Introduction

With a few notable exceptions, central bankers, financial supervisors/regulators, other policymakers, international organizations, the private sector, and academic economists failed to predict the current global financial crisis and underestimated its severity. Such a dramatic failure of the entire financial community warrants soul searching: Is it possible to prevent a systemic crisis? In this paper we argue that this is indeed possible and that the best way to prevent a financial crisis is to identify and act on systemic risk or sources of financial instability.

Using a new database, developed by Laeven and Valencia (2008), on the occurrence of systemic banking crises and policy responses to resolve them, one can see that all of the crises have two elements in common. Virtually all of the countries that suffered a crisis had made serious policy mistakes, and accumulated significant structural vulnerabilities and financial imbalances. In virtually all instances, the crisis was slow to unfold and could have been “spotted” in its early stages and managed better. In all instances, there were underlying vulnerabilities. The financial markets were very forgiving and often provided policymakers with the benefit of doubt. When it became obvious that policymakers were unable or unwilling to address the underlying problems, the financial markets were damaged by a loss of confidence, which eventually led to crises.

The devastating global financial crisis of 2007–2009 offers a set of initial lessons. The new lessons learned are more substantial than those learned in the past, as what was considered as the best financial systems—the United States (US), the United Kingdom (UK) and Continental Europe—all went wrong. The objective of this paper is to explore how to spot signs of systemic risk and prevent a financial crisis. We argue that an effective framework for systemic stability regulation should be established in each country, but that such a national effort would not be sufficient without the US and the UK—hosts to global financial centers and where the crisis originated—making a full political commitment to systemic stability regulation.

The paper is organized as follows. In Section 2 we discuss the importance of crisis prevention and argue that effective macroprudential supervision—a top-down approach complemented by bottom-up microprudential supervision—can effectively spot and prevent crises. In Section 3, we provide basic principles in establishing a systemic financial regulator from the perspectives of objectives and mandates, resources, implementation, and structure. Section 4 reviews recent reform proposals considered nationally and internationally to address systemic risk, and recommends that each country create a framework for systemic stability regulation or even an independent financial stability regulator. Section 5 concludes with recommendations for future action.

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