London, 24 April 2010

The International Monetary Fund has made proposals for new taxes on financial institutions - “A Fair and Substantial Contribution by the Financial Sector.” Institute of International Finance (IIF) Managing Director Charles Dallara has written to officials attending the meetings in Washington of the Group of 20 and the IMF to provide preliminary industry comment on these proposals.

Ministers and Governors of the Group of 20: In response to a request of G-20 leaders, the IMF staff has produced a timely analysis of the ways in which the financial sector might defray costs associated with recent, and possible future, failures.  As the report indicates, the issues are complex and the proposals warrant extensive further analysis and discussion.  This letter offers a preliminary perspective from the private financial community.

The paper and this response need to be seen in the broader context of a program of reforms aimed at making the financial system more resilient.  The IIF has been consistently supportive of major improvements in industry practices, enhanced regulation and strengthened supervision, more resilient markets and infrastructure and strengthened capital and liquidity requirements.  In this latter context, the potential contribution of contingent capital in addressing stress in financial institutions needs to be fully explored.  These constitute central elements of regulatory reform which should be the focus of our efforts at this crucial stage.  Through a coordinated approach to these issues, meaningful progress can be realized toward a more stable yet vibrant global financial system.

The IIF also believes that, as part of the reform process, there is an urgent need to develop a new regime to deal with the resolution of failing cross border institutions to ensure that there is no recourse to taxpayers.  However, the IIF sees no merit in the idea that any levy on the financial sector should be paid into general revenue.  Neither do we believe that an ex-ante levy on the banking system should be used to finance the bailing out or recapitalization of failing institutions.  Instead, we believe that there is a need to develop the conditions in which no institution, regardless of its size, complexity, interconnectedness or geographic reach should be seen as too systemic to fail.  That requires the creation of effective mechanisms for resolving failing cross border firms which would likely involve funding ex post by the financial sector.

Much of the analysis in the IMF paper seems to be rooted in a vision of resolution which is no longer tenable.  We can no longer contemplate a world in which public or private sector funds are used to bail out or recapitalize failing firms.  The IIF has been developing a new framework for cross border resolution with the following features:

•  Shareholders as well as unsecured creditors need to bear the costs of failure.  This needs to be clear and rigorously enforced.

•  Special resolution regimes are needed for financial institutions.  National regimes need to be coordinated internationally and to converge over time and resolution authorities need the powers to facilitate private sector solutions to failing firms wherever possible.

•  In order to achieve effective cross border resolution, there is a need for a global framework.  This needs to address, among other things, the complexities arising out of the distribution of global firms’ assets and liabilities at the time of failure.

The Institute will shortly be putting forward a paper to the Financial Stability Board which outlines conceptually such a resolution arrangement.  The paper will propose an ambitious approach by the G20 leadership to addressing the complex – but ultimately surmountable issues that would need to be faced in setting up an effective cross border resolution mechanism.  One approach to carrying this forward would be the creation of a special Task-Force under G20 auspices to address these matters.

The aim of the kind of regime envisaged in our work would not be to ‘bail out’ firms or to recapitalize them to allow them to continue as going concerns, as the IMF paper suggests.  But even with resolution arrangements confined to winding down failing institutions, there would still be a need for funding to support a defined set of costs in the period before an institution could be finally resolved.  These could arise from the administrative arrangements involved in running down the firm and, possibly, the need to finance any ‘bridging’ arrangements in an orderly manner, subject again to creditors and shareholders ultimately bearing the necessary losses.

The IMF paper suggests an ex-ante levy which would be available to meet a wide range of costs associated with financial failures.   We believe that the existence of an ex-ante fund would make it harder to allow firms to fail and to impose the necessary disciplines on shareholders and creditors.  That would contribute to the persistence of moral hazard and weaken market discipline.  The strong sentiment within the industry is that an ex-post arrangement limited to meeting the narrower set of costs of firm failures on the basis set out above would be more practicable and effective.  The basis on which such funds would be used would need to be clearly spelled out and circumscribed from the outset.

We therefore differ from the IMF paper both in the uses to which funding should be put and the proposal that this should be made available through an ex-ante levy.  There are nevertheless a number of general principles in the IMF report which, if applied to the ex-post funding of a resolution regime, we generally consider to be sound:

•  Any resolution funding by the financial sector should avoid exacerbating distortions to the tax systems or creating new ones.

•  The introduction of any arrangement needs to be internationally coordinated to avoid creating arbitrage and competitive disparities.  This is a huge challenge given the increasing number of uncoordinated national initiatives in the area of regulatory reform.

•  Any funding should come from a range of relevant institutions in the financial system in order fully to address systemic risk and reduce moral hazard.  There would be a need to avoid inequitable burdens on categories of firms such as those from emerging markets for example.

•  And we share the IMF’s assessment that a financial transactions tax would have unforeseeable consequences for financial markets and is therefore undesirable.

Finally, any additional financial burden on the banking sector must not undermine its ability to provide credit to support the recovery, particularly at a time when it is assimilating substantial new capital and liquidity requirements.  Concerns are already growing about the possible negative impact on jobs and growth of regulatory reform and this extra potential burden – exacerbated by the scope for double counting in the case of global groups - should not be overlooked.  We also need to be alert to unintended consequences such as the risk that certain types of charge – such as a flat charge on liabilities - may have the effect of discouraging low risk/low return activities.  This would be undesirable in its own right as well as inimical to the thrust of the Basel proposals.

We would welcome the opportunity to discuss these important issues in the months ahead.  As we do so, it is crucial that we renew our focus on the central pillars of a more stable and resilient financial system.  Better risk management, improved governance, enhanced supervision, strengthened capital and liquidity requirements have a central role in this, along with a global framework for resolution of failed institutions.

Yours sincerely, Charles Dallara, Managing Director.

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