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IMF
urges rethink of how to manage global systemic risk
- Market
discipline, regulations failed to keep up with innovation,
leverage buildup
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Macroeconomic policies did not respond to increase
in systemic risk
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Leadership needed at international level to detect
and respond to risks
In
the first comprehensive study of its nature, the IMF
has taken stock of the initial lessons learnt from the
global financial crisis and presses for a worldwide
rethink of how to handle systemic risk management.
“To look past blame in this crisis, it is useful
to ask why policymakers failed to heed the looming threat,”
the report said. “If there is an underlying theme
to the lessons here, it is of failing to come to grips
with fragmentation.”
The IMF’s work, initially requested by its policy
steering committee, the International Monetary and Financial
Committee, will feed into the work of the Group of 20
(G-20) leading economies to come up with a blueprint
for reforming the way financial markets are regulated
and for making international financial institutions,
such as the IMF and the World Bank, more effective.
The G-20 leaders will meet in London on April 2, 2009.
In its discussion of the analysis, the IMF’s Executive
Board stressed “the need for remedial actions across
a broad front and at many levels, implying an ambitious
agenda for policymakers and the need for coordinated
action.”
Why the crisis happened
Understanding what went wrong is key to restoring stability
to the global economy, which is suffering the worst
recession since the Second World War. “A key failure
during the boom was the inability to spot the big picture
threat of a growing asset price bubble. Policymakers
only focused on their own piece of the puzzle, overlooking
the larger problem,” Reza Moghadam, head of the
IMF’s Strategy, Policy and Review Department said.
The IMF’s analysis points to failures at three
different levels:
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Financial regulators were not equipped to see the
risk concentrations and flawed incentives behind the
financial innovation boom. Neither market discipline
nor regulation were able to contain the risks resulting
from rapid innovation and increased leverage, which
had been building for years.
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Policymakers failed to sufficiently take into account
growing macroeconomic imbalances that contributed
to the buildup of systemic risks in the financial
system and in housing markets. Central banks focused
mainly on inflation, not on risks associated with
high asset prices and increased leverage. And financial
supervisors were preoccupied with the formal banking
sector, not with the risks building in the shadow
financial system.
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International
financial institutions were not successful in achieving
forceful cooperation at the international level. This
compounded the inability to spot growing vulnerabilities
and cross-border links.
Light-touch regulation failed to spot risk
The IMF study on financial regulation notes how, over
the past decade, the financial system expanded massively
and created new instruments that appeared to offer higher
rewards at lower risk. This was encouraged by a general
belief in light-touch regulation based on the assumption
that financial market discipline would root out reckless
behavior and that financial innovation was spreading
risk, not concentrating it.
“A key failure during the boom was the inability
to spot the big picture threat of a growing asset price
bubble. Policymakers only focused on their own piece
of the puzzle, overlooking the larger problem.”
Both these assumptions proved wrong, and the result
was a massive asset price bubble, especially in housing,
and an enormous buildup of risk both inside and outside
the formal banking system. “What is clear from
the crisis is that the perimeter of regulation must
be expanded to encompass systemic institutions and markets
that were operating below the radar of regulators and
supervisors,” Jaime Caruana, head of the IMF’s
Monetary and Capital Markets Department, said. “We
are suggesting a two-tiered approach to expand regulation:
extending disclosure to provide enough information for
supervisors to determine which institutions are big
or interconnected enough to create systemic risk, and
intensified functional regulation and oversight.”
The study identifies five key weaknesses that need to
be fixed:
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First, the regulatory perimeter, or scope of regulation,
needs to be expanded to encompass all activities that
pose economy-wide risks. Regulation should also remain
flexible to keep up with innovation in financial markets,
and it should focus on activities, not institutions.
Risk concentrations should not be allowed to develop
beyond the regulatory perimeter. Clarifying the mandate
for oversight of systemic stability would be an important
first step.
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Second, market discipline needs to be strengthened.
The failures of credit rating agencies to adequately
assess risk have been criticized by many, and initiatives
to reduce their conflicts of interest and improve
investor due diligence are underway. Other steps could
include less reliance on ratings to meet prudential
rules, and a differentiated scale introduced for structured
products. Also, the resolution of systemic banks should
include early triggers for intervention and more predictable
arrangements for loss-sharing.
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Third, procyclicality in regulation and accounting
should be minimised. Increasing the amount of capital
required of banks during upswings would create a buffer
on which banks can draw during a downturn. An international
framework for provisioning is needed to reflect expected
losses through-the-cycle rather than in the preceding
period. Supervisors should also routinely assess compensation
schemes to ensure they do not create incentives for
excessive risk-taking. In addition, there is a strong
case for improving accounting rules by acknowledging
potential for mispricing in both good and bad times.
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Fourth, information gaps should be filled. Greater
transparency in the valuation of complex financial
instruments is needed. Improved information on off-market
transactions and off-balance sheet exposure would
allow regulators to aggregate and assess risks to
the system as a whole. Such measures would also strengthen
market discipline.
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Fifth, central banks should strengthen their frameworks
for systemic liquidity provision. The infrastructure
underlying key money markets should also be improved.
Macroeconomic policies did not target systemic risks
The crisis was preceded by a long period of robust global
growth and low interest rates. This encouraged investors
to seek higher returns, fuelling demand for the riskier
products generated by financial innovation. “At
the root of the crisis was the optimism that was brought
about by a long period of prosperity. This optimism
led to risks in the global economy not being assessed
as carefully as they should have been,” Olivier
Blanchard, Economic Counsellor and Director of the IMF’s
Research Department, said. “With large failures
in regulation and supervision, this fuelled high leverage
and build-up of risky assets.”
“What is clear from the crisis is that the perimeter
of regulation must be expanded to encompass systemic
institutions and markets that were operating below the
radar of regulators and supervisors.”
While monetary and fiscal policies did not play a major
role in the runup to the crisis, the crisis still holds
a number of lessons for policymakers on the macroeconomic
level.
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First, monetary policy should respond to the buildup
of systemic risk. Policymakers should focus on macro-financial
stability and pay greater attention to the buildup
of systemic risk. Of course, how to identify and then
to react to an inflating bubble is difficult. Typically,
monetary policy will be too blunt an instrument to
deal with asset price and credit booms: the response
has to be found mainly in prudential regulation. But
that first line of defense has failed in the past,
and did so again recently. So there is a case for
expanding the mandate of monetary policy to explicitly
include macro-financial stability, not just price
stability.
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Second, fiscal policy should be put on a stronger
footing in good times. Fiscal policy did not play
a major role in the runup to the crisis, but many
countries failed to pay down public debt and reduce
deficits during good times. As a result, these countries
now find themselves limited in their ability to stimulate
their way out of the crisis. Tax policy also encouraged
debt financing in recent years. Such tax rules could
usefully be changed. The IMF has developed detailed
analysis of available fiscal space in key countries,
how to design effective stimulus packages, and how
to ensure fiscal solvency over the medium term, in
light of the increase of debt and contingent liabilities.
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Third, while international capital flows are on the
whole beneficial,global imbalances have to be addressed.
Policymakers should use macroeconomic and structural
policies to rebalance savings and investment in their
own economies. They should also use regulation to
help reduce systemic risk stemming from capital flows,
for example by imposing constraints on the foreign
exchange exposure of domestic financial institutions
and other borrowers.
Failures of international cooperation
Despite the growing threat, the IMF and other institutions
failed to send a strong wakeup call to policymakers
and achieve a collaborative policy response. To be fair,
some warnings were issued. For example, the IMF and
others warned about risk concentrations in the financial
sector and the prospects of disorderly adjustment from
global imbalances. But what warnings were given fell
on deaf ears, partly reflecting their lack of urgency
and specificity.
There was also a lack of commitment on the part of policymakers
for coordinated policy action in response to global
threats. For instance, as the crisis unfolded, the initial
policy response was a rush to protect local banks, at
the risk of causing runs elsewhere.
“At the root of the crisis was the optimism that
was brought about by a long period of prosperity. This
optimism led to risks in the global economy not being
assessed as carefully as they should have been.”
The national deposit insurance schemes are just one
example of the many unintended consequences of countries
undertaking unilateral policy actions, which then cause
problems for other countries, magnifying the impact
of the problem.
The bottom-line is that the crisis has underlined the
need for clearer policy messages and for more, not less,
international cooperation across a range of economic
and financial issues. According to the IMF’s analysis,
action is needed in four areas.
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Policy warnings should be more focused and specific.
The IMF is working with the Financial Stability Forum
(FSF) on a new early warning exercise that will bring
together scattered macro-financial expertise and drill
down on key threats. More generally, the IMF’s
challenge will be to piece together macroeconomic
and financial sector developments into a big picture
scenario that also takes into account cross-country
spillover effects.
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Leadership is needed in responding to systemic global
risks. A range of organizations can claim a leadership
role, including the IMF, the G-7 and G-20, the FSF,
and the OECD, but none has been effective. The IMF
has the mandate, near universal membership, and a
blend of macroeconomic and financial expertise that
makes it particularly well-suited to assume leadership
on global risks, but its bureaucratic ways and rigid
power structures has shifted the policy debate towards
smaller, more flexible groups, including to the G-20
and the FSF. Yet these smaller groups have their own
problems of legitimacy and capacity for follow-up.
A satisfactory global solution would bring together
expertise, legitimacy, and effectiveness, and provide
a forum for engagement among high-level policy makers.
The IMF can be this solution, but this will require
a further rebalancing of voice and representation among
its members, to make its decision-making more accurately
reflect today’s global economic landscape.
• Rules for cross-border financial sector resolution
are needed to encourage collaboration rather than solutions
that minimize the burden on the local taxpayer with
potential beggar-thy-neighbor effects.
• A credible global liquidity framework is needed.
Access to large-scale financing or insurance remains
an issue for most emerging market countries. The IMF
is reviewing its lending framework to make sure it is
well-suited to members’ needs. If the Fund cannot
provide the needed insurance, countries may in future
seek to rely on self-insurance through surpluses and
reserve accumulation, which could distort global trade
for years to come.
The way forward
Implementing the recommendations summarized here will
be difficult both politically and technically. However,
the sheer scale of today’s crisis provides clear
evidence of the importance of learning from past mistakes.
One also should not underestimate the momentum today
toward decisive action and lasting solutions. The summit
of G-20 leaders on April 2, 2009 will be the first opportunity
to make real progress.
“The reform agenda is huge, and people come to
it with sometimes very different perspectives, but we
see a genuine desire to find common solutions. We hope
that the IMF’s analysis will be helpful in helping
build consensus on how to tackle these shared problems,”
Moghadam said.
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