Conclusion

In this paper, we have emphasized that certain elements are new to the current episode of financial turmoil, while many elements have remained the same. The new elements include structured credit, the broader use of the originate-to-distribute business model, and new arrangements in repo markets that allow the use of almost any financial asset as collateral. These are fundamentally good innovations but their reckless use has helped to underpin the crisis. The elements that have remained the same are those processes that underpin the basic procyclicality in the system, that is, the tendency for a build-up of risk-taking and leverage to occur in benign economic environments and the abrupt withdrawal from risk and an unwinding of leverage that typically happens once the environment turns bad.

In their short-term response to the dramatic loss of liquidity, central banks have had to trade the importance of ensuring the continued availability of market liquidity as a public good against the moral hazard that any market intervention is likely to induce. Over all, central banks have acted to broaden the scope of their liquidity operations. At the same time, however, central banks have had to deal with the stigma often associated with borrowing from them, which seems to get worse at the very time when liquidity from the central bank is needed the most.

In proposing long-term responses to the crisis, the FSF has focused on areas where incentives for risk-taking may be aligned more properly—for example, through strengthened capital requirements and more judicious use of credit ratings. Strengthened capital requirements help align incentives by making sure that capital charges (which represent a cost to shareholders, since they limit the ability of the firm to increase its leverage) are higher for riskier exposures. Better use of credit ratings help align incentives by obliging lenders and investors to take account of the range of risks related to a given exposure (including liquidity, price volatility, and tail risks), rather than simply using a credit rating. The FSF has also focused on areas where risk management may be made more robust, such as through better disclosure rules and valuation standards Nonetheless, recognizing that the procyclicality of the financial system lies at the root of this and other financial crises before it would suggest that more extensive policy responses may be required. The use of supervisory instruments in an explicitly countercyclical way is one avenue requiring further investigation. Polices here would be designed to build adequate buffers in the system to prevent shocks from propagating too far.

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