Importance of Crisis Prevention

2.1 Policy mistakes behind the global financial crisis

The root cause of the global financial crisis of 2007–09 traces back to the buildup of excessive optimism—created by a long period of world-wide high economic growth, low real interest rates and subdued volatility of financial prices—as well as the flood of liquidity. With these benign macroeconomic and financial environments, investors around the world were prompted to search for yield and underestimated the risks of investment, especially those in new financial products. From this perspective, the IMF (2009a) summarized causes of the global financial crisis in three dimensions: flaws in financial regulation and supervision; failure of monetary policy to address the buildup of systemic risk; and a weak global financial architecture.

2.1.1 Flaws in Financial Regulation and Supervision

Several excellent reviews of what went wrong in financial regulation (Group of Thirty 2009; Brunnermeier, et. al. 2009; de Larosiere Group 2009) point to the fact that there were regulatory and supervisory deficiencies, including inadequate macroprudential supervision.

Essentially, national financial regulators and supervisors failed to see the large buildup of systemic risks. In the US, the regulatory and supervisory framework was highly fragmented and its scope was narrowly focused on insured deposit-taking institutions and did not cover all financial activities that posed economy-wide risks. As a result, the “shadow banking” system grew among investment banks, mortgage-brokers and originators, special investment vehicles, insurance companies, and other private asset pools, as they had long been lightly regulated by a patchwork of agencies and generally not supervised prudentially.¹

Due to the propensity to focus on individual institutions, supervisors around the world failed to recognize interconnections and links across financial firms, sectors, and markets due to the lack of a macroprudential approach. Supervisors only focused on their own piece of the puzzle, overlooking the larger problem. Shin (2009) pointed out a fallacy of aggregation: “mis-educated” supervisors and examiners were focused on individual institutions, without regard to the impact on the system. There is thus growing realization that a macroprudential approach to supervision and an effective systemic stability regulator are needed to complement microprudential measures.

2.1.2 Failure of Monetary Policy to Contain Financial Imbalances

The latest IMF analysis pointed to “macroeconomic policies, which did not take into account building systemic risks”² and states that, “a key failure during the boom was the inability to spot the big picture threat of a growing asset price bubble.” Clearly, the US Federal Reserve underestimated the buildup of financial imbalances coming from housing price bubbles, high leverage of financial institutions, and interconnections between financial markets. In addition, Taylor (2009) argued that the Federal Reserve policies brought excessive liquidity and low interest rates to the US and that the federal funds rate was kept too low for too long, fueling the housing boom and other economic imbalances. The Federal Reserve may well have assumed that even if the asset price boom collapsed, the impacts on the financial system and the economy could be mitigated by lower interest rates.³

In theory, tighter prudential regulation could have been mobilized to contain systemic risk, but in practice, before the authorities realized it, huge systemic risks had accumulated below the regulators' radar, in the shadow banking system. Given the failure of prudential supervisory action to prevent a buildup of systemic risk, the central bank, as a macro-supervisor, should have reacted to credit booms, rising leverage, sharp asset price increases, and the buildup of systemic vulnerabilities by adopting tighter monetary policy.

2.1.3 Weak Global Financial Architecture

There were deficiencies in the global financial architecture—the official structure that facilitates global financial stability and the smooth flow of goods, services and capital across countries. There are three issues.

First, global institutions—like the International Monetary Fund (IMF), the Bank for International Settlements (BIS), and the Financial Stability Forum—failed to conduct effective macroeconomic and financial surveillance of systemically important economies, that is, they did not clearly identify the emerging systemic risk in the US, the UK and the Euro Area, send clear warnings to policymakers, or provide practical policy advice on concrete measures to reduce the systemic risk.⁴ Their analysis clearly underestimated the looming risk in the shadow banking system, interconnections across financial institutions, markets, and countries, and global macroeconomic-financial links.

Second, there was considerable discussion of global payments imbalances during 2002–2007. The IMF in particular warned repeatedly, particularly through the newly established Multilateral Consultation process, that global imbalances posed a serious risk to global financial stability. However, the global imbalance discussion may have diverted policymakers' attention away from US “domestic” financial imbalances toward “global” imbalances, the risk of dollar collapse, and the need to revalue the People's Republic of China's currency.

Third, the crisis has revealed the ineffectiveness of fragmented international arrangements for regulation, supervision, and resolution of internationally active financial institutions. The problem became particularly acute when such institutions showed signs of failing. Although home country authorities are mainly responsible for resolving insolvent institutions, host-country authorities were often quick to ring-fence assets in their jurisdictions because of the absence of clear international rules governing burden sharing mechanisms for losses due to failure of financial firms with cross-border operations.

2.2 Principles of Crisis Containment

The most fundamental approach to a financial crisis should be to prevent one from taking place in the first place. Once a crisis breaks out, however, efficient crisis management and resolution policies become important.

The key principle should be: ”Crisis prevention is better than cure.” This entails the prevention or mitigation of the buildup of vulnerabilities that could lead to systemic risk and eventually a financial crisis. The major preventive mechanisms should include: (i) establishment of effective regulation and supervision that monitors and acts on economy-wide systemic risk; (ii) a sound macroeconomic management framework (for monetary, fiscal, and exchange rate policies) that can counteract the buildup of systemic vulnerabilities such as asset price bubbles; and (iii) creation of a strong international financial architecture that can send pointed early warnings and induce effective international policy coordination to reduce systemic risk internationally. In the prevention exercise, the macroprudential approach is becoming increasingly important.

Once a financial crisis breaks out, it is necessary to adopt comprehensive policy measures so that the crisis does not magnify or prolong itself. Crisis management tools include: (i) provision of timely and adequate liquidity; (ii) rigorous examination of financial institutions' balance sheets, including through stress tests; (iii) support of viable but ailing financial institutions through guarantees, nonperforming loan removal, and recapitalization; and (iv) adoption of appropriate macroeconomic policies to mitigate the adverse feedback loop between the financial sector and the real economy, reflecting the specific conditions and reality of the economy. An important challenge is how to ensure that such management policies do not create moral hazard problems.

Finally if a financial crisis evolves into a full-blown economic crisis, with systemic damages to the financial, corporate, and household sectors, it is vital to quickly resolve the problem. Crisis resolution measures include: (i) use of mechanisms for restructuring financial institutions' impaired assets and, hence, corporate and household debt; (ii) use of well-functioning domestic insolvency procedures for nonviable financial institutions; and (iii) use of international mechanisms for resolving nonviable internationally active financial institutions, including clear burden sharing mechanisms. Without a clearly-defined regime for the resolution of financial institutions domestically and internationally, the crisis management process can create international conflict, such as ring-fencing of foreign bank assets.

It is noted that the nature of a crisis resolution mechanism affects crisis management policies and the degree of moral hazard for financial institutions. Later in this section we summarize the discussion by arguing that a systemic stability regulator with sufficient powers should be established at the national level that focuses on all the three dimensions: crisis prevention, management, and resolution. Given that the role of the global stability regulator—the IMF and the Financial Stability Board (FSB)—may be limited, the role of a national stability regulator will be critical.

2.3 Macroeconomic and Financial Surveillance and Macroprudential Supervision

Several excellent reports that have addressed the need to improve financial regulation and supervision from systemic perspectives agree on the following:⁵ the financial regulatory frameworks around the world have paid too little attention to “systemic risk”; current financial regulations have tended to encourage procyclical risk taking, which increases the likelihood of financial crises and their severity when they occur; and current regulations do not deal adequately with “large complex financial institutions”—financial intermediaries engaged in some combination of commercial banking, investment banking, asset management, and insurance—whose failure poses a systemic risk or “externality” to the financial system as a whole (Haldane 2009). They also point to the danger induced by implicit “too big to fail” or “too interconnected to fail” problems.

The traditional bottom-up supervision addressing the soundness of individual institutions is founded on the assumption that making each bank safe will make the whole system safe. The focus on individual institutions and the inadequate attention paid to the overall system evident in this approach explains how global finance has become so ripe for contagion without sounding regulatory alarms. Crisis prevention necessitates taking a macroprudential approach to complement the existing microprudential supervisory rules.

To understand the nature of macroprudential supervision, it is useful to consider the examples of a broad agenda to address systemic risk, outlined by Bernanke (2009) and Tarullo (2009).Box 1 [ PDF 49.3KB | 1 page ] lists a set of issues that effective supervisors and regulators should bear in mind. In our view, the financial stability monitoring agenda summarized in the Box might be suited to the US, but it is too narrow for emerging market economies. The objects of systemic oversight should be broader, including the corporate and household sector, as well as macroeconomic elements, such as capital flows and external debt.

Essentially the aim of macroprudential supervision is to preserve systemic financial stability by identifying vulnerabilities in a country's financial system and calling for policy and regulatory actions to address those vulnerabilities in a timely and informed manner to prevent a crisis. In contrast to microprudential supervision, which takes a “bottom-up” approach that focuses on the health and stability of individual institutions, macroprudential supervision takes a “top-down” approach that focuses on the economy-wide system in which financial market players operate, and helps assess sources of risks and incentives. It requires the integration of detailed information on banks, nonbank financial firms, corporations, households, and financial markets.

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