Conclusions

Our starting point is that a financial crisis is not an “unknown unknown,” though its precise timing and the magnitude of its severity might be. A crisis builds up over time in response to policy mistakes and investor herd behavior. While markets tend to be forgiving for a long time, the unsustainable imbalance is eventually corrected. By identifying and dealing with systemic risk—or sources of financial vulnerabilities—before it creates critical instability, policymakers could prevent a financial crisis. For this purpose, macro-financial surveillance and macroprudential supervision are vital, and a systemic stability regulator—or relevant financial authorities under a collective framework for systemic stability regulation—must act to avoid the buildup of large vulnerabilities and imbalances in each jurisdiction. In our experience, an inadequate effort to capture and analyze data is a key obstacle to conducting adequate macroprudential supervision.

Several models are possible to choose from in creating a systemic stability regulator, including a fully integrated model a la Singapore, a central bank-led model of the pre-1998 UK, and a coordinated “council” model that has yet to be tested. For most countries, a realistic approach would be to take a “council” model, where (i) all financial authorities (central bank, supervisors, and finance ministry) work in a coordinated manner, including intensive information exchange and consultation, and (ii) the central bank conducts macroeconomic and financial surveillance while the supervisors take macroprudential actions in addition to microprudential supervision. It is highly desirable for supervisors to consolidate their supervision over banks, nonbank financial institutions, and markets.

Even if such a framework for national systemic risk regulation is established, financial stability may be at risk without a global strategy to address financial crisis prevention, management and resolution. A successful international financial order can be constructed only with a binding set of minimum international standards. In the absence of such standards, the differences in national policies in accounting, information transparency, regulating leverage, and capital standards will likely lead to a regulatory arbitrage race to the bottom, with the competition from more pliant jurisdictions undermining more stringent regulatory regimes, and “exporting” financial instability.

In this sense, the Westphalian principles of sovereignty that govern international financial oversight are not suited to the realities of an interconnected financial system in the 21st century. If the financial authorities in major economies—such as the US, the UK, and the Euro Area—do not make progress in the creation of a binding global financial order, the prospects for attaining global financial stability are limited. The financially integrated world would have to continue to live with regulatory fragmentation, with all of its attendant risk to stability. In order to be successful, the recent reforms at the global level—that focus on the newly created Financial Stability Board—require that the US and the UK make strong political commitments to national and international financial stability regulation.

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