BIS’s Cecchetti envisages world without G-Sifis

The global financial system needs both more market discipline and more regulation and should eventually reach a stage where no banks are too big to fail, according to Stephen Cecchetti, head of the monetary and economic department at the Bank for International Settlements (BIS).

Setting out his priorities for financial reform during a speech in Frankfurt today (October 30), Cecchetti said there should come a time when the Financial Stability Board's list of global systemically important financial institutions (G-Sifis) was blank.

An important element of this goal is to impose market discipline on banks. "The right to succeed must be accompanied by the opportunity to fail," Cecchetti said. One "particularly appealing" option, he said, would be to have a system where the first bank to fail during a crisis would not be rescued. "If the system can live with any single firm failing, there is an incentive for managers, shareholders and creditors to make sure that their bank is not the weakest link," he said.

However, Cecchetti stressed that imposing market discipline would not be enough. "It is naïve to expect that market discipline alone will deliver financial stability," he said. In particular, market discipline still only forces a firm to moderate internal risks, not to concern itself with the health of the wider financial system.

Regulation could go some way to addressing this issue, Cecchetti said. For this reason, regulation should focus on systemic risk, not individual firms. "It is all macro-prudential," he said. Central clearing of derivatives trades, tight restrictions on financial innovation and a leverage ratio as a backstop were all important considerations, he said.

Nevertheless, firms should still be allowed to innovate. "Over-the-counter markets would exist, new products would appear there, and there they would be tested," Cecchetti said. "But the development, testing and ultimate standardisation of new financial products would be subject to strong regulatory requirements analogous to those for pharmaceuticals."

To deliver regulation in these areas, Cecchetti said regulation should be "simple but not simplistic". For example, assessing what level risk-weightings should be set at for individual assets was nearly impossible, he said – there was too much noise in the data. For this reason, "assets should be lumped together", he said, with the leverage ratio providing an additional safety net should it be necessary.