What Is to Be Done

• Author: Laura Kodres/Aditya Narain
• Position: Division Chief/Deputy Division Chief in the IMF's Monetary and Capital Markets Department
• Pages: 23-26

Page 23

The scope of financial regulation needs to be revamped and the provision of liquidity improved. Here's how

While there is enough blame to pass around, one key contributor to the global financial crisis was inadequate regulation-both in its fragmented nature and its lack of enforcement. Regulatory structures must be revamped to prevent another buildup of systemic risks, to provide a sounder footing for connecting global savers and investors (that is, global financial intermediation), and to ensure a clear and consistent method of dealing with financial instability when it does arise. Central bank methods of providing liquidity to markets must be looked at too.

The IMF has been examining several areas that will require attention to prevent systemic crises:

* the perimeter of regulation, or which institutions and practices should be within the purview of regulators;

* procyclicality, the tendency for some regulatory and business practices to magnify the business cycle;

* information gaps about risk and where it is distributed in the financial system;

* harmonizing national regulatory policies and legal frameworks to enhance coordinated supervision and resolution of firms and markets that operate across borders; and

* providing liquidity to markets to ensure the smooth flow of funds for investment and the effective transmission of monetary policy.

The perimeter of regulation

What is clear from the latest crisis is that the perimeter of regulation must be expanded to encompass institutions and markets that were outside the scope of regulation and, in some cases, beyond the detection of regulators and supervisors. Some of these entities were ablePage 24 to obtain short-term debt to invest in longer-term assets and increased their leverage (the use of debt to purchase assets) to a degree that threatened the stability of the financial system when those short-term lenders recalled their funds. However, coverage of all financial intermediaries is unnecessary and would limit the benefits some of them provide to the economy-such as innovation and efficient transfer of funds. To avoid overburdening useful markets and institutions it is important to identify carefully the specific weaknesses that wider regulation would seek to address (so-called market failures). This could be achieved by a two-perimeter approach. Many financial institutions and activities would be in the outer perimeter and subject to disclosure requirements. Those that pose systemic risks would be moved to the inner perimeter and be subject to prudential regulations.

At a first cut, unregulated activities or entities that should be placed within the new perimeter include:

* Institutions that are counterparties to risk transfers from the regulated sectors: new regulation should target off-balance-sheet entities such as structured investment vehicles that could be used to acquire risky assets from banks and other regulated firms.

* Investment firms that use leverage and are apt to amplify downward spirals of asset prices when they need to deleverage, that is to sell assets prematurely to reduce their reliance on debt when leverage is deemed to be excessive.

Making a clean distinction between entities that are systemically important and those that are not will be difficult, but ideally institutions that take on less leverage and are less interconnected should be less burdened by regulation. Still, regulators must be able to collect enough information about institutions to be able to decide whether they contribute to systemic risk.

Procyclical practices

Economic cycles are to be expected, but some regulatory and institutional practices can accentuate cyclical movements. These practices can range from capital regulations and provisioning rules for banks to the risk management and compensation practices in many financial institutions.

The challenge to prudential regulation is to remove procyclical elements without negating risk-based decision making within financial institutions. Moreover, any movement to add regulations that require additional capital should be gradual to avoid more damage to a weakened financial system.

One of the main items on the agenda to mitigate procyclicality would be regulation of capital-the funds institutions are required to maintain to absorb losses. (For instance, "core" capital is considered to be...