Creating More Stable Regulatory Regimes and Improving Supervision

The International Monetary Fund (IMF) notes that there are four key areas where the existing international financial architecture failed in the current crisis (IMF 2009):

1. Surveillance of global economic developments and policies did not give sufficiently pointed warnings about the risks building up in the international financial system. I might note that this is true despite various institutions that did identify—though, perhaps, they could have done it more forcefully—these risks, including the Group of Seven and Group of Eight, the Financial Stability Forum, and the IMF itself.

2. Coordination of macroeconomic policies across governments did not produce the international leadership needed for a concerted response to the global risks identified. In particular, on the debtor side, the US continued to run unsustainably high current account deficits, while on the creditor side, surplus countries accumulated US securities in order to keep stable currencies and retain international competitiveness. These imbalances were known well before the crisis hit. The problem was that there was no effective way—or at least no strong incentives—to engineer a soft landing through coordination. These issues were critiqued and discussed in many international forums but pointing out imbalances is easier than getting sovereign nations to do anything about them without ex ante agreements on burdens of adjustment.

3. Regulation and supervision of internationally active financial institutions did not provide a sufficiently robust framework to allow problems to be resolved smoothly. As I noted above, insufficient regulation of highly-leveraged investment funds, pricing problems of CDS and MBS and other complex derivatives, and failures of value-at-risk models in banks and other financial institutions suggested that the system of “best practices” was highly flawed.

4. Arrangements for international public liquidity and loans to support adjustment did not fill gaps adequately as the crisis spread, reflecting shortcomings in design and size. This critique obviously pertains to the international financial system and the financial fallout from the liquidity squeeze in late 2008. This is one area where the international community has responded, however, with a major increase in IMF resources, an expanded size and multilateralizataion of the Chiang Mai Initiative, and the like.

These shortcomings in the international system tend to be relatively uncontroversial. Topic (4) is briefly discussed in Section V. Topic (2) is a macroeconomic question that is beyond the scope of this study; so it is discussed here only in the context of surveillance.¹³ Instead, in this section, Topics (1) and (3) are focused on as good points of departure in the planning of how to create a more stable international regulatory system while outlining the major shortcomings of the existing system.

3.1 Key Issues in Creating a More Efficient Regulatory and Surveillance Framework

Many financial institution-related variables require reform in order to create a more stable and robust global financial system. Of course, as finance is the business of risk, there can be no iron-clad way of imposing certainty without stifling innovation and efficiency. Still, I would suggest that some of the most salient areas that beg reform would be the following.

1. The global economic crisis revealed a need to improve information dissemination and transparency. As previously mentioned, these areas would include: improved disclosures on exposures assumed by large and complex (bank and non-bank) financial institutions; greater disclosure, assessment, and analysis of complex “structured products”; revamping of indicators of financial stability analysis to focus on improved early-warning mechanisms; and improved transparency in over-the-counter derivatives markets, in particular CDS (Johnson et al. 2009). I would argue that these are the most important areas in need of reform in the post-global economic crisis era, not the least because they are so closely linked to all the other areas.

2. In a global economy, it is essential to develop common rules in order to prevent the most risky activities moving to areas where there is the least regulation. Thus, it is important to improve cross-border arrangements for financial regulations. There do exist best practices to avoid “regulatory arbitrage” and improve burden-sharing across jurisdictions by international financial institutions, but these need to be strengthened considerably given the nature of the modern international financial regime. In particular, ground rules should be improved and cooperative approaches in times of crisis ameliorated (IMF 2009).

While there has been a good deal of effort to harmonize bank prudential requirements and supervisory practices across countries, the threshold for intervention differs considerably across countries, as was clear in the global economic crisis (IMF 2009). This also could lead to regulatory arbitrage.

3. Related to issue (2), international rules on host vs. home responsibilities in times of crisis need to be enhanced, as the dearth in rules in this area has become increasingly problematic as international financial services become more integrated. Supervisors' obligations to their own citizens take priority over foreigners in the absence of ex ante agreements, and problems in a local institution can lead to crisis in a foreign country. For example, Italian-owned banks comprise 20% of the Polish banking market, but their assets account for only 4% of the Italian market (IMF 2009). Burden-sharing and rules-covering cross-border bank resolution, therefore, need to be clearly specified, as in the time of even a small crisis in an Italian bank, Italian regulators could provoke a crisis in Poland.

4. While there were many warnings that the financial systems in the US, European Union, and elsewhere were exhibiting problems well before the crisis hit, the speed and severity of the collapse beginning in 2008 were unanticipated. Clearly the system requires improved surveillance and early-warning systems. Given its mandate, the IMF has been quite pro-active in stressing the need to improve these. For example, IMF (2009: 1) notes that:

Vulnerabilities can arise from a variety of sources, including unexpected events, bad policies, misaligned exchange rates, credit-fueled asset booms, external imbalances, or data deficiencies that obscure trends. To gain traction, surveillance needs to be reoriented to ensure warnings are clear, to successfully connect the dots, and to provide practical advice to policy makers.

It would be difficult to disagree with such a recommendation. However, the devil is in the details. When is it clear that an asset boom is a problem? What are acceptable imbalances, and who should bear the burden of adjustment? For example, prior to the global economic crisis, many pundits stressed that there were, indeed, asset bubbles that eventually would pop, and imbalances were obvious.¹⁴ What is needed is not only an objective framework but also an effective way to determine the burden of adjustment. I would argue that in the current crisis, the latter issue was more of a problem than the former. It may be easier to address the burden of adjustment in the context of subregional and regional cooperation than at the global level, however.

5. In terms of macroeconomic surveillance, more attention needs to be focused on the exchange-rate issue. A considerable amount of attention has been paid to global imbalances and exchange-rate misalignments generally, though as I argue above, there is no reliable model that indicates when a situation is at the breakpoint. But there are also exchange rate issues that are recognized but generally ignored. For example, the “carry trade” phenomenon has been cited as a major force in moving exchange rates, especially the value of the Japanese yen but also the US dollar (e.g., vis à vis the euro). A lack of data on carry-trade transactions is probably to blame for this; still, if exchange rates adjust rapidly during times of crisis, they should be part of the metric. Also, there is, perhaps, a problem in terms of currency mismatches exacerbated by excessive leverage that persists. As noted by Morris Goldstein in a recent speech (Goldstein 2009):

Clearly, regulation and supervision are not doing enough to discourage currency mismatching. We are not reflecting enough in our capital charges the message from uncovered interest rate parity that when an entity borrows in a low-interest foreign currency, it faces a higher risk that repayment will be made in a currency that has appreciated relative to when the borrowing was undertaken. We are not paying enough attention in our supervisory practices to the fact that foreign-currency loans to borrowers without a ready source of foreign-exchange earnings are more risky than those to borrowers with foreign-currency earnings: A foreign-currency mortgage for a homeowner carries greater currency risk than a foreign-currency loan to an exporter. And we are not putting enough of a public spotlight on rapidly growing currency mismatches before they unravel.

6. In order to avoid the pro-cyclical nature of financial crises, financial authorities need to adopt correct prudential regulations and encourage larger liquidity buffers. Value-at-risk models are structured such that a firm will take on more risk during benign periods but will retrench during a crisis. Hence, they lead to pro-cyclical investment strategies. Credit-risk management has the same effect. This problem is another reason why risk-management models need to be improved—e.g., applying smoothing techniques to credit risk capital allocations (Andritzky et al. 2009).

7. The “too big to fail” issue. The moral hazard problem is inherent in international finance. Hence, it is something that needs to be watched closely. As banks form the core of all financial systems and the moral hazard problem is clear in banking they tend to be the most closely watched. During the Asian crisis, just a few key banks dominated the financial markets of the crisis-affected economies, which led to excessive risk-taking.

But the same problems emerge in the case of large non-bank financial institutions, particularly highly-leveraged ones, and as they are less regulated, the potential for disaster can be even worse. Now, if these institutions did not pose a systemic risk, there would be less concern. But the global economic crisis has underscored that they definitely do.

In the post-global economic crisis world, this issue will need to be addressed, though there is surprising little work on it in the academic literature. Trillion-dollar bailouts of financial institutions are socially intolerable, particularly when it would appear that the current system is allowing the privatization of profits and the socialization of risks. One approach to regulation in this regard would be to keep it as light as possible, but to ensure that the failure of one financial institution would not cause systemic risk and force a government-engineered bailout. This would provide a very strong incentive for non-bank financial institutions to auto-regulate—e.g., improve significantly their risk and investment strategies and adopt best-practices. However, the issue begs the question as to what is “too big to fail” and what to do about those that meet that criteria.

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