How could this happen?
No one thought that the financial system could collapse. Sufficient safeguards were in place. There was a safety net: central banks that would lend when needed, deposit insurance and investor protections that freed individuals from worrying about the security of their wealth, and regulators and supervisors to watch over individual institutions and keep their managers and owners from taking on too much risk. And when an individual country faced a banking crisis, experts – feeling they knew better – would criticise the authorities for their mistakes. Prosperity and stability were evidence that the system worked. Inflation was low, growth was high, and both were stable. The policy framework, built on sound economic principles combined with a bit of learning, had delivered the Great Moderation in the advanced economies. The emerging market world was wisely following the lead.
What a difference two years make.
Since August 2007, the financial system has experienced waves of critical failures. Beginning in mid-September 2008, despite more than a year of bold efforts by policymakers, the financial crisis intensified to the point where it overwhelmed the real economy. Central banks had been supplying short-term funding to smooth needed adjustments in the banking system, but that alone could not stem bank losses. And what had been addressed as a liquidity crisis was confirmed to be a solvency crisis. The bankruptcy of Lehman Brothers on 15 September triggered a run in the interbank lending market, a dramatic spike in corporate bond rates, and a global loss of consumer and business confidence. The resulting collapse of consumer durables spending in the advanced economies was quickly felt in emerging economies through both a sharp drop in trade volumes and a reversal of capital flows. The global spread of the recession fed back into financial markets, generating price declines for both equities and bonds that spared only the highest-quality sovereign debt.
The 79th Annual Report of the Bank for International Settlements (2009) discusses the risks posed by the massive policy initiatives that have been implemented and some suggestions for reform of the system.
Starting with the risks, the first, and most urgent, task for the authorities is to persevere in the repair of the financial system – a job that is not yet complete. And then they will need to find ways to exit from the rescues that have involved a combination of guarantees, transfers of assets, recapitalisations and outright government ownership. Failure to execute these tasks would risk strangling the economic recovery, as normal intermediation would not resume.
Turning to fiscal policy, the near-term global efficacy of stimulus plans is hampered, not only because of the impaired financial system but also because the need for expansionary programmes and the capacity for them vary by country. And the rapid rise in debt-to-GDP ratios in many countries creates significant longer-term risks. To ensure that the path of fiscal spending is sustainable, authorities must plan credible exit strategies now (Hannoun 2009).
Finally, it is fair to say that central bankers are operating well outside their comfort zone. Their unprecedented rate cutting and balance sheet expansion has averted a major slump. Nevertheless, these measures pose a myriad of economic risks. Central banks may find it difficult to unwind those actions in time to prevent inflation from rising as growth and employment recover.
Turning to medium-term reforms, making sure that the next crisis is both less likely to occur and less damaging when it does necessitates creating a framework for financial stability that incorporates both macro-prudential policies, in which regulators and supervisors adopt a system-wide perspective, and macroeconomic policies designed to lean against asset price booms and credit cycles.
The key to success in building a more resilient financial system, one less prone to failure and more resilient even if major problems occur, is to identify the sources of systemic risk in each of the financial system’s three essential parts:
- instruments, including loans, bonds, equities, and derivative instruments;
- markets, ranging from bilateral over-the-counter trading to organised exchanges; and
- institutions, comprising banks, securities dealers, insurance companies, and pension funds among others.
For financial instruments, a possible solution is to require some form of product registration that could limit the use of instruments according to their degree of safety. In such a scheme, the safest securities would be available for purchase by everyone; next would be financial instruments available for use only to those with a licence; another level down would be securities available in only limited amounts to highly qualified individuals and institutions; and at the lowest level might be securities deemed illegal. Such a registration and certification system would create transparency.1
For financial markets, systemic risk can be mitigated by substituting central counterparties for the bilateral arrangements that are the hallmark of over-the-counter markets. A central counterparty is an entity that interposes itself between the two sides of a transaction, becoming the buyer to every seller and the seller to every buyer. While it appears to be perfectly hedged – it has bought exactly what it has sold – the central counterparty still faces the risk that it will become insolvent. Although this risk can be addressed by holding capital and imposing margin requirements, the central counterparty is ultimately going to rely on public authorities in the case of a large, systemic event.2
And for financial institutions, addressing systemic risk means strengthening the macro-prudential orientation of regulation and supervision.3 For a number of years, work at the BIS has emphasised the need for regulators and supervisors to adopt macro-prudential policies, which are attuned to the control of system-wide risks.4 This means calibrating prudential tools – capital requirements, provisioning, leverage ratios, and the like – to address common exposures and joint failures (at a point in time) on the one hand and procyclicality (over time) on the other. Mitigating systemic risk arising at a point in time means requiring that institutions hold capital in proportion to their contribution to the risk they pose to the system – for example, larger institutions would be required to have higher capital ratios. Similarly, reducing procyclicality requires adjusting capital (and other tools, such as loan provisioning, liquidity standards, etc) countercyclically, building up defensive buffers in good times, when capital is relatively plentiful and inexpensive, and drawing them down in bad times, when capital is relatively scarce and costly.5
Officials are also seeking to strengthen micro-prudential safeguards, especially by enhancing the management of regulatory capital and liquidity, by introducing simpler measures of leverage, and by improving the assessments of more complex risk. In the future, financial institutions must be simpler, smaller, and ultimately safer – a financial firm that is too big to fail must be too big to exist.
Finally, it is not enough to reform the institutional and regulatory structure of financial instruments, markets, and institutions. Macroeconomic policies can and must play a role in promoting financial stability. For monetary policy, this means taking better account of asset prices and credit booms; for fiscal policy, it means putting a premium on medium-term fiscal discipline and long-term sustainability.
We have no choice but to take up the challenge of first repairing and then rebuilding the international financial system, all the while cushioning the impact of the crisis on individuals’ ability to live productive lives. Efforts to do all that have fully engaged the fiscal, monetary, and regulatory authorities for nearly two years now. Recovery will come at some point, but there are major risks ahead. First and foremost, policies must aid adjustment, not hinder it. That means retreating from leverage-led growth in some advanced economies and from export-led growth in emerging market economies. It means repairing the financial system quickly. It means putting policy on a sustainable path by exhibiting restraint now and by promptly reducing spending and raising taxes when stable growth returns. And it means the exit of central banks from the intermediation business as soon as financial markets resume normal operations. In the long term, addressing the broad failures revealed by the crisis and building a more resilient financial system requires that we identify and mitigate systemic risk in all its guises.
Disclaimer: The views expressed here do not necessarily reflect those of the Bank for International Settlements.
1 For a discussion of this proposal see Cecchetti (2007) and Recommendation 5 in Buiter (2009).
2 Kroszner (2006) provides a summary of the history of central counterparties while the European Commission (2009) contains a detailed introduction to over-the-counter derivatives.
3 For a summary of the macroprudential approach see Borio (2009).
4 Crockett (2001) is one of the earliest examples.
5 For a discussion of the sources of procyclicality together with a framework for addressing them, see Financial Stability Forum (2009).
Bank for International Settlement. 79th Annual Report. Bank for International Settlements: Basel, Switzerland, 2009.
Borio, C, “The macroprudential approach to regulation and supervision,” VoxEU.org, 14 April 2009,
Buiter, W, "Lessons from the global financial crisis for regulators and supervisors", Paper presented at the 25th anniversary Workshop " The Global Financial Crisis: Lessons and Outlook" of the Advanced Studies Program of the IFW, Kiel on May 8/9, 2009.
Cecchetti, S, “Preparing for the Next Financial Crisis,” VoxEU.org, 18 November 2007.
Crockett, A (2000) “Marrying the micro- and macroprudential dimensions of financial stability”, BIS Speeches, 21 September.
Financial Stability Forum, “BIS Note: Addressing financial system procyclicality: a possible framework,” April 2009.
European Commission, “Ensuring efficient, safe and sound derivatives markets,” Commission Staff Working Paper to Commission Communication, 3 July 2009, SEC(2009) 905.
Hannoun, H, “Long-term sustainability versus short-term stimulus: is there a tradeoff?” speech at the 44th SEACEN Governors’ Conference on “Preserving Monetary and Financial Stability in the New Global Financial Environment”, Kuala Lumpur, 7 February 2009.
Kroszner, R, “Central counterparty clearing: history, innovation and regulation,” Economic Perspectives of the Federal Reserve Bank of Chicago, 2006 Q4, p. 37-41.