Transcript Containing a Systemic Risk: Is There a Playbook
Containing a Systemic Risk : Is There a Playbook?
Masahiro Kawai (ADB Institute) Michael Pomerleano (World Bank)
“The International Financial Crisis: Have the Roles of Finance Changed?” Federal Reserve Bank of Chicago and World Bank Chicago, 24-25 September 2009
Outline
1. Introduction 2. The Global Financial Crisis of 2007-2009 3. Crisis Prevention, Management and Resolution 4. Recent Regulatory Reforms to Address Systemic Risk 5. Conclusions
1. Introduction
• • • •
Failure
to predict the current global financial crisis and to assess the severity of its impact Is there a
playbook
financial crisis?
to contain a systemic All the crises in the past had major
policy mistakes
, leading to structural vulnerabilities and systemic risk, and were slow to unfold. They could have been
“spotted”
in early stages What is needed to make a playbook, if there is one, effective?
Why do we care? Output losses and fiscal costs are staggering. A crisis lasts long.
2. Global Financial Crisis, 2007-09
• • •
2.1 Policy mistakes behind the crisis
Failure of macroeconomic policy, particularly monetary policy, to contain the build up of domestic financial vulnerabilities and systemic risk Flaws in financial regulation and supervision Weak global financial architecture
IMF, “Initial Lessons of the Crisis for the Global Architecture and the IMF” (February 2009).
Major policy mistakes led to this crisis: rapid credit growth, housing bubbles, etc.
• Bernanke: “The Fed cannot reliably identify bubbles in asset prices…” -
“Aftermath: Implications for Monetary Policy,” NBER Working Paper 8992, June 2002
• The Taylor rule ignored: •
“Getting off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis
Greenspan’s belief that monetary policy should not prick asset price bubbles, but should respond to the bursting of the bubble to mitigate its negative impact
What went wrong in financial regulation?
• Several excellent reviews of what went wrong in financial regulation and how to remedy the situation: -
Group of Thirty Report on Financial Reform
-
Geneva Report No. 11, Fundamental Principles of Financial Regulation
• -
de Larosiere Group, Report on Financial Supervision
Supervisors/examiners were “mis-educated”: “A key failure during the boom was the inability to spot the big picture threat of a growing asset price bubble. Policymakers only focused on their own piece of the puzzle, overlooking the larger problem.” (IMF, 2009) • Financial regulation has been founded on a fallacy of composition —assumption that making each bank safe makes the system safe • This explains how global finance has become so fragile without sounding regulatory alarm bells
Weak global financial architecture
• • • Failure of global institutions (IMF, BIS, FSF) to conduct effective
macro-financial surveillance
of systemically important economies (US, UK, the euro zone) and provide compelling warnings The discussion of “global payments imbalances” diverting attention away from the build up of US domestic financial vulnerabilities (towards China’s exchange rate policy) Ineffectiveness of
fragmented international arrangements
for regulation and supervision (and resolution) of internationally active financial institutions and markets
• • • • •
2.2 Crisis management not always effective
Collapse of Lehman Brothers Troubled Asset Relief Program (TARP) Blanket protection of deposits and guarantees of interbank loans Asset stress tests of US financial institutions Public-Private Investment Program (PPIP) • • • • •
2.3 Consequences of crisis
Financial sector impact Output and employment losses Central bank balance sheets Fiscal costs Moral hazard issues
3. Crisis Prevention, Management and Resolution
3.1 Containing systemic risk
•
Systemic risk:
the potential for an event or shock triggering a loss of economic value or confidence in a substantial portion of the financial system (through contagion effects), with resulting major adverse effects on the real economy • The strategy to contain systemic risk involves oversight of the financial system
as a whole
, and not just its individual components, as potential events or shocks can affect the economy as a whole
• • •
Principles of crisis containment
Crisis prevention is better than cure
- establishment of effective framework of macro prudential surveillance that monitors, and triggers action to reduce, economy-wide risk - consolidated supervision of all systemically important financial institutions Effective
crisis management
can minimize economic and fiscal costs of the crisis
Crisis resolution
: The development of an orderly resolution mechanism, nationally and internationally, of systemically important banks and nonbank financial institutions is essential
Table 5. Summary of Policy Lessons from the Global Financial Crisis
Objective Preventing or reducing the risk of systemic crises National Measures Global Measures Regional Measures
Establish effective financial regulation & supervision to monitor and act on economy-wide systemic risk
Establish a national systemic stability regulator or council in charge of containing systemic risk Improve information transparency and disclosure in financial & corporate sectors Strengthen macro-prudential supervision with focus on consolidated supervision of systemically important institutions Improve monitoring of household and corporate sectors Reduce pro-cyclicality of regulation Strengthen capacity, resources and effectiveness of FSB to promote global systemic stability Support implementation of international standards and codes, and best-practice corporate governance Agree on regulations over rating agencies, hedge funds, remunerations, etc Establish a regional systemic stability council, such as the European Systemic Risk Board and the proposed Asian Financial Stability Dialogue Strengthen regional monitoring of financial markets Develop regional early warning systems
Adopt sound macroeconomic management (monetary, fiscal, exchange rate, and public debt)
Pursue non-inflationary monetary policy Maintain sound fiscal policy Manage public debt prudently Avoid large current account deficits Use monetary policy to head off excesses, booms and asset price bubbles Strengthen IMF surveillance and early earning systems, with focus on systemically important economies Utilize private-sector monitoring agencies Strengthen regional macroeconomic policy dialogue and monitoring Develop regional early warning system
Maintain sustainable current account positions
Avoid excessive currency overvaluation Avoid persistent current account deficits and heavy reliance on ST capital inflows Coordinate policies to avoid unsustainable global payments imbalances Expand regional demand where savings rates are exceptionally high
Authors’ compilation
Managing crises Resolving systemic crises
Table 5. (continued)
Provide timely liquidity of sufficient magnitude
Restore market confidence through consistent policy packages Reduce moral hazard problems Strengthen IMF liquidity support, including the new Flexible Credit Line Strengthen a regional liquidity support facility to contain crises and contagion
Support the financial sector within a consistent framework
Extend guarantees of bank obligations Conduct stress tests to identify losses and capital needs of financial institutions Establish a consistent framework for NPL removal and recapitalization Establish a common international rule for public sector interventions in the distressed financial system Avoid financial protectionism Harmonize national interventions in the financial system —such as bank deposit guarantees —at the regional level
Adopt appropriate macroeconomic policies to mitigate the adverse feedback loop between financial and real sectors
Adopt an appropriate monetary and fiscal policy mix contingent on the specific conditions of the economy Be prepared for extraordinary policies Streamline IMF conditionality Design international fiscal support programs for fiscally constrained economies Strengthen regional capacity to formulate conditionality Create regional fiscal support systems
Establish frameworks for resolving financial institutions’ impaired assets and corporate & household debt
Establish frameworks for resolving bad assets of financial institutions Introduce legal and out-of-court procedures for corporate debt workouts Harmonize national frameworks for resolving bad assets of financial institutions Provide international support Finance regional programs to help accelerate bank and corporate restructuring
Introduce rules for exit of non-viable financial institutions
Establish clear procedures for exits of financial institutions, and rehabilitation Establish legal & formal procedures for corporate insolvencies and workouts Harmonize national resolution regimes for non-viable financial institutions Harmonize insolvency procedures by adopting good practices
Introduce international insolvency mechanisms for resolving internationally active fin. institutions
Strengthen national insolvency procedures of banks, non-bank financial institutions and corporations Introduce international procedures for cross-border insolvencies Develop regional insolvency procedures to support the global effort
3.2 Crisis prevention
• Establish effective financial regulation and supervision to monitor and act on economy wide systemic risk • - focus on not only financial institutions, but also corporations and households (and their links with the financial system) Adopt sound macroeconomic management (monetary, fiscal, exchange rate, and public debt) • - be ready to use monetary policy to reduce macro financial instability Maintain sustainable current account position
• • • •
Macro-prudential surveillance
A methodology that aims to preserve systemic financial stability by identifying vulnerabilities in a country’s financial system and triggering policy and regulatory actions in a timely and informed manner to prevent crises from occurring The focus is the
system
and therefore includes corporations and households, and does not rule out contained failures of individual institutions It is a
“top-down”
approach that focuses on the environment (e.g., macroeconomic, regulatory, legal) in which financial systems operate and helps assess sources of risks and incentives
Micro-prudential
supervision is a approach that focuses on the health and stability of individual institutions
“bottoms-up”
• • •
3.3 Crisis management
Provide timely
liquidity
of sufficient magnitude (to individual institutions and the market) Support the financial sector within a consistent framework of
supporting viable institutions
(NPL removal, recapitalization, etc.) and allowing exit of nonviable institutions Adopt appropriate macroeconomic policies to mitigate the
adverse feedback loop
between the financial system and the real sector
•
3.4 Crisis resolution
Build consistent frameworks for resolving financial institutions’ impaired assets and corporate and household debt • - a need for a
coordinated approach to bank and corporate restructuring
• Establish orderly exit rules for nonviable financial institutions Introduce international insolvency mechanisms for resolving internationally active financial institutions
• • • •
3.5 Systemic stability regulator
Clear regulatory
objectives and mandates
(crisis prevention, management and resolution) Effective regulatory
structure
agency vs. a council) (a single Sufficient regulatory
resources
(political backing, and legal, human and financial resources) Effective regulatory
implementation
(instruments and tools)
• • • • • •
Clear objectives and mandates of a systemic stability regulator
Monitoring
systemic risks —such as large or growing credit exposure to real estate —across firms and markets
Assessing
the potential for deficiencies in risk-management practices, broad-based increases in financial leverage, or changes in financial markets/products, creating systemic risk
Analyzing
possible spillovers between financial firms or between firms and markets —for example through the mutual exposures of highly interconnected firms
Identifying possible regulatory gaps
system as a whole , including gaps in the protection of consumers and investors, that pose risks for the
Curtailing systemic risks
across the entire financial system —through legislative action, prudential measures, advising on monetary policy, intervention in individual institutions
Issuing periodic reports
system on the stability of the financial
• • •
Effective organization of a systemic stability regulator
Independent, credible and transparent Nick Stern: “Any forthright, disinterested assessment of the global economic system’s stability requires two sorts of independence.. must not have anything other than its own reputation riding on its assessment… It must be independent of the G 7.” -The systemic stability regulator should complement, not displace, micro-prudential supervision
A single agency approach
- a fully consolidated model (Singapore, pre-1998 Japan) - a central bank-led model - a new national agency in charge of systemic stability
A “council” approach
: a coordinated framework with the central bank, financial regulator(s) and supervisor(s), and finance ministry, supported by a powerful working group
• • •
Sufficient regulatory resources to fulfill responsibilities
Adequate authority and powers backed up by legal and legislative support Staffing – Requires knowledge and experience across a wide range of financial institutions and markets to offer a comprehensive and multi-faceted approach to systemic risk – Substantial analytical resources to identify the types of information needed and to analyze the information obtained, and – Supervisory expertise to develop and implement the necessary supervisory response Broad authority to obtain information – Rely on the information, assessments, and supervisory and regulatory programs of existing financial supervisors and regulators whenever possible; however, – Broad authority to obtain information—through data collection and reports, or when necessary, examinations —from a range of financial market participants, including banking organizations, securities firms, and key financial market intermediaries
• • •
Effective implementation by a systemic stability regulator Macro-prudential measures
-
Warnings
of signs of built-up vulnerabilities -
Sector targeted tools
(tightening loan and underwriting standards, limiting loan-to-value ratios, limiting debt-to-income ratios) -
Stress tests
- Higher
capital ratios and provisioning
Monetary policy
as a last-resort tool against a build up of systemic risk through the market (in a non-inflationary environment)
Legislative initiatives
regimes for non-viable banks and nonbank financial institutions such as insolvency
Stress testing & scenario analysis
• Stress testing is a technique to assess the vulnerability of the financial system (and macro “top-down” on the entire economic system) to exceptional but plausible shocks • Stress tests impose a coherent structure in which to discuss risks and can add rigor to systemic analyses
4. Recent Regulatory Reforms to Address Systemic Risk
• •
4.1 Global financial architecture
With sweeping mandates, can the FSB be effective?
- weak political commitments by the G20 to make the FSB a credible and powerful global institution lack of capacity to provide “high-powered” analytical surveillance What can be done to make the FSB effective?
- need for a full support by the US & UK in expanding the number of experts, providing independent assessment, and compelling member countries to take necessary actions
• • • • • • • • •
Financial Stability Board: Mandate
Assess vulnerabilities affecting the financial system; Identify and oversee action needed to address them; Promote coordination and information exchange among authorities responsible for financial stability; Monitor and advise on market developments and their implications for regulatory policy; Advise on and monitor best practice in meeting regulatory standards; Undertake joint strategic reviews of the policy development work of the international standards setting bodies; Set guidelines for and support the establishment of supervisory colleges; Manage contingency planning for cross-border crisis management; and Collaborate with the IMF to conduct Early Warning Exercises
4.2 National efforts to establish a systemic stability regulator
• • • • •
US stability reform plan
The Federal Reserve would become the nation’s most powerful financial overseer. The Fed would win power to monitor risks across the financial system, and sweeping authority to examine any firm that could threaten financial stability, even if the Fed wouldn't normally supervise the institution.
The nation’s systemically important financial institutions (“Tier 1 institutions”), whether or not they are banks in the old-fashioned sense, will be more tightly regulated by the Fed.
A proposed “rapid resolution plan” requires systemically important financial companies to regularly file a “funeral plan”: a set of instructions for how the institution could be quickly dismantled should the need to do so arise.
A new insolvency regime will cover all such firms, modeled on the scheme run by the FDIC for ordinary banks
• • • • •
UK stability reform plan
Supervision will be top well as bottom down “macro-prudential”, i.e., monitoring the financial system as a whole, as up “micro-prudential”, i.e., keeping an eye on individual firms. The Financial Services Authority (FSA) will be in charge of macro-prudential regulation and address systemic risks such as rapid credit surges, for example by requiring more bank capital FSA will also have the micro-prudential supervisory powers over banks The Bank of England (BOE) will have statutory responsibility for financial stability, and will be given new powers to deal with troubled banks But the BOE objects that it does not have the tools it needs, leading to open confrontation between King and Darling
• • • • •
Global practices of central banks in regulation and financial stability
Of the 84 economies listed in Table 6, 30 have an integrated prudential supervision, 20 have supervisory agencies in charge of two types of financial intermediaries, and 34 have multiple sectoral supervisors The central banks of 48 countries (57% of the total) have the authority of banking supervision In countries with multiple sector supervisors, central banks tend to have the banking supervision authority In all G20 countries, the central bank is in charge of
price stability
and
payment system stability
Most of the central banks publish
financial stability reports
, while close to half have
financial stability committees
(Table 7)
Table 6. Economies with Single, Semi Integrated, and Sectoral Prudential Supervisory Agencies, 2009
Single Prudential Supervisor for the Financial System (year of establishment)
Australia (1998) Austria (2002) Bahrain* (2002) Belgium (2004) Bermuda* (2002) Cayman Islands* (1997) Denmark (1988) Estonia (1999) Germany (2002) Gibraltar (1989) Guernsey (1988) Hungary (2002) Iceland (1988) Ireland* (2002) Japan (2001) Kazakhstan* (1998) Korea, Rep. (1997) Latvia (1998) Maldives* (1998) Malta* (2002) Netherlands* (2004) Nicaragua* (1999) Norway (1986) Singapore* (1984) South Africa* (1990) Sweden (1991) Taipei,China (2004) United Arab Emirates* (2000) United Kingdom (1997) Uruguay (1993)
Total - 30 Agency Supervising Two Types of Intermediaries Banks and securities firms Banks and insurers Securities firms and insurers Multiple Sectoral Supervisors (at least one each for banks, securities firms & insurers)
Finland Luxembourg Mexico Switzerland Uruguay
Total - 5
Canada Columbia Ecuador El Salvador Guatemala Malaysia* Peru Venezuela, Rep. Bolivarian a de
Total - 8
Bolivia Bulgaria* Chile Jamaica* Mauritius* Slovak Rep.* (b) Ukraine*
Total - 7
Albania* Argentina* Bahamas, The* Barbados* Botswana* Brazil* Croatia* Cyprus* Czech Republic (b) Dominican Rep* Egypt* France * Greece * Hong Kong SAR * India * Indonesia * Israel * Italy * Jordan* Lithuania* New Zealand* Panama Philippines* People’s Republi c of China (PRC) Poland* Portugal* Russia* Slovenia* Sri Lanka* Spain * Thailand * Tunisia * Uganda * United States *
Total - 34
Country/Region Argentina Australia Brazil Canada China (PRC) Euro Zone Hong Kong India Indonesia Japan Malaysia Mexico Philippines Russia Saudi Arabia Singapore South Africa South Korea Switzerland Thailand Turkey United Kingdom United States Table 7: Mandates for the Major Central Banks Financial stability committee
- Yes - - Yes Yes**** Yes**** Yes*** - - - - Yes Yes**** Yes Yes - - - Yes*** - Yes Yes****
Financial system stability analysis/report
Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes - - Yes Yes Yes Yes Yes - Yes Yes --
• • • • •
The “council” approach to systemic stability regulation
US, UK and Japan: possible to expand the existing framework of crisis management to broader crisis containment, including crisis prevention UK government’s proposal to create a “Council for Financial Stability” to bring together the BOE, FSA and HM Treasury Australia: Council of Financial Regulators, with RBA as chair, APRA, ASIC and Treasury Korea: Financial policy coordination by the Finance Ministry as chair, BOE and Financial Supervisory Commission For the council approach to be successful, it needs - clear
mandates
and
division of labor
- analytical
resources
and capacity collectively - all the necessary
macro-prudential tools
Table 8. Existing Framework of Systemic Crisis Management
United States United Kingdom Japan Key Processes Members
The following approvals are required to apply the systemic risk exceptions: 2/3 of the FDIC Board 2/3 of the Board of Governors of the Fed Treasury Secretary after consulting with the President Based on the MOU, HM Treasury, the FSA, and the BoE shall take coordinated actions for crisis management.
HM Treasury has the authority to nationalize banks.
HM Treasury shall provide blanket guarantee of deposits, based on the common law power Treasury Secretary Chairman of the Federal Reserve Head of FDIC Chancellor of Exchequer President of the Bank of England (BoE) Chairman of the Financial Services Authority (FSA) The Prime Minister shall decide if the systemic risk exception (Article 102, Deposit Insurance Law) should be applied, after consulting with the Financial Crisis Management Council (members listed below).
Prime Minister (Chair) Chief Cabinet Secretary Minister of Financial Services Commissioner of FSA Minister of Finance Governor of the BOJ
4.3 Regional initiatives
• • •
European Union reforms European macro-prudential surveillance:
European Systemic Risk Board to watch for the build-up of financial risk and sound the alarm over the build-up of risk. To be headed by ECB president
Europe-wide bank oversight:
border financial institutions European System of Financial Supervisors in charge of coordinating national supervisors and monitoring large cross-
Europe-wide bank restructuring
for the resolution of cross – Legal form not functioning ‐ . EU’s weak cross-border framework for crisis management and border banks – Risk of asset grab impeding information sharing & collaboration – Multiple (conflicting) proceedings and competencies – Existing resolution tools not effective at crisis time
• • • •
Asian Financial Stability Dialogue
Initially a forum for information exchange and policy dialogue among Asia’s finance ministries, central banks and financial regulators/supervisors To strengthen the current ASEAN+3 finance ministers process, and may have an expanded membership To work with the CMIM (a future AMF) for Asian financial stability To evolve into a more systematic body, like an Asian FSB in the future
4.4 An international framework for the 21
st
century
• • • •
Who is going to do the heavy-lifting?
The present voluntary cooperative efforts at the international level are not adequate The FSF (FSB) and IMF have done little more than issue statements of principles since the start of the crisis The Westphalian principles governing international financial oversight (sovereignty of states) are not suited to address today’s global financial system The international financial community needs to make progress with a binding global financial order.
• • • • •
5. Conclusions
A playbook to contain a systemic financial crisis does exist The best way is to
prevent
a crisis by identifying and acting on sources of instability A systemic stability regulator should be created at the national and regional levels, and support the global efforts For effective crisis management and resolution, there is a need to create a
binding cross-border resolution regime
for internationally active financial institutions The
US
and the
UK
need to commit themselves to effective financial stability regulation
For More Information:
Dr. Masahiro Kawai Dean & CEO Asian Development Bank Institute
+81 3 3593 5527 www.adbi.org