XXXPFDEPSHQVCMJTIJOH CRISIS REFORM MARKETS MARKETS REFORM CRISIS REFORM MARKETS CRISIS REFORM CRISIS MARKETS REFORM CRISIS MARKETS MARKETS CRISIS REFORM MARKETS CRISIS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRI CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM C REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS R REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM C CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFO MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS M REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM M REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS C CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM C CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REF MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS M REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFO R REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS R MARKETS CRISIS REFORM MARKETS CRISIS REFORM MARKETS CRISIS REFORM MA CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS MARKETS REFORM CRISIS M AR CRISIS REFORM MARKETS CRISIS REFORM MARK E MARKETS REFORM CRISIS MARKETS REFORM C REFORM MARKET S -:HSTCQE=U\XUVW: The full text of this book is available on line via these links: www.sourceoecd.org/finance/9789264073012 www.sourceoecd.org/governance/9789264073012 Those with access to all OECD books on line should use this link: www.sourceoecd.org/9789264073012 SourceOECD is the OECD online library of books, periodicals and statistical databases. For more information about this award-winning service and free trials, ask your librarian, or write to us at SourceOECD@oecd.org. ISBN 978-92-64-07301-2 21 2009 03 1 P The Financial Crisis REFORM AND EXIT STRATEGIES The financial crisis left major banks crippled by toxic assets and short of capital, while lenders became less willing to finance business and private projects. The immediate and potential impacts on the banking system and the real economy led governments to intervene massively. These interventions helped to avoid systemic collapse and stabilise the global financial system. This book analyses the steps policy makers now have to take to devise exit strategies from bailout programmes and emergency measures. The agenda includes reform of financial governance to ensure a healthier balance between risk and reward, and restoring public confidence in financial markets. The challenges are enormous, but if governments fail to meet them, their exit strategies could lead to the next crisis. The Financial Crisis REFORM AND EXIT STRATEGIES The Financial Crisis REFORM AND EXIT STRATEGIES 212009031cov.indd 1 02-Sep-2009 2:36:15 PM The Financial Crisis REFORM AND EXIT STRATEGIES ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT The OECD is a unique forum where the governments of 30 democracies work together to address the economic, social and environmental challenges of globalisation. The OECD is also at the forefront of efforts to understand and to help governments respond to new developments and concerns, such as corporate governance, the information economy and the challenges of an ageing population. The Organisation provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies. The OECD member countries are: Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Commission of the European Communities takes part in the work of the OECD. OECD Publishing disseminates widely the results of the Organisation’s statistics gathering and research on economic, social and environmental issues, as well as the conventions, guidelines and standards agreed by its members. ISBN 978-92-64-07301-2 (print) ISBN 978-92-64-07303-6 (PDF) Also available in French: La crise financière : Réforme et stratégies de sortie Corrigenda to OECD publications may be found on line at: www.oecd.org/publishing/corrigenda. © OECD 2009 You can copy, download or print OECD content for your own use, and you can include excerpts from OECD publications, databases and multimedia products in your own documents, presentations, blogs, websites and teaching materials, provided that suitable acknowledgment of OECD as source and copyright owner is given. All requests for public or commercial use and translation rights should be submitted to rights@oecd.org. Requests for permission to photocopy portions of this material for public or commercial use shall be addressed directly to the Copyright Clearance Center (CCC) at info@copyright.com or the Centre français d’exploitation du droit de copie (CFC) at contact@cfcopies.com. This work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries. 3 THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 978-92-64-07301-2 – © OECD 2009 Foreword The crisis that struck in 2008 forced governments to take unprecedented action to shore up financial systems. As economic recovery takes hold, governments will want to withdraw from these extraordinary measures to support financial markets and institutions. This will be a complex task. Correct timing is crucial. Stepping back too soon could risk undoing gains in financial stabilisation and economic recovery. It is also important to have structural reforms in place so that markets and institutions operate in a renewed environment with better incentives. From the start OECD has said "Exit? Yes. But exit to what?" It is obvious that financial markets cannot return to business as usual. But the incentives and failures that led institutions to this perilous situation were many: remuneration structures, risk management, corporate board performance, changes in capital requirements, etc.; and they interacted in unexpected ways with tax rules and even the structure of institutions themselves. Sorting through all these issues will take time, but some are urgent. There can be no question that the effort is necessary. Financial markets cannot again be allowed to expose the global economy to damage like what has been suffered over the past year. Two questions, then, are at the core of this report: How and when can governments safely wind down their emergency measures? And how can we sensibly reform financial markets? The purpose is to draw together and demonstrate the interconnections among a wide range of issues, and in doing so to contribute to global efforts to address these challenges. Carolyn Ervin Director, Financial and Enterprise Affairs 4 THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 978-92-64-07301-2 – © OECD 2009 ACKNOWLEDGEMENTS This book was written by a group of authors in the OECD’s Directorate for Financial and Enterprise Affairs. The drafting group was chaired by Adrian Blundell-Wignall and comprised Paul Atkinson (consultant), Sean Ennis, Grant Kirkpatrick, Geoff Lloyd, Steve Lumpkin, Sebastian Schich and Juan Yermo. 5 THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 978-92-64-07301-2 – © OECD 2009 Table of Contents Summary of Main Themes 9 Reform Principles 9 Exit Strategy Principles 10 I. Introduction 13 Where are we in dealing with the crisis? 20 Requirements of reform and exit from extraordinary policies 20 Exit strategies need to be broadly consistent with longer-run economic goals. 23 Notes 23 II. Priorities for Reforming Incentives in Financial Markets 25 A. Lessons from past experience 27 B. Strengthen the regulatory framework 29 1. Streamline regulatory institutions and clarify responsibilities 29 2. Stress prudential and business conduct rules and their enforcement 32 3. Beware of capture 34 C. Focus on integrity and transparency in financial markets 36 1. Restore confidence in the integrity of financial markets 36 2. Strengthen disclosure and information processing by markets 36 3. Audit 37 4. Credit rating agencies 38 5. Derivatives 39 6. Accounting standards 39 D. Strengthen capital adequacy rules 41 1. Ensuring capital adequacy: more capital, less leverage 41 2. Strengthening liquidity management 42 3. Avoiding regulatory subsidies to the cost of capital 43 4. Avoiding pro-cyclical bias 43 5. The leverage ratio option 44 6 – TABLE OF CONTENTS THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 978-92-64-07301-2 – © OECD 2009 E. Strengthen understanding of how tax policies affect the soundness of financial markets 45 1. Debt versus equity 45 2. Capital gains versus income and securitisation 47 3. Possible tax link to credit default swap boom 47 4. Tax havens and SPVs 48 5. Mortgage interest deductibility 49 6. Tax and bank capital adequacy 49 7. Further work 51 F. Ensure accountability to owners whose capital is at risk 51 1. Strengthen corporate governance of financial firms 51 2. Deposit insurance, guarantees and moral hazard 53 G. Corporate structures for complex financial firms 57 1. Contagion risk and firewalls 57 2. The NOHC structure 60 3. Advantages of the NOHC structure 63 H. Strengthening financial education programmes and consumer protection 64 Notes 65 III. Phasing Out Emergency Measures 71 A. The timeline for phasing out emergency measures 73 B. Rollback measures in the financial sector 77 1. Establishing crisis and failed institution resolution mechanisms 77 2. Establishing a revised public sector liquidity support function 80 3. Keeping viable recapitalised banks operating 81 4. Withdrawing emergency liquidity and official lending support 81 5. Unwinding guarantees that distort risk assessment and competition 82 C. Fostering corporate structures for stability and competition 83 1. Care in the promotion of mergers and design of aid 83 2. Competitive mergers and competition policy 84 3. Conglomerate structures that foster transparency and simplify regulatory/supervisory measures 85 4. Full applicability of competition policy rules 85 D. Strengthening corporate governance 86 1. Independent and competent directors 86 2. Risk officer role 87 3. Fiduciary responsibility of directors 87 4. Remuneration 87 TABLE OF CONTENTS - 7 THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 978-92-64-07301-2 – © OECD 2009 E. Privatising recapitalised banks 88 1. Pools of long-term capital for equity 88 2. A good competitive environment. 89 3. Aligning deposit insurance regimesl. 89 F. Getting privatisation right 89 G. Maximising recovery from bad assets 91 H. Reinforcing pension arrangements 92 Notes 98 Boxes II.1. G 20 reform of financial markets 28 II.2. Staffing financial supervision 32 Tables I.1. Selected support packages 18 II.2. Financial Intermediation And Supervisory Resources In Selected OECD Countries 33 II.3. Pre-crisis leverage ratios in the financial sector 42 II.4. Tax bias against equity in OECD countries 46 II.5. Deposit insurance schemes in selected OECD countries 52 II.6. Payments to major AIG counterparties 16 September to 31 December 2008 55 II.7. Affiliate restrictions applying prior to Gramm-Leach-Bliley 59 III.8. General government fiscal positions 73 III.9. Policy responses to the crisis: Financial sector rescue efforts 75 III.10. Private pension assets and public pension system's gross replacement rate, 2007 94 Figures II.1. Credit default swaps outstanding (LHS) & Positive replacement value (RHS) 40 II.2. House prices and household indebtedness 50 II.3. Glass-Steagall and periods with firewalls shifts 62 II.4. Opaque universal banking model 63 II.5. Non-operating holding company structure, with firewalls 64 [...]... public to the private balance sheet and the cutting of budget deficits) begins to take place; stagflation pressures; and a failure to use the current crisis as the catalyst for far-reaching and globally-consistent regulatory reform based around the six key building blocks noted above THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 I INTRODUCTION – Exit strategies. .. outflows from unemployment THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 27 28 – II PRIORITIES FOR REFORMING INCENTIVES IN FINANCIAL MARKETS Box II.1 G 20 reform of financial markets The November Declaration of the Summit on Financial Markets and the World Economy by the Leaders of the Group of Twenty provides the starting point for systemic reform by offering a... money when they make mistakes This will help to reduce moral hazard issues THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 10 - SUMMMARY OF MAIN THEMES arising from the exceptional emergency measures taken and guarantees provided • Strengthen understanding of how tax policies affect the soundness of financial markets • Respond to the increased complexity of financial. .. approaches THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 I INTRODUCTION – The problems the world faces in dealing with the global financial crisis are far from over Much work remains to remove toxic assets from bank balance sheets, recapitalise banks, and for governments to exit from their extraordinary crisis measures And there is a long way to go in the reform. .. past experiences, and emphasises the need to clarify the responsibilities of regulatory institutions and to restore confidence in the integrity of financial institutions THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 II PRIORITIES FOR REFORMING INCENTIVES IN FINANCIAL MARKETS - The current crisis has already required support for failing or failed financial institutions... in the hope that hold-to-maturity values might be better than current mark-to-market values of illiquid toxic assets 3 Recapitalise asset-cleansed banks, and get out (sell the government’s holdings of shares and transfer any loans and guarantees from the public balance sheet back to the private sector) THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 19 20 – I... Macfarlane at the 2009 ASIC Summer School conference THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 23 25 II Priorities for Reforming Incentives in Financial Markets As a result of the current financial crisis, governments have supported failed financial institutions and may need to continue to do so Many banks are not functioning normally, and confidence in financial. .. enforcing them These rules influence behaviour and if well-designed they can and should align incentives to generate market outcomes that reflect a prudent balance between risk and search for return Their enforcement is essential since rules that are not enforced will THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 II PRIORITIES FOR REFORMING INCENTIVES IN FINANCIAL. .. Reserve as the consolidated supervisor Otherwise it reaffirmed THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 29 30 – II PRIORITIES FOR REFORMING INCENTIVES IN FINANCIAL MARKETS the role of functional regulation (similar activities should be regulated by the same regulator) of the various affiliates by state and other federal financial regulators, while allowing... FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 31 32 – II PRIORITIES FOR REFORMING INCENTIVES IN FINANCIAL MARKETS however, should be that the creation of new agencies without reducing the number of existing ones and reformulating mandates should be avoided 2 Stress prudential and business conduct rules and their enforcement Better (which is not the same as more) . meet them, their exit strategies could lead to the next crisis. The Financial Crisis REFORM AND EXIT STRATEGIES The Financial Crisis REFORM AND EXIT STRATEGIES 212009031cov.indd 1 02-Sep-2009. issues 10 - SUMMMARY OF MAIN THEMES THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009 arising from the exceptional emergency measures taken and guarantees. necessarily reflect the official views of the Organisation or of the governments of its member countries. 3 THE FINANCIAL CRISIS: REFORM AND EXIT STRATEGIES – ISBN 97 8-9 2-6 4-0 730 1-2 – © OECD 2009