back

Speech by Jean-Claude Trichet,
Governor of the Banque de France

International Financial Reforms and the Global Agenda for Good Governance

It is a great pleasure for me to take the opportunity of this first Conference in Paris to present some views on international issues. I would like to concentrate on the following points:

• the strengthening of the architecture of the World Financial System is being debated in international fora; many ideas have been exchanged and it is now possible to draw some lessons, especially as regards the macro-economic framework and policies;
• nevertheless, further efforts are still needed, in the fields of transparency or of private sector involvement in the prevention and the resolution of crises ; the progress toward a more coherent governance of the international financial system will help reach further progress in these areas.

1. The international financial reform and the macro-economic framework : where do we stand ?

Several complex issues, often inter-related, are currently debated. On each of them, the Eurosystem (i.e. the ECB and the eleven NCBs of the Euro Area) has elaborated a common view since these issues -namely monetary and exchange rate policy, financial stability - are part of the traditional areas of competence and expertise of the central banking community.

I will in turn deal with the following topics:

• the orderly liberalisation of capital movements
• reserve and debt management
• transparency and multilateral surveillance
• the choice of the exchange rate regime

1.1 Orderly liberalisation of capital movements

The liberalisation of capital movements benefits both individual countries and the world economy: it enhances long-term growth potential and improves savings/investments allocation. However, the following principles need to be carefully taken into account in order to minimise risks:

• First of all, the restructuring of domestic financial systems and the strengthening of domestic regulatory and supervisory frameworks are pre-conditions of utmost importance: everyone knows the core role of domestic financial systems in the intermediation of capital flows and in the building up and propagation of crises. As a consequence, emerging economies should bring their domestic financial systems in line with regulatory and supervisory minimum requirements prevailing in mature economies. In that respect, the international community plays an important role by developing and/or certifying internationally agreed standards and monitoring their implementation :
   
  among these standards, one should quote the Core Principles for Effective Banking Supervision developed under the aegis of the Basel Committee on Banking Supervision; they define the basic conditions for a supervisory system to be effective;
   
  the Financial Sector Assessment Programs (FSAP) developed by the IMF are a core instrument for identifying financial systems' vulnerabilities, especially in emerging countries, and providing for a better coverage and analysis of member countries' financial systems.
• Secondly, the liberalisation process should be carefully sequenced, starting from the more stable capital flows (e.g. FDI) ; this is an issue of key importance as illustrated in recent crises by disruptive capital outflows generated by external debts highly concentrated on short-term maturities

1.2 Improved reserve and debt management

To mitigate the volatility of capital flows and especially short term flows and reap the benefits of capital account liberalisation, one should adopt a risk management strategy that involves a system for monitoring and assessing the risks and liquidity of the economy as a whole, including at a sectoral level.

Irrespective to the exchange rate regime and maturity profile of the public sector liabilities, debtor countries may have to maintain a relatively high level of external reserves as a buffer against external shocks, for instance by ensuring that external reserves exceed the sovereign external debt falling due in the coming year (the "Guidotti rule").

The international community may assist in developing best practices related to reserve and debt management : let me quote for example the more stringent publishing obligations on net foreign exchange reserves adopted within the context of the IMF Special Data Dissemination Standard (SDDS) or the IMF and the World Bank initiative to promote good practices in reserve and sovereign liability management.

As recommended by the FSF Working Group on Capital Flows, an improved risk management by the banking sector is desirable, particularly as regards banks in emerging markets receiving flows and international banks extending cross-border credit, with the help of revised Guidelines from the Basel Committee on managing liquidity risk.

Greater risk management by non-bank financial and non-financial institutions to ensure prudent behaviour is also recommended , including actions by national authorities to promote good corporate governance.

To implement a strategy assessing the liquidity risk and foreign exposure of the economy as a whole requires adequate balance sheet information from both the public and the private financial and corporate sectors.

1.3. Transparency and enhanced surveillance

Ensuring more stable capital flows to emerging markets hinges on efficient international capital markets ; it depends on the availability of reliable and timely information both on debtor countries and market participants. Initiatives launched by the international community to enhance transparency in assessing economic and market developments have to be supported. The public sector as well as International Financial Institutions have to lead by example in this area. However, there is also a need to pursue parallel efforts to enhance transparency of private sector market participants.

• As regards the public sector, many efforts have been achieved: I could mention the design by the IMF of Codes of good practices on transparency in the field of fiscal policy or monetary and financial policies, the promotion by the IMF of statistical standards (the so-called SDDS), e.g. demanding practices of disclosure of exchange reserves.
• International Financial Institutions have also continued to progress toward greater transparency. More specifically, as far as the IMF is concerned, greater transparency in its assessments of members' policies should improve the effectiveness of its surveillance and Fund supported programs and enhance public dialogue on members' policies. Several initiatives have been launched among which: the participation of 60 countries on a voluntary basis in the pilot experience for the release of IMF article IV reports; the Fund has decided a widespread release of documents such as Public Information Notices following article IV consultations, letters of intent and other papers underpinning Fund financial programs.
• As far as the private sector is concerned, progress may take the form of improved disclosure, more demanding statistical reporting or extended requirements for non-transparent segments of the financial markets, paying due regard to cost/benefit considerations.

Efforts to improve transparency have undoubtedly a bearing on the way surveillance is implemented, an issue of crucial importance in the aftermath of recent financial crises and in the context of rapid changes in the global financial system. The focus of surveillance must be defined in terms of the IMF's responsibility for the promotion of external sustainability: it encompasses first issues relating to the sustainability of a country's balance of payments, its overall macroeconomic developments and policies and issues that bear on vulnerability to crises. Important progress is being made to strengthen surveillance in key areas, including financial sector issues, external debt and capital account developments; a sharper focus is also devoted to exchange rate policies.

1.4. Choice of the right exchange rate regime

The sustainability of any exchange rate regime depends on its consistency with a country's domestic macroeconomic and structural policy framework. In other words, no single exchange rate regime is appropriate for all countries in all circumstances. The choice of an exchange rate regime should be guided on the following principles:

• Corner solutions , as currency boards or "pure" floating exchange rates, are not the only available options. As regards free floating rates, they may help to accommodate volatile capital flows and asymmetric shocks; however, they might not prevent misalignments leading to balance of payments desequilibrium , they might prove disruptive for the real sector of small open economies, which often lack the size for developing the necessary market infrastructure to cope with exchange rate instability. As regards currency boards, they can be warranted only under specific circumstances (e.g. the soundness of the financial system).
• Requirements for sustaining pegs have become very demanding in an environment of high capital mobility; however, " intermediate solutions " may still remain a relevant option for a number of countries; I think about small open economies with close financial and trade links to a partner country that maintains price stability (especially when seen against the background of growing regional economic integration) or for less developed countries experiencing high inflation. In such cases, anchoring the currency provides a simple and credible rule for monetary policy.
• In cases where countries need to respond to large capital inflows and related risks of inflation and real appreciation, greater exchange rate flexibility might become desirable. The success of this policy will depend on whether macroeconomic stability and financial soundness can be maintained and whether monetary policy can be conducted in an independent and transparent manner. In this context, closer integration into international capital markets together with greater transparency on foreign exchange reserve positions will have a disciplinary effect on economic and monetary policies.

As a provisional conclusion for this first part, I would like to stress that the global economy is doing much better than one and a half year ago. This calls for two "hat tricks":

• One to the Asian economies themselves which have demonstrated a remarkable capacity to adjust in a very short span of time.
• The second to the IFIs, and in particular the IMF, which in the most difficult circumstances demonstrated lucidity, determination and courage. I know that saying so is not fashionable, but it is precisely because it is not fashionable that it is worth saying it.

However, on many issues, progress still needs to be done. I would like now to focus on these issues to specify what can be done now to reach more concrete steps.

2. The international financial reform and the good governance : what is still to be done ?

I see four main priorities:

• The implementation of the recommendations recently issued by the Financial Stability Forum;
• The implementation of Standards and Codes;
• The ongoing design of a new capital adequacy framework;
• The progress on private sector involvement in crisis prevention and resolution.

2.1. Recommendations of the FSF

The Financial Stability Forum that brings together supervisors of major financial centres has recently issued a number of recommendations in two main areas:

• Highly leveraged institutions (HLIs)
• Off-shore financial centres (OFCs)

I will in turn deal with these two issues.

• As regards HLIs, the FSF report recognises that "high leverage - and its interaction with other elements of risk- can produce significant concerns from the perspective of the financial system as a whole". In order to constrain leverage at HLIs, it calls for several orientations among which:
   
• The adoption of or the improvement in the national legal framework to improve mandatory disclosure requirements on large HLIs; the US were urged to adopt such disposals and OFCs are invited to implement complementary disposals to ensure that HLIs do not escape from disclosure requirements.
   
• Improvements in counterpart risk management to cope with risks raised by the accumulation of excessive leverage and strengthening of risk management by hedge funds.
   
• Enhanced regulatory oversight of HLI credit providers, to make sure that the latter comply with sound practices. In particular, the FSF calls for the development and the adoption by market participants of guidelines for good practices in foreign exchange markets.
   
• Concerning the implications of Offshore Financial Centres (OFCs) for global financial stability, the FSF report on OFCs noted that offshore financial activities are not inimical and/or detrimental to global financial stability provided they are well supervised and supervisory authorities co-operate. Some OFCs are well supervised and co-operate with other jurisdictions. At the same time, OFCs that are unable or unwilling to adhere to internationally accepted standards for supervision, co-operation, and information sharing create a potential systemic threat to soundness and transparency in the global financial system.

To address the concerns posed by some OFCs, the FSF recommends to:

• set out a process for assessing OFCs adherence to international standards, for which the IMF should have a central role,
• identify standards for priority implementation and assessment,
• draw a menu of incentives that could be applied by national authorities to enhance OFCs adherence to international standards,

To support these recommendations, a survey of banking, insurance and securities supervisors in both onshore and offshore jurisdictions was conducted. The results of this survey, which grouped OFCs into three categories reflecting their quality of supervision and degree of co-operation, were published.

2.2. Implementation of standards and codes

Standards help promote sound financial systems domestically and stability in the international financial system. They play an important role in strengthening financial regulation and supervision, enhancing transparency, facilitating institutional development and reducing vulnerabilities.

The strategy considered by the FSF Task Force on Implementation of Standards involves:

• first, a prioritisation of Standards and Codes : given limited available resources there is a need to identify the key standards taking into account country circumstances. The Task Force identified 12 of such Codes and Standards out of 65.
• second, the design of incentives to implement them : the commitment to implement Codes and Standards will be reinforced if market participants reflect information on observance of Codes and Standards in differentiated credit ratings; market incentives would be enhanced by the disclosure of public assessments of progress in implementing Standards (the Report on Observance of Standards and Codes - ROSC), by the improved understanding by market participants of international Standards and by official incentives provided by the international community (e.g. the extension of implementation of Codes and Standards as criteria allowing access to IFIs resources)
• third, the IMF has authority to play a central role in the area of co-operation between standard-setting bodies, especially in designing methodologies for assessing observance of their respective Codes and Standards as already done for the Basel Core Principles by the Core Principles Liaison Group. Furthermore, through the IMF/World Bank Financial Sector Assessment Report, it should contribute to the identification of structural financial vulnerabilities which should help determine which codes should be implemented first. Last, it will help assessing the observance of Standards and Codes in co-operation with the standard setting bodies.

2.3 A new capital adequacy framework

As an important step towards a better functioning of the international financial markets, I would like to mention the ongoing work on a new capital adequacy framework which is to replace the previous "Capital Accord", issued in 1988. This new framework is designed to better align regulatory capital requirements to underlying risks and to recognise the improvements in risks measurement and control. It consists of three pillars:

• a minimum capital requirement, which seeks to develop and expand on the standardised rules set forth in the 1998 Accord : the objective is to have a more comprehensive and risk-sensitive treatment of credit, with the possibility for banks to use their internal rating system;
• the supervisory review of an institution's capital adequacy and internal assessment process: the second pillar will seek to ensure that a bank's capital position and strategy is consistent with its overall risk profile and strategy and, as such, will encourage early supervisory intervention if the capital does not provide a sufficient buffer against risk;
• effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices : effective market discipline requires reliable and timely information that enables market participants to make well-founded risk assessments.

2.4. The progress on private sector involvement in crisis prevention and resolution

The principle that the private sector should be more systemically and directly involved in the prevention and resolution of financial crises is broadly shared by the International Financial Community. The main objectives of PSI is to avoid moral hazard and other distortions in the functioning of international financial markets and to facilitate more orderly adjustments in case of crisis.

Market participants should be encouraged to assess adequately the risks involved in investment decisions on the basis of a country's underlying fundamentals, including the soundness of its financial system, rather than on the expectation that official flows will possibly support repayments to them in times of crisis. Private sector involvement must rely on the working of market incentives for capital to be effectively priced according to the financial risks involved.

If we look at what has been done so far in this area, we observe that progress has been mainly made on the less co-operative solutions of the spectrum of proposals that have been put forward for private sector involvement. More efforts should be devoted to the promotion of approaches that overcome co-ordination problems, among creditors, or between creditors and borrowers. Debtor countries and private creditors should seek in normal times to establish strong and continuous relations, including better channels of communication. Instruments to foster this include collective action clauses, private contingent credit lines, call options on inter-bank credit lines and the removal of put options from bond contracts. This could be achieved by increasingly linking access to IMF financing to the adoption of such mechanisms.

Industrial countries can play a facilitating role for private sector involvement, in particular by seeking to identify and remove all regulatory and legal obstacles to the use of collective action clauses by all borrowers that raise capital in their markets.

While pragmatism should prevail as to the form of the private sector involvement in crises resolution, there is a need for general principles to highlight the roles and responsibilities of the public and private sectors. such principles have been defined in the framework adopted by the G7 at the Köln Summit in June 1999. I would like to stress three of these principles:

• first, the main focus should be on the medium term sustainability of a country's financing position;
• second, in seeking this, the objective should be to achieve comparability of treatment between and within a country's bilateral official and private creditors;
• third, there should be a clear allocation of responsibilities between the various players involved in the resolution of crises : in particular, the IMF should not be directly involved in bilateral negotiations between the debtor country and its creditors.

To implement these principles, the main following tools and procedures could be used:

• the IMF should concentrate on agreeing with the crisis country a programme which ensures adjustment and financing over the short and medium-term ; in particular, the IMF should indicate the relative contributions of official finance, private sector finance and domestic economic adjustment required to fill the gap;
• the country should open negotiations with all creditors;
• the IMF, before disbursing its share of financing, should review and assess the country's efforts to secure the contributions from private creditors required to ensure medium-term sustainability;
• failing to secure the needed contribution from private creditors could lead to a revision of the programme to require additional domestic adjustment;
• the IMF could decide to lend into arrears if the country has suspended payments while seeking to work co-operatively and in good faith with its creditors;
• if a debtor country would decide to take temporary measures to restrict, in exceptional circumstances, capital flows, it should preliminarily consult the IMF.

On the very important issue of PSI, I will recommend being as pragmatic and as consistent as possible. Pragmatic because a case by case assessment is always needed and there is, in my opinion, no mechanistic "a priori" approach which would be advisable. Consistent, meaning that once the assessment is made by the International community on the concept of the participation of the private sector in the crisis solution, we have to stick to it and remain absolutely steady. The worst behaviour is for the country concerned and for the international community to change its position vis ā vis the private sector during the course of the negotiation.

Let me conclude this part with the following observations : the implementation of these measures should be facilitated by two recent institutional "innovations", namely the creation of the G-20 and the transformation of the Interim Committee of the Board of Governors of the IMF into the International Monetary and Financial Committee.

As a new mechanism for informal dialogue in the framework of the Bretton Woods institutional system, the aim of the G-20 is to broaden dialogue on key economic and financial policy issues among systemically significant economies. While the FSF is well placed to develop analytical work on issues of particular interest to the international financial community, the G-20 could play an important role in building the political consensus necessary for the implementation of the FSF's recommendations.

The transformation of the Interim Committee into the permanent International Monetary and Financial Committee (IMFC) and the decision to hold preparatory meetings at the Deputy-level twice a year should contribute to a more open and consequently a more efficient debate on the International Financial Reform.

Let us now work actively and as professionally as possible within the present framework which, in my opinion, is well designed and promising.

As a conclusion, I would like to stress the ongoing world-wide efforts to build more stable economic and monetary relationships in our increasingly globalized world. In that respect, let me focus on challenges ahead related to the global financial markets and the international monetary relationships.

I will draw your attention on one of the most important challenges we have to face up with: the "herd instinct" of market participants, which, in certain cases, can amplify considerably volatility, create or augment misalignments and induce large-scale global contagion in case of local crisis. The herd instinct is probably profoundly enshrined in the functioning of the marketplace. In order to minimize its effects, I have three provisional conclusions:

• Perhaps we should have a second look at the very rapid generalisation of day to day mark to market accountings. Perhaps a better medium term functioning of the market would call for a clear distinction between various market participants depending on their own time horizons.
• It seems to me that it would also be important to reflect upon the consequences of the very rapid increase of mutual funds in some major markets. All the managers of these funds have to prove permanently on a very short-term basis that they are better managed than the average. This creates a very powerful potential herd instinct.
• Finally, I profoundly think that full transparency is the most efficient tool to counter the setting up of a "herd" and to cope with potential "herd" behaviour. When one knows all about a particular "signature" or about a particular country, there is much less reason to embark into blind crisis contagion. Here is the motto I would like to be accepted globally by market participants: "Let us judge the quality and creditworthiness of any particular signature upon its own peculiar fundamentals, upon its own, particular, assets and liabilities".

 
top