Preventing Future Crises
| Author | Noel Sacasa |
| Position | Senior Financial Sector Expert in the IMF's Monetary and Capital Markets Department |
| Pages | 11-14 |
-
Priorities for regulatory reform after the meltdown
Page 11
The financial crisis has exposed weaknesses in the current regulatory and supervisory frameworks. The recent developments have made it clear that action is needed in at least four areas to reduce the risk of crises and address them when they occur. These are (a) finding a better way to assess systemic risk and prevent its buildup in good times; (b) improving transparency and disclosure of risks being taken by various market participants; (c) expanding the cross-institutional and cross-border scope of regulation while safeguarding constructive diversity; and (d) putting in place mechanisms for more effective, coordinated actions.
Effective regulation is needed to realize the potential of open financial markets. how to improve regulation was central to the discussion at the November G-20 Summit on Financial Markets and the World Economy. Financial innovation and integration have increased the speed and extent to which shocks are transmitted across asset classes and countries, blurring boundaries between systemic and nonsystemic institutions.
But regulation and supervision have remained geared toward individual financial institutions. The regulatory mechanisms do not adequately consider the systemic and international implications of domestic institutions' actions.
This article takes a look at substantive issues in the current debates on reforming the financial sector. The first section identifies crucial weaknesses that the reforms need to address, and the second outlines key areas for policy action.
Reform proposals should address destabilizing failures in markets and regulation. Although the jury is still out, three groups of mutually reinforcing factors that did not receive adequate attention from regulators and monetary authorities arguably contributed to increased systemic risk. First, global macroeconomic imbalances resulted in lower interest rates during the past decade, inducing more risk-taking and contributing to the creation of asset price bubbles worldwide. Second, changes in financial sector structure and the failure of risk management to keep up with financial innovation during the past two decades rendered the system more prone to instability. And, third, leveraged financial institutions have inherent incentives to take on excessive risks without internalizing systemic risk, which is the main reason they need to be regulated.
Regulators and central banks failed to adequately acknowledge and deal with the systemic risks attached to fast credit growth and asset price bubbles. During this decade, some economies ran persistent large current account surpluses, which generated a huge demand for financial assets issued in defi- cit countries-notably for U.S. assets. This, together with an accommodative U.S. monetary policy, contributed to low real interest rates worldwide, which in turn induced considerable risk-taking and fed fast credit growth. In the United States, the credit market debt of households and nonfinancial businesses grew from 118 to 173 percent of GDP between 1994 and 2007 (see chart). The growth of the credit debt of households accelerated even more since 2000, jumping in seven years from 98 to 136 percent of disposable personal income. During the same period, similar ratios grew from about 120 to 180 percent in the United Kingdom and from 72 to 91 percent in the euro area. At the same time, an unprecedented home price increase in the United States was accompanied by similar booms in many developed economies.
In their April 2008 analysis of the causes behind the current crisis, both the IMF and the Financial Stability Forum (FSF) highlighted the striking nature of shortcomings in risk management practices, as well as the collective failure to assess and address the extent of leverage-the ratio of debt to equity-taken on by a wide range of institutions and the associated risks of a disorderly unwinding (IMF, 2008; and FSF, 2008). Risk management, disclosure, regulation, and supervision did not keep up with rapid innovation, leaving scope for excessive risk-taking and asset price inflation.
Four sets of innovations and structural changes in particular have contributed to weakening risk management and rendering the system more prone to instability: the originateto- distribute business model and reliance on wholesale funding markets; procyclical capital and accounting practices and regulations; excessive reliance on backward-looking, marketbased risk management models and systems; and a more complex and opaque configuration of players.
The originate-to-distribute model and wholesale funding. Securitization and the development of private-label com-Page 12plex structured credit instruments have undeniably improved access to credit. however, they may also have contributed to greater aggregate...
To continue reading
Request your trial