Dombret speaks: an influential Bundesbank policy strategist offers his take on the IMF, hedge funds, the rating agencies, and the alleged design flaws in monetary union.



TIE: To what degree was the global financial crisis the result of Anglo-Saxon countries' lack of regulatory oversight and overconfidence in the efficiency of the market system?

Dombret: With the benefit of hindsight, we might say that our belief in the efficiency of markets in the pre-crisis years was somewhat naive, but it was accompanied by other misjudgments and economic policy errors. It is common knowledge that market transactions can only have efficient outcomes under certain conditions, which include well-aligned incentives, an absence of significant externalities, fully competitive markets, and so on.

What is therefore needed is a supplementary framework for legal and regulatory oversight that is continuously adjusted to innovations in the financial system. This was not adequately achieved for innovations in the originate-to-distribute model, where credit risk transfer into the shadow banking system turned out to be flawed, where risks were underpriced, where overall leverage in the system was too high, and where compensation schemes strongly rewarded short-term risktaking. Of course, internationally active banks domiciled outside the Anglo-Saxon world, including Germany, participated in this credit boom partly because they wanted to diversify their domestic exposures.

TIE: Did developed world policymakers underestimate the problems resulting from the financial crisis?

Dombret: What was widely underestimated was the scale of the damage following the initial "correction" in the U.S. housing market, the subprime mortgage market, and the more exotic segments of the structured credit markets. The collapse of leading financial institutions, rising unemployment, and increasing default risk for sovereigns went far beyond a cyclical process of "creative" destruction. There is no social consensus for this kind of economic volatility.

It is my impression that this experience has brought regulators in the United States, in the United Kingdom, and on the European continent closer together on many regulatory issues. For example, capital and liquidity standards as postulated by Basel I, and also in certain respects Basel II, are generally regarded as too lax now, and this has led to the development of stricter standards in different streams of regulatory reform.

TIE: What lessons can we learn from the experience of the last three years? What have policymakers learned about risk?

Dombret: There is now also a global consensus that financial stability can be assured only if the financial system is viewed and treated as a whole. The crisis has painfully demonstrated that supervising individual financial institutions alone is not sufficient. This traditional microprudential perspective primarily aims at ensuring the stability and solvency of single entities. Yet it often fails to identify and adequately address systemic risks because it tends to neglect the interplay of individual market players and their interaction with the economy as a whole. This needs to change, and change is underway all over the globe--something you can really sense in all international forums.

The new concept of macroprudential oversight takes a step back and tries to look at the forest instead of the trees. It alms at mitigating risks arising from contagion effects and the interaction of financial institutions, markets, market infrastructures, and the macroeconomy. We call this the cross-sectional dimension of systemic risk. In addition, macroprudential oversight pays attention to the time dimension of systemic risk by seeking to prevent financial imbalances from building up over time. As much as we will not be able to do away with the financial cycle, we are confident we can dampen it and so enhance financial stability.

TIE: How has the Bundesbank in particular changed its position toward financial risk?

Dombret: In response to the crisis, national financial authorities and international institutions are now expanding financial supervision by establishing macroprudential oversight regimes or extending existing surveillance activities. Institutional frameworks are being set up and analytical toolkits are becoming more sophisticated. Central banks play a crucial role, both in national arrangements and at an international level. In the European Union, for example, we have recently established the European Systemic Risk Board. On this Board, central banks are key players. And I personally feel that that is a great leap forward. One of the ESRB's main objectives is to improve the understanding of how risks potentially interact and to recommend policy actions to counteract and mitigate such risks at an early stage.

The Bundesbank also plays a central role in macroprudential oversight...

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