Introduction
The International Monetary Fund (“IMF”) has summarised the causes of the global financial crisis in three dimensions:
- Flaws in financial “regulation” and “supervision”.
- Failure of monetary “policy” to address the build-up of systemic risk.
- Weak global “financial architecture”.
Set out below is an analysis of these dimensions and a review of systemic risk, including what steps Regulators can take to mitigate the effect of systemic risk.
1. Flaws in financial regulation and supervision
What has become known as the “shadow banking system” became larger as it was wedged in among lightly regulated financial services businesses such as Investment Banks and Mortgage Originators. At the time traditional financial services businesses were lightly regulated by a disjointed assortment of regulators. The process of deregulating financial markets had begun in ernest during the 1980’s and steadfastly increased in pace as prosperity and the good times seemed to be here to stay.
By 2008, it was estimate that in the United States the shadow banking system was as large as USD 10.5 trillion. It was made up of USD 4 trillion in assets from large investment banks, USD 2.5 trillion in overnight repos, USD 2.2 trillion in structured investment vehicles, and another USD 1.8 trillion in hedge fund assets. This should be compared with the USD 10 trillion in assets held in the conventional United States banking system.
Regulators were focused on individual institutions, without regard for the impact on the wider financial system. There is therefore a realisation by supervisors today that a macro-prudential approach to the supervision of financial markets is necessary.
2. Failure of monetary policy to address the build-up of systemic risk
The latest IMF analysis points to “macroeconomic policies, which did not take into account rising systemic risks and states that a key failure during the boom period was the inability to spot the big picture threat of a growing asset price bubble” (IMF, 2009b).
Clearly, the U.S. Federal Reserve underestimated the build-up of financial imbalances coming from housing price bubbles, high leverage of financial institutions, and interconnections between financial markets. In addition, Taylor (2009) argues that the Federal Reserve policies brought excessive liquidity and low interest rates to the U.S. and that the federal funds rate was kept too low for too long, fuelling the housing boom and other economic imbalances. The Federal Reserve may well have assumed that, even if the asset price boom collapsed, the impacts on the financial system and the economy could be mitigated by lower interest rates.
In theory, tighter prudential regulation could have been mobilised to contain systemic risk; but in practice, before the authorities realised, huge systemic risks had accumulated below the regulators’ radar in the shadow banking system.
Given the failure of prudential supervisory action to prevent a build-up of systemic risk, the central bank — as a macro-supervisor — should have reacted to credit booms, rising leverage, sharp asset price increases, and the build-up of systemic vulnerabilities by adopting tighter monetary policy.
3. Weak global financial architecture
There were also deficiencies in the global financial architecture the official structure that facilitates global financial stability and the smooth flow of goods, services, and capital across countries. There are three issues.
First, global institutions like the IMF, the Bank for International Settlements, and the Financial Stability Forum failed to conduct effective macroeconomic and financial surveillance of systemically important economies. That is, they did not clearly identify the emerging systemic risk in the U.S., the U.K., and the euro area; send clear warnings to policymakers; or provide practical policy advice on concrete measures to reduce the systemic risk. Their analysis clearly underestimated the looming risk in the shadow banking system; interconnections across financial institutions, markets, and countries; and global macroeconomic-financial links.
There was considerable discussion of global payments imbalances during 2002–2007. The IMF in particular warned repeatedly, especially through the newly established multilateral consultation process, that global imbalances posed a serious risk to global financial stability. However, the global imbalance discussion may have diverted policymakers’ attention away from U.S. domestic financial imbalances, the risk of U.S. dollar collapse, and the need to revalue the Chinese currency.
The crisis has revealed the ineffectiveness of fragmented international arrangements for the regulation, supervision, and resolution of internationally active financial institutions. The problem became particularly acute when such institutions showed signs of failing. Although home-country authorities are mainly responsible for resolving insolvent institutions, host-country authorities were often quick to ring-fence assets in their jurisdictions because of the absence of clear international rules governing burden-sharing mechanisms for losses due to failure of financial firms with cross-border operations.
Addressing systemic risk
The purpose of macro and micro-prudential supervision is to preserve financial stability by identifying vulnerabilities in a financial system and calling for policy and regulatory actions to address those vulnerabilities in a timely and informed manner so as to prevent systemic risk and crisis.
What are micro and macro-prudential regulation?
- Micro-prudential supervision takes a bottom-up approach to analysis and preservation of systemic financial stability, focusing on the health and stability of individual institutions.
- Macro-prudential supervision takes a top-down approach to analysis of systemic risk with a focus on the economy-wide system in which financial institutions operate. This approach aids in the identification of risks and perverted incentives that could result in systemic instability. It requires the integration of detailed information on banks, non-bank financial institutions, corporations, households, and markets.
Taking into account the different approached of micro and macro-prudential regulation, what actual steps can be taken by Regulators.
Competition regulation
- Limits on the “too big to fail” or “too interconnected to fail” problem
- Market conduct regulation
- Enhanced transparency and competition Macro-prudential measures
- Higher standards on capital requirements and risk management for systemically important firms
- Limits on financial firms’ leverage, such as setting maximum leverage ratios and/or credit growth
- Efforts to mitigate procyclicality with automatic countercyclical provisioning, such as a form of dynamic provisioning
- Limits on sectoral exposure
Households
- Loan-to-value (LTV) restrictions for mortgages
- Limits on consumer debt, such as debt-to-income ratios
Corporations
- Limits on leverage, such as limits on debt/equity ratios
- Limits on tax advantages, such as disallowing interest deductibility for leverage exceeding a certain level or foreign currency-denominated loans External
- Limits on external debt
- Limits on currency and maturity mismatches
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