Reform of the Global Financial System

31 January 2009

Speech by Dr Tony Tan Keng Yam, Deputy Chairman and Executive Director, Government of Singapore Investment Corporation (GIC), on "Scenarios for the Future of the Global Financial System" at the World Economic Forum, Davos, 30 January 2009, 8:30am – 10:00am

In the wake of the huge economic and financial damage caused by the current economic and financial crisis, global policy makers face enormous challenges to formulate and implement fundamental and radical measures to stabilise the world economy and stave off a potentially disastrous economic collapse and protracted global stagnation. Central to the efforts to ensure sustained financial stability will be the need to design and implement a radical overhaul of the existing global financial system and its regulatory architecture.

With policy makers currently focused on containing the financial crisis and engineering an economic recovery, the reform of the global financial architecture itself and its regulatory infrastructure is still in an initial and very fluid state. Nevertheless at an early stage, the efforts of the US, at the epicentre of the current crisis, will set the pace for the reform of the global financial system. The rest of the world, including key partners in Europe and Asia, will also have to participate in restructuring the national and global financial regulatory architecture.

Major central banks will be deeply involved in both designing and managing the new regulatory regimes. Financial stability will likely become a distinctly more important mission for global central banks, together with their traditional primary mandates of maintaining price stability and promoting economic growth.

Hitherto, the shaping of the global financial regulatory architecture has largely been the province of governments, central banks and financial institutions including international and investment banks. However, given the involvement of financial institutions in the current crisis, global institutional investors (like the GIC) – with their potentially significant role in helping to stabilise the current crisis by taking part in the recapitalisation of key financial institutions as well as by providing capital in the post-crisis financial system – will become important players.

Global institutional investors and SWFs should therefore contribute constructive inputs to the design of the new regulatory system and its effective functioning to help guard against the danger of financial protectionism.

Directions for the regulatory architecture and the new emphasis on financial stability

Some commentators have speculated that US regulatory changes are likely to move in a direction more in line with Europe’s more conservative, relationship-based universal banking model, and less encouraging of excessive leverage and financial innovation.

Another possible scenario for the future financial landscape could be one more reminiscent of the Glass-Steagall era. This could be characterised by a tightly regulated, government guaranteed core of commercial banks focused on traditional banking, as well as a periphery of relatively less regulated non-banks, including private equity funds and hedge funds. While investment banks could belong to the non-core banking sector, they would be more tightly supervised than in recent history.

In general, financial institutions would likely be allowed much lower leverage ratios than in the past few years.

The major trends of deregulation, dis-intermediation, and derivative-led securitization that have marked financial sector development over the last two decades are also likely to be reversed, slowed down, or modified severely.

Importantly, following the huge output, employment and fiscal losses due to the global financial crisis, and because of their pivotal importance in stabilising financial crises, the US Fed and other major central banks will play leading roles in both designing and managing the new regulatory regimes. Financial stability will likely become a distinctly more important and active mission for global central banks, together with their traditional primary mandates of price stability.

The current crisis has vividly demonstrated the globalized nature of the current financial system and stability issues. Many key financial institutions are globally interconnected, very large and highly complex organisations. To be truly effective, the reform of the current regulatory system will need to be international in nature. How financial regulatory policies can be co-ordinated on a global level, especially for the non-bank sector, has not been thought through in much depth yet. This is likely to be a complicated, controversial and protracted process. Existing institutions, especially the Financial Stability Forum (FSF), but also the International Monetary Fund (IMF) and perhaps the Bank of International Settlements and Basel Committee would need to be strengthened and made more globally representative to manage international financial stability. They would also be important in leading and shaping changes to the new international financial regulatory landscape.

Greater Government Intervention

Over the near term, stabilising the financial crisis is likely to require extensive government intervention in the financial sector and economy. Governments in the US, UK and parts of Europe have injected capital into financial institutions to stabilise the financial system and to kick-start credit creation. Public recapitalisation of banks and financial institutions may have to be extended to a much greater degree before sustained economic recovery is possible. Nationalisation and equity dilution are thus key near term risks for global investors with respect to their holdings in the financial sector.

Governments and central banks are likely to end up taking over and owning large swathes of assets from distressed holders as part of the de-leveraging process.

A significant section of these assets may be good quality but undervalued due to the inability of de-leveraging financial institutions to continue to hold them.

There may also be government purchases of other strategically important industries to prevent them from failing and exacerbating the economic downturn, although the degree of intervention by government outside of the financial sector would likely be significantly less.

As the financial system and economy stabilise, governments will have to eventually divest their asset holdings, if public debt levels are to be brought back to more sustainable levels. Governments will thus eventually need to re-privatise government-hold assets on a massive scale, not just to reduce debt, but also to get out of businesses that the private sector can manage more efficiently. It is therefore in the interest of governments to retain the confidence of investors in their markets by keeping their economies and markets open, competitive and attractive for private investors.

Thus huge government sector interventions and subsequent privatisations needed to stabilise and normalise the current crisis will inevitably need to involve long-term international institutional investors as key players.

Relative importance of real money investors versus leveraged investors

In the medium to longer term, the importance of the "shadow banking sector", represented by the growth of credit dis-intermediation from commercial banks, arms length securitisation and distribution, leveraged non-bank capital suppliers, as well as widespread use of credit derivatives will likely become markedly less dominant in global capital markets.

Leveraged financial institutions have been significantly damaged by the disruptions in funding markets, and the bursting of the housing bubble, and their ability to provide capital will also be dampened given expected tighter regulations.

Similarly, leveraged investors like hedge funds and leveraged private equity players will find their activity and growth markedly more constrained. In this context, close attention should be given to facilitating the continued smooth flow of global capital to aid the recapitalisation of financial institutions and other businesses.

Real money investors, particularly un-leveraged, global institutional investors, would become relatively more important players in financial markets and the global financial system. In particular, big institutional investors including the Sovereign Wealth Funds (SWFs), given their large and growing total asset size under management, would be an important part of the key global investor community.

With many key debt and equity real estate markets pushed to extreme under-valuations relative to long term fundamental values, institutional investors like pension funds and SWFs will play an important role in the stabilisation and eventual recovery of asset markets. Such institutions, with their long term investment horizons could be important sources of demand for undervalued assets. This would contribute to stabilising financial and household sector losses, thereby helping to restore both credit creation and demand in the real economy.

In this connection, SWFs, in particular, should stand by the generally accepted principles and practices agreed in Santiago to help assuage the concerns of investee countries. Investee countries on their part, need to be equally mindful of adopting common best practices towards foreign investors that prevent a slide into regulatory fragmentation and financial protectionism.

With the relative decline of leveraged capital suppliers and the tightening of supply of capital via securitisation, global institutional investors would also likely become relatively more important sources of long term capital and finance for the global economy.

Conclusion

The coming redesign of the global financial regulatory architecture will be a major and difficult exercise with its share of opportunities and risks.

There are three major risks: First, the major national efforts of governments to stabilise and then regulate the financial system or may not be adequate, or effectively coordinated internationally.

Second, a lack of coordination in regulatory architecture and practice, together with the rising global unemployment in coming years, may lead to the "fragmented protectionism" scenario or the "financial regionalism" scenario as described in the recently released WEF publication: The Future of the Global Financial System.

Third, the swing of the political and policy pendulum towards greater regulation may end up with overregulation which stifles financial sector efficiency, productive financial innovation and helpful market discipline.

In the past, it was mainly governments, central banks and financial institutions who were involved in shaping the global financial regulatory architecture. However, given the involvement of financial institutions in the current crisis, global institutional investors, with their potentially important role both in financial stabilisation as well as capital providers in the post crisis financial system, can contribute constructive inputs to the design of the new regulatory regime. Taking into account the views of global investors in the process of redesigning the global financial system will greatly help the efficient functioning of markets in the world financial system. It will also strengthen global coordination and minimise the risks of protectionism, regional fragmentation and over-regulation.