sheet repair in some financial sectors. Banks will need to remove the dead wood and address asset quality problems, with some having to increase provisioning for bad loans and add fresh capital. Some banks will prove to be non-viable and will need to be wound down in an orderly manner.

This banking sector cleanup must be complemented by a smooth unwinding of public and private debt overhangs. If these medium-term challenges are not adequately addressed, the recent rally in global markets may prove unsustainable. And the still fragile confidence in banks and the wider financial system could turn into fear, which could trigger a renewed sense of crisis.

Regulatory Reform

One of the sources of recent confidence gains—the G-20-led global regulatory reform process—must be protected. Policymakers need to maintain the reform momentum and start implementing the new rules. There has been significant progress. Most G-20 countries are starting to implement the so-called Basel III capital rules designed to enhance the quantity and quality of loss-absorbing bank capital. The Basel III new bank liquidity standard has been finalized. The framework for identifying and setting capital surcharges for globally systemically important banks (G-SIBs) has been agreed and will be extended to domestic SIBs by 2016. And guidance on the monitoring and regulation of money market funds has been published.

But is the global financial system any safer than it was five years ago? I believe the answer is yes, but is it safe? Not yet. We still have much work to do. Think of it as a huge safety net that has been mended and strengthened, but still has enough holes that we cannot yet feel protected.

The progress of agreeing and implementing the global regulatory reform agenda has been viewed as gradual. In many countries, banking systems remain weak the pace of reform needs to be adjusted to ensure banks are able to regain strength and lend to the economy. But in some areas, the gradual progress of reform reflects more a lack of agreement on specific issues, where a coherent global consensus has yet to emerge and the pull of national interests remains strong. That is more problematic.

Delays and dilutions to the agreed reform agenda provide a continuing source of vulnerability; they add to regulatory uncertainty and weigh heavily on the financial sector. Banks and other financial entities are unable to make longer term business decisions with the potential that funding and credit markets become strained, raising overall systemic risk and spilling over to the economy.

Let me now address in turn the critical issues we face, beginning with bank capital and liquidity:

Bank Capital and Liquidity

On capital rules, the differential speed and lack of consistent implementation at the national level could add to delay and dilution of such global minimum standards. A particular worry is the delay in implementation of Basel III in the EU and the U.S. Another concern has been the significant differences across countries in banks’ calculations of basic Basel III metrics such as risk-weighted assets. That goes to the heart of distinguishing which banks are adequately provisioned with appropriate capital buffers and which banks need to issue greater loss absorbing capital to cover asset quality problems.

The short-term liquidity metric—the liquidity coverage ratio—has been finalized with a wider set of high quality assets being included and a longer phase-in of the standard from 2015-2019. Implementation of this liquidity standard and the finalization of the longer term liquidity metric, the Net Stable Funding Ratio, are the next key steps.

On these big ticket Basel III items, policymakers must encourage a steady, and internationally consistent, buildup of the new capital and liquidity buffers to minimize the risk of banks seeking out jurisdictions with the most lenient rules. IMF research has shown that larger, shock-absorbing capital and liquidity buffers contribute to lower financial stress and higher and more stable economic growth.² This is particularly true in cases where these buffers consist of high-quality capital and more liquid assets.

Over the Counter Derivatives

Less progress has been achieved regarding the reform of the derivatives market. The wider use of derivatives clearing houses, known as central counterparties, will increase transparency in the over-the-counter derivatives market and will help make the financial system as a whole less risky. But national authorities have not met recent deadlines to implement these reforms, reflecting the legal complexities of this opaque industry. Failure to ensure all standardized derivative contracts are traded through organized platforms and cleared through central counterparties may mean complex derivatives continue to grow outstripping banks’ internal risk controls. The resulting disarray could see investors, regulators, and banks having to buffer against large losses and mitigate systemic spillovers.

Too Big to Fail

Some banks are still considered “too-important-to-fail,” due to their size, complexity, and interconnectedness. Policymakers must remove this unacceptable moral hazard. The preparation of firm-specific recovery and resolution plans for Globally Systemically Important Financial Institutions (G-SIFIs) needs to proceed and jurisdictions should implement reforms to meet the new FSB led international standard on Effective Resolution Regimes.³

Resolution regimes

The IMF encourages globally systemic financial centers to agree on cross-border resolution regimes. The United States and the United Kingdom have recently become trail-blazers in this area. They have agreed to coordinate their contingency plans for winding down failing cross-border banks. I for one, strongly support jurisdictions’ actions to remove obstacles to cross-border coordination and move ahead in outlining strategies for effective cooperation in a cross-border resolution, including in scenarios where public funding would be needed, at least on a temporary basis.

National Initiatives (Structural Measures)

Responding to intense political pressure to act to contain the risks posed by banks, national and regional authorities have proposed initiatives to limit the size and scope of firms’ activities (such as the Liikanen, Vickers and Volcker proposals). While these measures answer the call to do something tangible, they all lack as yet a deep assessment of their costs and benefits and their global impact. Coordination on such measures is essential to prevent unintended consequences, incompatible national schemes, and regulatory arbitrage, especially for cross-border banking groups.

Shadow Banking

In the sphere of shadow banking, it is a positive that guidance on the monitoring and regulation of money market funds has been published. But, there remains little consensus on implementation. There is some urgency here, in particular as policy recommendations are due in time for the G20 St. Petersburg Summit in September 2013.

Accounting and Disclosure

One area particularly troubling to many global stakeholders is the lack of movement towards a single set of global, high quality, principle-based financial reporting standards, which were formally called for by the G20.

Yes, in the past few years there have been good strides towards improving accounting for off-balance sheet securitizations and enhanced disclosures of credit risk and transfers of financial assets. Moreover over 100 countries including the European Union have adopted the International Financial Reporting Standards (IFRS), but nagging delays and convergence problem remains in four areas. First, the adoption of the IFRS by other countries including major economies such as U.S. and Japan has not happened. Second, there is an inconsistency in the application and implementation of the IFRS worldwide which inhibits comparability and transparency. Third, there is glaring lack of convergence between the IFRS and U.S. GAAP. Finally, the IFRS Foundation has yet to fully engage national accounting standard-setting bodies on detailed matters.

The IMF’s concern over the convergence between the IFRS and U.S. GAAP is twofold. First, the overall progress has been slow and the convergence has missed the G20 target. Given the impact on the financial market of the four convergence projects, timely completion is highly desirable. Secondly, the diverging views of the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) on the credit loss recognition models based on expected rather than incurred losses is a major setback to the convergence process. That will leave European and U.S. banks estimating loan loss provisions with different methodologies. It is not an academic exercise. It materially affects a financial institution’s assessment of asset quality, its valuation and it informs investors and assures regulators of an institution’s financial strength.

In fact the U.K. authorities have been so concerned about the integrity of UK bank published accounts that they have undertaken an asset quality review of the banks to determine if valuation and risk weights of assets are appropriate. This will go some way to inform regulators about banks’ appropriate provisioning and loss-absorbing capital buffers. The UK are not alone in conducting such exercises.

The Norwegian Ministry of Finance (MoF) has asked the regulator to examine risk weights used for mortgages. The Norwegian MoF has concerns on the systemic implications of currently low mortgage risk weighted assets in the context of bank capital levels, rapid house price appreciation and the costs of a banking crisis.

Moreover, under proposals for Banking Union and the Single Supervisory Mechanism (SSM) in the Eurozone, the European Central Bank (ECB), as it assumes supervisory responsibilities, would undertake an asset quality review to address the problem of losses on legacy assets⁴.

The IMF is strongly supportive of such investigations to address thoroughly the problem of legacy assets. Studies by the IMF and the Basel Committee on Banking Supervision (BCBS) and the European Banking Authority (EBA) on European Banks’ have found a wide variation in bank risk weights even for banks with similar risk-profiles.⁵ Some of this variation is due to the banks use of internal models and valuation differences on key portfolios, and some of you will be well aware of this. Investigations will continue with regulators looking at deeper granular issues of credit risk parameter variation. So much remains to be done to add transparency to banks’ published accounting metrics.

Notwithstanding such doubts ,and just when policymakers felt all hope was lost in determining the veracity of bank published financial data, the work of a private sector group, the Enhanced Disclosure Task Force (EDTF), formed at the encouragement of the FSB suggested some key initiatives to improve the clarity, comprehensiveness, consistency, comparability and timeliness of financial reporting by banks.

The IMF is calling on banks across the globe to implement the EDTF standards as an important first step to overcome deficiencies over currently reported data. I am heartened that the CFA Institute has been particularly active in the EDTF both through its membership and through its earlier published work on enhanced risk disclosures in 2011. No doubt further work will be required to increase the granularity of risk reporting, including publication of key risk parameters such as probabilities of default, and loss given default to further explain risk weight variation across banks globally. This is something the EBA will be undertaking soon and we should all support such work.

Supervision

I don’t want you to leave today simply with the impression that rules and regulations are all that that matter. We also need stronger supervisors who can provide the requisite oversight and enforce the new rules and regulations in a fair and effective manner. Supervision of a large internationally active firm is extremely challenging. Many of them are global in nature and often include complex activities and booking models that can involve trades originated in one jurisdiction with various sub components being executed and booked in one or more other domiciles⁶. For supervisors, keeping up with the innovations and engineering in our financial institutions will always be a challenge. The IMF supports the establishment of supervisory colleges, which are multilateral working groups of supervisors formed for the purpose of enhancing effective consolidated and cross-border supervision of a particular international financial group on an ongoing basis

The potential for spillovers between home and host countries of a large international financial groups and banks are very real. Policymakers largely ignored these spillovers and systemic risks in the run-up to the recent global financial crisis. Many national authorities are pressing ahead with the implementation of new macroprudential policies to identify and mitigate risks to the financial system as whole⁷. This requires national decisions on the institutional and operational aspects of these policies. The IMF has been heavily involved in the development of the new macroprudential frameworks and policies. And we will support their implementation by integrating the new concepts into our surveillance and technical assistance work.⁸

Governance

Let’s be honest. No amount of regulation or intensive supervision will be able to catch poor risk practices, malfeasance, poor financial conduct or unlawful activity everywhere and always. As Mark Carney has recently remarked “virtue cannot be regulated.”⁹ Over the last year or so a few major foreign banks and their employees have been exposed to large conduct costs and fines. Some of them have been exposed to charges of criminal activity, including manipulation of financial benchmarks such as LIBOR, money laundering, unlawful foreclosure and unauthorized use of client funds. There may still be headwinds in this area for the foreseeable future as regulators carry out further investigations.

The vast majority of banks and their employees are hardworking and honest. Through their work they play a key role in supporting the real economy. It is unfortunate that all banks and their employees are being tarred with the same brush.

There is a morality tale here resembling the recent discovery of the remains of England’s Richard III”. Shakespeare's Richard was a physically misshapen, tyrannical usurper, but now we learn he may have been more of a reformer and we got confirmation of how he died at the hands of the Tudors.

No one would wish such a harsh fate for bankers who fall from grace, but we should seek better governance with consequences for excessive risk taking. Better risk management and curbing the incentives for excessive risk taking is critical to maintaining financial stability. This is an issue for supervisory follow up but more importantly for the shareholders and management of institutions to continue to grapple with. We support initiatives to align risk with reward and encourage countries to pursue policies in line with the FSB principles on compensation.

Conclusion

I hope I have convinced you that much still needs to be achieved in the area of financial and regulatory reform. The IMF, together with other global stakeholders, will help the G20 identify key obstacles and bottlenecks and establish an action plan for their removal. We need to ensure that regulatory reform strengthens global financial stability so that our financial system supports our macroeconomy, and helps bring the growth, trade and jobs we all desire.

The IMF supports whole-heartedly the efforts by the FSB and standard setters, and welcomes the recent establishment of the FSB under the authority of the G20 as a legal entity with greater financial autonomy and enhanced capacity to coordinate the development, harmonization and implementation of global financial regulatory policies.

I hope that we can count on your support for this very important work. As practitioners on the very front line, you (and CFA’s everywhere) will play an essential role in the success of the reform process.

Thank you

¹ See, Global financial Stability Report, Chapter 1, April 2013, forthcoming for more details.

² Chapter 4: Changing Global Financial structures: Can they Improve Economic Outcomes? GFSR, October 2012, IMF.

³ Publications Resolution Regimes: http://www.financialstabilityboard.org/list/fsb_publications/tid_146/index.htm

⁴ Speech by Vítor Constâncio, Vice-President of the ECB, on the Establishment of the Single Supervisory Mechanism; the first pillar of the Banking Union 11th Annual European Financial Services Conference, Brussels, 31 January 2013, see. http://www.ecb.int/press/key/date/2013/html/sp130131.en.html

⁵ Vanessa Le Lesle and Sofiya Avramova, Revisiting Risk-Weighted Assets: Why do RWAs Differ Across Countries and What can be Done About It?” IMF Working Paper, WP/12/90. Basel Committee on Banking Supervision: Regulatory consistency assessment programme (RCAP) – Analysis of risk-weighted assets for market risk, February 2013, www.bis.org/publ/bcbs240.pdf. European Banking Authority: Interim Results of the EBA review of the consistency of risk-weighted assets, Top-down assessment of the banking book, EBA, 26 February 2013

⁶ Sarah Dahlgren: Supervisory Reform for Global Banks, Federal Reserve Bank of New York, February 12, 2013

⁷ Jose Vinals iMFdirect blog: Macroprudential Policy – Filling the Black Holes. http://blog-imfdirect.imf.org/2011/04/08/macroprudential-policy-filling-the-black-hole/ . April 8 2011.

⁸ Jose Vinals iMFdirect blog: Time For A Spring Cleaning: The Global Economy Will Thank You, February 25 2013.

⁹ Mark Carney: Rebuilding Trust in Global Banking, Bank of Canada, 25 February 2013.