PARTICIPANTS: Jan Brockmeijer Gaston Gelos Nico Valckx Luis Bandao Marques Keiko Utsunomiya

MS. UTSUNOMIYA: Hello, everybody. Thank you for participating in this press conference on the release of analytical chapters of the Global Financial Stability Report. We are releasing today two chapters. Chapter 2 is entitled “Shadow Banking around the Globe: How Large and How Risky?” And Chapter 3 is “Risk Taking by Banks: The Role of Governance and Executive Pay.”

Let me introduce today’s speakers. On my left is Mr. Jan Brockmeijer, Deputy Director for the IMF’s Monetary and Capital Markets Department who oversees the analytical work in this area. Next to Jan is Mr. Gaston Gelos who oversees the work on the analytical chapters of the Global Financial Stability Report. Then Nico Valckx who is the lead author of Chapter 2 about shadow banking; and then Luis Brandao Marques, the lead author of Chapter 3 on bank governance.

Jan and Gaston will make brief opening remarks and then we’ll take questions online. Thank you.

MR. BROCKMEIJER: Thank you, Keiko, and welcome to all of you here, present and online. We are as usual having a separate press conference on the analytical chapters of the Global Financial Stability Report to emphasize the more structural nature of the work that these chapters represent. You’ll be aware that next we will be presenting Chapter 1, the conjunctional chapter, and that is where the assessment will be provided on how we see the present state of risks in the financial system.

Just going back for a moment, the analytical chapters of the GFSR have had a history over a number of years of keeping track of the different reforms and policy initiatives and their effectiveness in the course of time. And they’ve covered both banking and nonbanking sectors, including the capital markets. And often this work has highlighted the challenges that we face in interpreting and understanding the underlying drivers of these changes and also in obtaining the necessary data to fully understand the implications of the shifts that are occurring in financial intermediation.

The chapters that we are presenting today very much follow in this same vein, with one chapter exploring the ways in which developments outside the traditional banking sector, the shadow banking sector, have developed overtime, increasing the understanding of these activities and importantly trying to explore ways how one can track the risks that emerge in this activity. And the other chapter looks at risk taking within the banking system. And here in particular it looks at the important roles that governance and executive pay play as drivers of such risk taking.

I would just emphasize that both of these chapters represent very important issues. In the case of shadow banking, in the end the bottom line is the tradeoff, the challenge, to reap the benefits of this type of financial intermediation while avoiding undue buildup of systemic risk outside the regulated system. As will be explained in our presentation and in the chapters, the key to this approach we feel is a macroprudential approach to monitoring such risks and international cooperation in the regulatory response.

And in the case of risk taking, we are dealing with the fundamental question of how to align individual incentives with the legitimate interests of other stakeholders and society at large. The good news here is that the analysis points to several policy measures that can be and have, in fact, been taken in some instances to influence this behavior in a more desired direction.

So with these short introductory remarks, I’d like to pass the floor to Gaston Gelos who has overseen the work on these chapters and will introduce them further. Thank you.

MR. GELOS: Thank you very much, Jan. Shadow banking, broadly defined as credit intermediation outside the conventional banking system, has recently attracted much attention. In the U.S., the sector is nearly twice as large as banks. In the euro area, nonbanks are increasingly providing credit to firms as traditional banks are retrenching. In emerging market economies, the growth of shadow banking is outpacing that of traditional banks. In China, the shadow banking sector by now is roughly between 35 percent and 55 percent of GDP.

What do we make of this phenomenon? What is behind it? To what extent is it beneficial? And to what extent does it pose new risks to the financial system?

We tried to assess these issues in a systematic manner, examining the drivers and characteristics of shadow banking around the globe. We find that although shadow banking takes vastly different forms within and across countries, the drivers of this growth tend to be fundamentally very similar. Shadow banking tends to flourish when tight banking regulations encourage regulatory circumvention, when ample liquidity and low interest rates induce a search for yield, and when firms and institutional investors grow and seek ways to invest their cash.

In advanced economies, while activities such as securitization have seen a decline, others such as investment funds have been expanding strongly. Overall our analysis suggests that the financial environment in advanced economies remains conducive to further growth in shadow banking.

In emerging markets, the growth is not confined to a few countries, but it is broad-based. To some extent this is a natural byproduct of the deepening of the financial markets with a concomitant rise in other financial institutions.

Now, what does this mean for risks? In advanced economies we observe a migration of some activities from the banking to the nonbanking sector. This can have beneficial aspects, for example, when shadow banking entities fill voids left by banks. But it also has risks. In advanced economies, entities traditionally considered less risky, such as investment funds, have been growing fast in recent years. However, these funds are now holding a higher proportion of less liquid assets. This can potentially cause problems if redemptions are easy and if many investors want to get out of a fund at the same time. In the United States, shadow banking accounts for at least a third of total systemic risk in the financial sector, as you can see on this slide. This is likely an underestimate, though, since we do not capture the whole shadow banking sector. In the euro area and in the UK, the sector’s relative contribution to systemic risk is much smaller relative to that of banks mainly because these systems are more bank-based.

Among emerging market economies, the large size and fast growth of shadow banking in China stands out and warrants close monitoring. Overall, whether the shift of risk to the shadow banking sector results in an increase or decline in overall systemic risk is difficult to assess at this juncture.

Shadow banking is usually not shadowy, but it still often operates in the shadows in the sense that we lack data about it. An international effort by the Financial Stability Board is making some encouraging progress in data collection. Still, we are worried about what we do not know.

So besides collecting and sharing more data, what needs to be done to address the challenge? Well, the chapter advocates a macroprudential approach to the monitoring of risk in the shadow banking sector in which specific entities and activities are not seen in isolation, but are assessed by the degree to which they contribute to systemic risk. The chapter proposes a concrete framework in which microprudential and macroprudential regulators work together to overcome the problem that activities may simply shift from more to less regulated sectors. International cooperation is also crucial. Regulatory tightening in one sector, for example, may lead to migration of activities to others with laxer rules.

Our second chapter examines the relation between bank governance, executive pay, and bank risk taking. Although the causes of the global financial crisis are complex, there’s a broad consensus that excessive risk taking by some banks was a contributing factor. Since then, reforms are underway to address the issue. To be effective, however, such reforms must be based on a thorough understanding of what really drives the risk taking in banks. This chapter contributes to that understanding through a novel empirical investigation relating various measures of risk taking in banks around the world to bank characteristics of governance, risk management, pay practices, and ownership structures.

The first thing to note is that banks are special. The typical tensions of governance in corporations may make shareholders versus managers are only one part of the problem in banks. Even if shareholders manage to align the incentives of bank CEOs and their staff with their own, these incentives may not necessarily be in the best interests of bond holders and depositors. The reason is that shareholders have limited liability, which means that they have limited downsides to their investment, but receive all the gains. For banks, this is a bigger problem than for other companies because deposit insurance and explicit or implicit government guarantees mean that market discipline does not work very well. But it gets worse.

A more important conflicting interest is between shareholders, managers, and debt holders on one side, and society at large on the other side. While the risk taking is an essential part of a bank’s mission, banks may take more risks than is socially desirable, as evidenced by the recent global financial crisis. In our analysis we find that the strongest link is between board independence and lower risk taking. In addition, although the level of compensation is not consistently associated with the degree of risk taking, its composition is. A larger share of long-term pay for CEOs is related to lower risk in banks. The existence of risk committees is also associated with lower risk taking. Banks with a larger share of institutional investors are also less risky.

The interesting thing is that these effects are economically important compared to say -- you can compare them to variations in Tier 1 capital ratios, for example, to illustrate that and this is shown on this slide. So the point is that these things matter economically. They don’t only matter at the margin; they matter substantively.

The empirical results support some of the policy measures currently being debated or implemented and suggest some new ones. First, banks should better align compensation with the overall risk. They could link compensation better with their credit worthiness by, for example, paying managers partly with long-term bonds. Second, variable compensation should be deferred in time and include clawback provisions, which are contractual clauses that may force bank managers to return past bonuses in certain cases. Third, the boards of directors of banks need to be independent of bank management and should establish risk committees. Fourth, policymakers should consider measures to ensure that boards take into account not only the interests of shareholders, but also those of debt holders. Fifth, financial supervisors have a role in ensuring that boards conduct effective oversight of risk taking in banks and that banks’ risk cultures are consistent with financial stability. Thank you.

MS. UTSUNOMIYA: Thank you, Gaston. Now we would like to take questions. There’s one online. “Can shadow banking serve as a substitute for regular banking for countries facing regular banking restrictions such as Russia?” He has another question. “How large is shadow banking in absolute terms?”

MR. GELOS: Thank you. We did not study the role that shadow banking can play in such specific circumstances. It really depends on the nature of the country and the measures that we’re talking about.

In terms of the size of the shadow banking system around the world, it’s roughly estimated at over $70 trillion. So it’s quite large.

MR. BROCKMEIJER: I might just add the extent to which shadow banking activities can complement the role of traditional banks, as Gaston said, very much depends on particular circumstances. But it is obvious that the possibilities for it to do so are greatest when there are particular constraints on banks to perform their role. But if there is, if there are conditions in the economy where there’s a healthy demand for credit that through the traditional banks cannot be accommodated, then certainly an additional flow of credit that can be generated in a responsible manner through shadow banking entities can be very helpful. Thank you.

MS. UTSUNOMIYA: We have received another question online. “What would the IMF like to see happen with the findings of the report?”

MR. GASTON: Well, there are various measures that I just alluded to that we would consider to be helpful. In the area of shadow banking that would imply more efforts to collect and disseminate detailed data on shadow banking activities and entities. Again, it’s very important to understand what’s going on there to be able to assess risks.

Second, we propose -- and this is in line with the thinking of the FSB, for example -- we propose a kind of macroprudential approach to monitoring and addressing shadow banking risks, meaning that macroprudential supervisors should be on the lookout for activities or entities that can pose risk to the system and then work with microprudential regulators to really tackle them. And how to tackle them will really depend on the nature of the activity, and you have to look both at activities and entities in this context. And then this needs to be continuously reassessed because this is a very dynamic sector. So this is, in essence, what we recommend in terms of shadow banking.

Turning to the issue of bank governance, I just mentioned a number of things that we would consider desirable and some of them are being implemented. I mentioned the linking of compensation with the overall risks of the bank, meaning also credit worthiness. I mentioned the deferral in time of compensation so that bankers are not rewarded for taking short-term bets, but for creating long-term value. And in that context it’s also important to have things like clawback clauses, bonus-malus arrangements as a fourth.

We think it’s important that boards are independent or have at least a significant share of independent board members. Risk committees seem to help steer the banks’ risk taking well. And there is one recommendation, which is new and hasn’t been discussed that much, but we consider is important, namely that policymakers should consider ways to ensure that debt holders’ interests are also represented on boards.

So I think these are some of the key elements.

MS. UTSUNOMIYA: Here is the next question. “Could you elaborate a little bit on the shift to less well understood and monitored activities? What does it mean in practical terms and does it apply to any specific countries?”

MR. GASTON: Yes. One activity or one shift that we highlight in the report is lending, lending to corporations, lending to firms. Banks in Europe have been deleveraging, retrenching, from particularly long-term lending and there are new entities all over that are stepping in and providing loans to companies. We see that happening in Europe quite a bit, but also in the U.S. We have a chart in the report that looks at mutual fund loans in the U.S. It’s growing quite rapidly.

We also see new developments such as peer-to-peer lending, which is still small, but it’s again a form of credit intermediation that’s shifting from banks to a new form of providing credit to companies.

And then we see some more specialized activities, a mortgage service rise in the U.S. and various more technical and specific activities that we discuss in the report. So there’s a range. But if I had to highlight one, I would say lending is a particularly growing activity.

MS. UTSUNOMIYA: We have no more questions, so this will conclude our press conference. Thank you very much, again, for your participation. Let me remind you that the release of Chapter 1 of the GFSR will be next week on Wednesday, October 8, at 9:00 Washington time. Thank you.

* * * * *