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Shaping financial market regulation for sustainable development

Past financial crises have highlighted the major failures in the financial sector and of financial regulation and supervision. The Addis Agenda emphasizes the importance of strengthening regulatory frameworks at all levels to further increase transparency and accountability of financial institutions, and to address the regulatory gaps and misaligned incentives in the international financial system. Regulatory frameworks need to foster stability, safety and sustainability, while also promoting access to finance and sustainable development.

Implementation of financial regulatory reforms

On-going work on financial regulatory reform can be broken down into four main components: resilience of financial institutions, solving the too-big-to-fail problem, making derivatives safer, and transforming shadow banking. This work is coordinated through the Financial Stability Board (FSB), which promotes international financial stability through information exchange and cooperation of national financial authorities and international standard-setting bodies, such as the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions, and the International Association of Insurance Supervisors (IAIS).

The 2016 report of the FSB to the G20 on implementation of post-crisis reformed regulatory standards concluded that implementation progress remains steady but uneven, and that strengthened resilience due to the reforms has assisted in the smooth operation of the global financial system.

Banks continue to build capital and liquidity buffers to meet the new Basel III capital adequacy standards, with the estimated capital shortfall nearly zero and capital ratios at highs. However, substantial work remains in implementing the policies designed to solve the too-big-to-fail problem, for example in achieving effective resolution regimes and operationalising plans for systemically important banks and non-bank financial institutions. Over 60 per cent of jurisdictions (over 40 per cent by market size) have not yet fully implemented the recommended transfer and temporary stay powers in their resolution regimes for failing banks.

Implementation of over-the-counter (OTC) derivatives reforms is well underway, but progress remains uneven. Implementation of the agreed reforms for shadow banking remains at a relatively early stage and more work is needed. By the time of the G20 Leaders’ Summit in July the FSB will publish a review of the evolution of shadow banking risks since the financial crisis and the adequacy of monitoring and policy tools put in place after the crisis to address them.

There are some concerns, however, that existing reforms do not fully cover systemic risks from the financial system. Within the Task Force, UNCTAD feels that the stronger capital adequacy requirements still allow banks to maintain high leverage ratios that pose systemic risks.

The Addis Agenda also calls for strengthened frameworks for macroprudential regulation and countercyclical buffers. In August 2016 the FSB, IMF and BIS published a paper that takes stock of international experience since the financial crisis in developing and implementing macroprudential policies. Following the crisis, many countries have introduced frameworks and tools aimed at limiting systemic risks that could otherwise disrupt the provision of financial services and damage the real economy. The paper describes the accumulated experience, documents useful design principles for macroprudential frameworks, but also suggests that there is no one size-fits-all for macroprudential policy making. Key elements include clear mandates, well-defined policy objectives, accountability mechanisms, and provision of the power and incentive to act to the relevant agency. The paper suggests that the need for a comprehensive monitoring framework, including of early warning indicators, the ex ante establishment of effective macroprudential tools, and coordination of policies across countries in order to deal with spillovers.


Financial spillover risks and unintended consequences

The Addis Agenda emphasizes the importance of ensuring that incentives underlying financial market regulations are aligned with sustainable development. All regulatory frameworks create incentives. In particular, there are risks that regulations will have unintended consequences and spillovers by reducing incentives to lend to sectors or countries where financing is critical to achieving the SDGs.  

The FSB’s monitoring work includes the impact of financial regulatory reforms on emerging market and developing economies and considers the effect of the reforms on financial intermediation. FSB reports on implementation in 2015 and 2016 found that no major ‘unintended consequences’ in emerging market and developing countries had yet been identified or reported by emerging market countries. However the reports acknowledged that evidence was largely qualitative. It noted that some countries had been affected by spill-overs from reform implementation in the home jurisdictions of global financial institutions. It also noted that it was empirically difficult to single out the effects of reforms, either positive or negative, which was particularly the case for long-term reforms that were still under implementation. One area of concern, although not as a result of the post-crisis regulatory reforms, has been the decline in correspondent banking relationships, which also affects the transfer of remittances.

There is anecdotal evidence on how countries are addressing unintended consequences. States in the European Union have included carve-outs to the implementation of the Basel III capital adequacy framework that allow lower risk weights for exposure to sovereign debt and loans to small- and medium-enterprises, in an attempt to ensure sufficient access to credit in these areas, though this has led to them being judged materially non-compliant with the Basel III standard in reviews by the BCBS.

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There may be unintended consequences from financial regulation at the national level. There is a concern that, by generally raising the cost of lending, the Basel capital adequacy rules may have the effect of limiting riskier lending. Indeed, the rules are designed to impose higher costs on risky activities of banks to internalize the costs of risky behaviour. Yet, some higher risk sectors are precisely those that need investment for achieving sustainable development. For example, longer-term lending, entities with low credit ratings, as well as areas where it is more costly to get information, such as those without sufficient data on default histories or without credit ratings, are naturally subjected to higher capital and provisioning costs. As a result, there has been particular concern regarding the impact of these regulations on long-term lending, including infrastructure lending, trade finance, innovation and green technologies, small and medium-sized enterprise financing, as well as lending to sovereigns which are perceived to be risky. While there is no aggregate monitoring of such consequences, there is anecdotal evidence on how countries are seeking to address these impacts. States in the European Union have included carve-outs to the implementation of the Basel III capital adequacy framework that allow lower risk weights for exposure to sovereign debt and loans to small- and medium-enterprises, in an attempt to ensure sufficient access to credit in these areas, though this has led to them being judged materially non-compliant with the Basel III standard in reviews by the BCBS.

Capital account management

Capital flows are an important aspect of the international monetary system. Capital flows should bring investment and finance to countries that do not have sufficient domestic resources, bringing both direct and indirect benefits to the receiving countries. At the same time, capital flows can carry significant risks, especially when they are short-term oriented. The Addis Agenda underscores the importance of the quality of capital flows, in terms of long-term investment that is aligned with sustainable development. A key challenge for countries is how to harness the benefits while managing the risks. The Addis Agenda’s support for appropriate capital flow management measures speaks to this challenge.

In the 1990s and early 2000s there was a large divergence of views as the appropriateness and efficacy of capital account management techniques. These divergences have reduced in recent years, as demonstrated by the adoption in 2012 of the IMF’s institutional view on the liberalization and management of capital flows. This development informed the agreement in the Addis Agenda, though some differences in view remain.

To help countries better understand and address the impact of cross-border capital flows, in 2016 the IMF reviewed countries’ experience with its institutional view.  The IMF Executive Board considered that the institutional view remains relevant in the current environment, and that there is no need for substantive adjustment at this point, but would need to remain flexible and evolve over time. They also agreed that further clarification or elaboration was warranted in relation to the interaction between macroprudential and capital flow policies, especially the role of macro-prudential policy frameworks in addressing systemic financial risks arising from capital flows; clarifying further the relevant conditions for the re-imposition of capital flow management measures during liberalization and when countries face particular challenges; and how the institutional view can serve as a framework for greater multilateral consistency in the design of policies for dealing with capital flows. The IMF staff analysis of how macro-prudential policies can contribute to resilience to capital flow risks is expected to be discussed at the IMF board in June 2017.

Credit rating agencies

By providing creditors with information on the creditworthiness of borrowers, credit ratings agencies (CRAs) play an important role in the functioning of capital markets and influence the flow of finance towards countries, companies and projects across the globe. However, the financial crisis demonstrated the impact inaccurate ratings can have on the stability of the international financial system. There are two main channels through which CRAs impact behaviour. The first is through mechanistic reliance on ratings in standards, regulations and laws. The second is through investors that choose to rely on ratings for their investment decisions, often because they lack the capacity to evaluate ratings internally. Ratings have been found to be inaccurate when they are influenced by the business objectives of the ratings agency and when they fail to take account of systemic risks.

In 2012, the FSB set out a roadmap to implement the 2010 Principles for Reducing Reliance on CRA Ratings. Implementation of the roadmap was designed to reduce mechanistic reliance on credit ratings by removing mandatory use of credit ratings in national laws and regulations. The 2014 peer review of national authorities’ implementation of the principles found that more could be done to address gaps in individual action plans, however the FSB plans no further peer reviews leaving further review to the national level. As one example, a report by the European Securities and Markets Authority, a European Union regulatory authority, from October 2015 found that references to credit ratings still remained in national and EU legislation, as well as within the collateral frameworks of some central banks.

The 2014 peer review also found that CRA assessments still have an impact on asset allocation, particular in some sectors such as pension funds. In the home jurisdiction of the largest CRAs, annual assessments still find gaps in policies and practices which create financial risks, including insufficient separation between credit risk analysts and CRA business concerns and the issuance of unsolicited ratings motivated by the CRA’s own profit.

In 2013 and 2014, the United Nations held two special meetings on the Role of Credit Rating Agencies and on their impact on financing for sustainable development. The meetings discussed ideas on the establishment of a global rating platforms based on uniform rating scales, initiatives for investors to better understand and make better use of credit ratings, proposed measures to increase transparency and competition, alternative structures to the issuer-payer model to address potential conflict of interest and the push for establishing more domestic or public CRAs.

There have been some further efforts to better align CRAs with sustainable development. In 2016, eight CRAs, including Standard and Poors and Moody’s, agreed to a UN-PRI-led statement on environmental, social and governance impacts in credit ratings. However, while the agreement focuses on analysing risks to companies’ businesses, it does not incorporate the impact of company actions in these areas.