## 040908 ## Source details **Canonical URL:** [040908](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_040908.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_040908.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_040908.pdf.json) --- ### Executive Summary — Overview and context - IMF staff assessed causes of the present turbulence and drew tentative lessons to inform future bilateral and multilateral surveillance, in response to the IMFC’s October 2007 communiqué; effort involved collaboration with the Financial Stability Forum (FSF) and its working groups, and consultation with the private sector, national authorities, standard setters, and other bodies. - Conclusions are tentative and need refinement given rapidly evolving market developments and forthcoming reports from the FSF and other bodies. - Paper focuses principally on structural, medium-term policy implications; immediate policy priorities are discussed in more detail in the Global Financial Stability Report (GFSR). - Central observations shaping policy lessons: - Market practice, regulatory and prudential norms, and oversight lagged during benign economic conditions, leaving the system vulnerable to excessive risk taking. - Financial innovation, globalized credit markets, proliferation of business models (such as “originate-to-distribute”), and the complexity and opacity of structured credit instruments undermined market discipline and increased systemic exposure. - Regulation and supervision cannot substitute for effective private-sector risk management and may exacerbate moral hazard if overused; focus should be on improving market discipline and internalizing systemic effects of collective actions. - The origins of the crisis were broad and complex, implying multi-faceted policy responses are required. - Prior warnings about excessive risk taking, loose underwriting standards, and asset overvaluations had little impact, raising questions about coordination among national supervisors and the effectiveness of bodies such as the FSF, BIS, and the Fund. ### Key near-term developments described - Fault lines emerged in early 2007 from rising delinquencies on U.S. subprime mortgages, increased leverage, realization of heavy exposures to complex structured products with uncertain or dropping valuations, a seizing up of interbank markets, and large losses and write-downs among several banks and large financial institutions. - Policy responses taken: - Central banks in major industrial countries provided unprecedented liquidity support and eased monetary policy. - Fiscal and other measures mitigated mortgage market downturns; weak institutions were recapitalized or taken over. - National regulators, supervisors, and governments worked to identify and address regulatory gaps. - Private institutions took significant write downs and sought capital injections. - Conditions worsened: intensified de-leveraging pressures risked becoming self-reinforcing, systemically important institutions remained under stress, and global macroeconomic slowdown strained corporate and household credit quality, increasing danger of a global credit crunch. ### Lessons and policy areas covered - Preliminary views and recommendations organized in five main areas: - Risk management - Credit rating agency practices - Valuation, disclosure, and accounting - Central bank liquidity frameworks - Supervision and crisis management - The Fund’s role: facilitate dissemination of lessons and best practice, monitor and evaluate policy implementation and impact on the financial sector, and provide feedback to member countries, standard setters, and international bodies. ### Risk management (Section B) — Findings - Risk management failures in large and sophisticated financial institutions were a major cause of the crisis and reflected shortcomings in judgment and governance compounded by weaknesses in accounting and regulatory standards. - Managers often failed to challenge assumptions underlying risk management and pricing models, especially for new and complex products; insufficient scrutiny of off-balance sheet liabilities and hedging robustness; over-reliance on credit ratings; concentrated positions in illiquid structured products. - Supervisors were not active enough in challenging risk management practices and lacked adequate resources and expertise. - Structured products (e.g., ABS CDOs built on subprime collateral) exposed firms to tail risks and multiple-notch rating downgrades; institutional silos sometimes prevented risk managers’ warnings from reaching senior management. - Market (vs. credit) risk in senior and super-senior CDO tranches was underestimated; hedges were concentrated among a few counterparties (the “monoline” insurers). - Liquidity of structured products was generally low; many buy-side institutions maintained ill-advised portfolio concentrations and funded these instruments with short-term asset-backed commercial paper issued by conduits and SIVs, often subject to performance “triggers” that could accelerate unwinding and liquidation. - Inter-relationship between regulation, accounting practices, and ratings may have exacerbated turbulence: Basel capital requirements encouraged securitization and off-balance-sheet funding, while fair value accounting and illiquid markets contributed to procyclical selling and price gapping. ### Risk management — Key lessons and recommendations - Managers: - Aggressively challenge assumptions underlying risk models, especially for new and complex products. - Adopt more rigorous stress testing for extreme or worst-case scenarios. - Pay greater attention to robustness of hedging strategies and firms’ broader exposures, including second-round effects on counterparties and off-balance-sheet obligations. - Do not equate credit ratings with liquidity; limit concentrated positions in illiquid structured products; ensure funding better reflects portfolio duration and liquidity. - Supervisors: - Encourage and assess more rigorous stress testing, especially in “good times,” and use results to inform supervisory practices. - Assess quality of risk management and governance to ensure senior management is well informed about risks. - Ensure supervisors have required skills and resources. - Structural considerations: - Risk management cannot be achieved solely by regulation; senior management retains primary responsibility for robust internal governance. - International dialogue and coordinated cross-border supervisory efforts are useful; the Senior Supervisors Group is a welcome development. - The future role of some structured credit products (e.g., ABS CDOs) requires scrutiny; these instruments are relatively opaque, illiquid, complex, and diminish signaling value—prudential or other measures may be needed if they remain significant. ### Credit rating agencies (Section C) — Findings - Crisis illustrated limitations of credit ratings for structured credit products, potential conflicts of interest at CRAs, and injudicious investor reliance on ratings. - CRA methodologies failed to capture complexity of structured instruments with multiple tranches and susceptibility to rapid, multiple-notch downgrades. - Investors relied too heavily on ratings, reinforced by investor mandates and regulatory requirements; downgrades were sluggish leading up to the crisis. - Existing CRA methodologies applied the same default-centered rating scale used for corporate debt, missing sensitivity to tail, market, and liquidity risks inherent in structured products. ### Credit rating agencies — Recommendations and lessons - CRAs should improve methodologies and adopt differential ratings systems for structured instruments that better account for their distinct risk profiles. - Increase methodological transparency and disclosure, including disclosure of the stability and limitations of ratings for structured products. - Regulators should use approval and licensing procedures to reduce conflicts of interest and spur improvements in transparency and disclosure of rating methodologies. - Review the use of ratings in prudential regulations to account for differential scales that would be applied to structured instruments. - Needed improvements highlighted: - Differentiate between credit risk ratings of structured products and of corporate and other debt. - Fully account for multiple risk factors influencing structured credit product pricing. - Provide investors with more useful information on sensitivity and stability of CRA ratings. - Caution against over-regulation: avoid dictating rating methodologies, standards, and technical criteria that could stifle innovation or convey impression of public-sector guarantee of ratings. - Multilateral approaches may be valuable, particularly for major financial standard-setters to reconsider the prudential role given to credit ratings. ### Valuation, disclosure, and accounting — Weaknesses and causes - Weak application of accounting standards and gaps in valuation and disclosure for complex structured finance products contributed to crisis depth and duration. - Need further guidance on applying fair value accounting through the cycle, particularly when markets are illiquid. - Fair value accounting and procyclicality: - Structured products often classified in categories subject to fair value accounting. - During the upturn, booming demand boosted valuations; during the downturn, valuations became depressed as demand and liquidity evaporated, arguably meaning fair value accounting did not provide accurate information about banks’ true risk profile through the cycle. - Frequent incremental revisions in bank losses after onset of turmoil further reduced market confidence. - Portfolio covenants or triggers amplified procyclicality by requiring sales, margin calls, or additional collateral as valuations declined. - Shortcomings in valuation models and practices: - Key assumptions proved inadequate, especially assumptions of single common factors and independence of default probabilities and recovery rates. - Practitioners relied on limited datasets to estimate default probabilities (notably for subprime mortgages with short histories). - Deficiencies in governance of valuations: senior management decisions to take risks to spur growth, lack of independent verification of valuations, and underestimation of contingent liabilities and liquidity risks associated with off-balance sheet entities. - Many conduits and SIVs should have been treated on a consolidated basis from the outset; banks were often forced to bring these claims back on balance sheet for reputational or contractual reasons. - Financial reporting shortcomings: - Inconsistent reporting of structured product holdings: few banks provided breakdowns by tranches; inconsistent reporting of net versus gross exposures; hedges not disclosed; limited disclosure of assets held by non-consolidated entities. - These shortfalls made it difficult to estimate actual and potential losses and exacerbated loss of market confidence. ### Valuation, disclosure, and accounting — Key recommendations - Apply fair value accounting better through the cycle to mitigate procyclicality; avoid changing accounting standards at the height of a crisis but provide more guidance on calculation and application of fair value rules for assets not actively traded. - Require specific disclosure of the origin of “write-ups” as well as “write-downs.” - Supervisors should: - Encourage development of more robust models addressing identified problems. - Require and review more prudent and reliable pricing assumptions and stress testing methodologies. - Monitor internal processes, models, and controls for managing risk and evaluate rigor of institutions' fair value measurement practices. - Encourage larger capital and provision buffers against such instruments where appropriate. - Accounting standard setters should work with supervisors and the industry to better account for financial stability implications of accounting standards and practices. - Standardize bank disclosure requirements to cover quantity and sensitivity of exposures to credit, market, foreign exchange, and liquidity risks; require separate disaggregated disclosure of off-balance sheet entities when material. - Address gaps in price discovery mechanisms: - Standardization of securitized instruments to enhance transparency, liquidity, and risk assessment. - A centralized over-the-counter (OTC) registry to collect and distribute transaction data would improve price discovery and capacity to develop accurate market-based valuations. ### Central bank liquidity frameworks — Experience and lessons - Swift central bank liquidity support was critical to averting more severe interbank market disruption, but crisis revealed shortcomings and cross-border differences in liquidity management. - Many central banks widened counterparties and acceptable collateral and improved cross-border cooperation, narrowing differences among facilities; convergence is welcome but care needed to avoid undue credit and counterparty risk. - Differences in central bank practices: - Variation in range and type of counterparties and collateral policies; differing capacities to address funding strains in international contexts (e.g., liquid foreign-exchange swap markets). - Changes in liquidity provision can confuse market participants about monetary policy intentions; sterilization of large-scale short-term injections can be difficult. - A “stigma” attaches to standing facilities, deterring stressed banks from accessing them and increasing interbank rate pressures and solvency risk. ### Central bank liquidity frameworks — Key lessons and recommendations - Ensure ability to lend to a sufficiently broad set of counterparties; broadening counterparties can ease market strains when gaps occur in interbank networks. - Widen range of eligible collateral; central banks with wider collateral definitions coped better. - Avoid “bad collateral driving out good” and excessive credit and counterparty risk: - Limit placement of nontraditional and less creditworthy collateral via concentration limits and differential pricing. - Keep pricing and collateralization practices broadly in line with market practice to facilitate transparency and minimize central bank exposure. - Communicate early and often during stress to clarify how emergency liquidity operations relate to broader monetary policy stance and short-term interest rate objectives. - Enhance cross-border collaboration in liquidity provision; participation of the ECB and Swiss National Bank in the Federal Reserve’s TAF illustrated merits by allowing dollar provision to European banks without interfering with the Fed’s domestic liquidity management. - Consider establishing more permanent emergency swap lines modeled on recent procedures and broadened to other central banks. - Examine ways to avoid stigma attached to use of standing facilities; instruments flexible enough to scale up in turmoil may be more effective than “emergency” bilateral facilities, while recognizing potential moral hazard trade-offs. ### Regulation, supervision, and crisis management — Shortcomings and findings - Crisis exposed shortcomings in regulatory, supervisory, and crisis management frameworks in mature market economies. - Shortcomings highlight merits of Basel II’s more risk-sensitive supervision, but transition to Basel II must be managed carefully; partial or incomplete implementation poses risks. - Need for effective consolidated supervision of off-balance sheet entities; minimum underwriting and consumer protection standards should extend to all financial intermediaries. - Strengthen resolution frameworks and deposit insurance systems and improve interagency coordination, ensuring central banks retain a key role for systemic stability and emergency liquidity provision. - Supervisors did not sufficiently monitor bank exposures to structured debt or use of off-balance sheet conduits and SIVs. ### Risk-sensitive supervision and Basel II (paras. 45, 47) — Key points - Basel II framework will better align capital charges with underlying risk and reduce incentive for shifting assets off balance sheet. - Basel Committee’s decision to review aspects of Basel II in light of recent developments is appropriate. - Review priorities include: - the adequacy of capital charges, including those that apply to highly-rated CDOs and liquidity lines under Pillar 1; - the treatment of implicit support and reputational risk under Pillars 2 and 3; - managing the transition to Basel II and risks from “cherry-picking” elements of the framework. - Implementation guidance: - Supervisors should pay particular attention to impact analysis from the parallel run period and be prepared to extend the capital floors to longer periods, if warranted. - Use existing elements of Basel II to reduce its procyclicality; calculation of risk factors and calibration of rating systems should take into consideration at least a full cycle. - Banks should have strategic plans for raising sufficient capital in good times to endure a stressful economic environment when the cycle turns. - Countries with internationally active or sophisticated banks engaged in rapid innovation will need to move more quickly to Basel II, but only where supervisory capacity and other preconditions are in place. ### Crisis management, bank resolution, and supervisory capacity (paras. 46, 49–51, 55) — Recommendations - Resolution framework recommendations: - Include specific triggers to initiate action; identify and correct banking stresses early. - Supervisors should have credible authority to intervene at the first sign of weakness; resolution action could commence at some positive level of risk-weighted capital. - Bank failures should be covered by specialized financial sector insolvency proceedings and dealt with by a specialized court or specialized agency. - Bankruptcy laws should clearly identify loss-sharing arrangements and facilitate transfer of control to an official administrator. - Receivers should have a broad range of instruments; supervisors’ actions should have finality and not be automatically suspended by the courts. - Supervisory powers and resources: - Remove ambiguity about mandates where institutions answer to multiple regulators; the lead agency must have full authority for enforcement and early remedial action. - Provide supervisors with sufficient resources—including staff—to carry out responsibilities given increasing business complexity. - Consolidated supervision and prudential reporting: - Apply to off-balance sheet entities associated with financial institutions and to loans sold with implicit or explicit recourse (e.g., SIVs and conduits). - Revisit presumptions that loans sold no longer pose a liability when the seller maintains any relationship with the purchaser. - Minimum underwriting and consumer protection standards should apply to all financial intermediaries to limit excessive risk taking and regulatory arbitrage. - Monoline financial insurers need reconsideration given their critical role and vulnerability; they have shown themselves to be thinly capitalized and vulnerable to market risk. ### Deposit insurance and central bank roles (paras. 52–53) - Deposit insurance design: - Aim to limit retail depositor runs; include all deposit-taking institutions and cover adequately the large majority of retail depositors. - Have capacity to pay depositors quickly; public awareness of terms and coverage is critical. - Co-insurance arrangements need careful design. - Funding mechanisms should be in place to enable payouts; ex ante funding systems are more effective and less procyclical. - Role and function of deposit insurance must be unambiguous and have adequate authority and resources within the bank resolution framework. - Central banks: - Regardless of national supervisory arrangements, central banks need to play a central role given responsibilities for systemic stability and emergency liquidity provision. - Central banks should continuously monitor risk profiles of individual institutions, especially those material to payments systems and money and interbank markets. - Supervisory frameworks for group-wide risks need to be complemented with coordinated arrangements among agencies responsible for supervision, liquidity provision, and bank resolution. ### Implications for IMF surveillance (paras. 56–59) - The Fund’s role: - Contribute to emerging consensus on causes of financial market turmoil and lessons for policymakers. - Collaborate with the FSF and its working groups, private sector, regulators, national authorities, standard setters, and other bodies. - Share assessments and recommendations appropriately while remaining open to progress in other fora. - Surveillance sharpening through Article IV consultations and FSAP assessments: - Dialogue with supervisors and regulators to ensure adequacy of risk management, robustness of stress testing, and vigilance on liquidity, contingency planning, bank resolution, and deposit guarantee frameworks. - Assess cooperation between central banks and banking supervisors where central banks lack supervisory functions and evaluate provisions for emergency liquidity that balance access and central bank credit risk. - Pay special attention to emerging markets with large current account deficits financed by debt-creating capital inflows and/or financial sectors dominated by banks from mature markets—focus on authorities’ stress testing, bank resolution frameworks, and cross-border supervisory cooperation. - Provide capacity building to strengthen domestic policy frameworks. - Multilateral surveillance: - April 2008 GFSR drew policy lessons and emphasized central bank liquidity frameworks and risk management. - Fund staff, encouraged by the G7, is coordinating closely with the Financial Stability Forum and other international organizations to forge a broad policy consensus and to discuss emerging issues in future multilateral consultations. *Source: Executive Summary* ### Executive Summary ### Executive Summary ### Overview and context - IMF staff assessed causes of the present turbulence and drew tentative lessons to inform future bilateral and multilateral surveillance, in response to the IMFC’s October 2007 communiqué. This effort involved collaboration with the Financial Stability Forum (FSF) and its working groups, as well as consultation with the private sector, national authorities, standard setters, and other bodies. - Conclusions are tentative and need refinement given rapidly evolving market developments and forthcoming reports from the FSF and other bodies. - The paper focuses principally on structural, medium-term policy implications; immediate policy priorities to manage and mitigate systemic costs are discussed in more detail in the Global Financial Stability Report (GFSR). - Central observations that shaped policy lessons: - Market practice, regulatory and prudential norms, and oversight lagged during benign economic conditions, leaving the system vulnerable to excessive risk taking. - Financial innovation, globalized credit markets, proliferation of business models (such as “originate-to-distribute”), and the complexity and opacity of structured credit instruments undermined market discipline and increased systemic exposure. - Regulation and supervision cannot substitute for effective private-sector risk management and may exacerbate moral hazard if overused; focus should be on improving market discipline and internalizing systemic effects of collective actions. - The origins of the crisis were broad and complex, implying multi-faceted policy responses are required. - Prior warnings about excessive risk taking, loose underwriting standards, and asset overvaluations had little impact, raising questions about coordination among national supervisors and the effectiveness of bodies such as the FSF, BIS, and the Fund. ### Key near-term developments described - Fault lines emerged in early 2007 from rising delinquencies on U.S. subprime mortgages, increased leverage, realization of heavy exposures to complex structured products with uncertain or dropping valuations, a seizing up of interbank markets, and large losses and write-downs among several banks and large financial institutions. - Policy responses taken by authorities and institutions: - Central banks in major industrial countries provided unprecedented liquidity support and eased monetary policy. - Fiscal and other measures were used to mitigate mortgage market downturns; weak institutions were recapitalized or taken over. - National regulators, supervisors, and governments worked to identify and address regulatory gaps. - Private institutions took significant write downs and sought capital injections. - Conditions worsened: recent intensified de-leveraging pressures risk becoming self-reinforcing, systemically important institutions remained under stress, and global macroeconomic slowdown strained corporate and household credit quality, increasing the danger of a global credit crunch. ### Lessons and policy areas covered - The paper outlines preliminary views and policy recommendations in five main areas: - Risk management - Credit rating agency practices - Valuation, disclosure, and accounting - Central bank liquidity frameworks - Supervision and crisis management - The Fund’s role: facilitate dissemination of lessons and best practice, monitor and evaluate policy implementation and impact on the financial sector, and provide feedback to member countries, standard setters, and international bodies. ### Risk management (Section B) Findings - Risk management failures in large and sophisticated financial institutions were a major cause of the crisis and reflected shortcomings in judgment and governance compounded by weaknesses in accounting and regulatory standards. - Managers often failed to challenge assumptions underlying risk management and pricing models, especially for new and complex products; insufficient scrutiny of off-balance sheet liabilities and hedging robustness; over-reliance on credit ratings; concentrated positions in illiquid structured products. - Supervisors were not active enough in challenging risk management practices and lacked adequate resources and expertise. - Structured products (e.g., ABS CDOs built on subprime collateral) exposed firms to tail risks and multiple-notch rating downgrades; institutional silos sometimes prevented risk managers’ warnings from reaching senior management. - Market (vs. credit) risk in senior and super-senior CDO tranches was underestimated; hedges were concentrated among a few counterparties (the “monoline” insurers). - Liquidity of structured products was generally low; many buy-side institutions maintained ill-advised portfolio concentrations and funded these instruments with short-term asset-backed commercial paper issued by conduits and SIVs, often subject to performance “triggers” that could accelerate unwinding and liquidation. - Inter-relationship between regulation, accounting practices, and ratings may have exacerbated turbulence: Basel capital requirements encouraged securitization and off-balance-sheet funding, while fair value accounting and illiquid markets contributed to procyclical selling and price gapping. Key lessons and recommendations - Managers: - Aggressively challenge assumptions underlying risk models, especially for new and complex products. - Adopt more rigorous stress testing for extreme or worst-case scenarios. - Pay greater attention to robustness of hedging strategies and firms’ broader exposures, including second-round effects on counterparties and off-balance-sheet obligations. - Do not equate credit ratings with liquidity; limit concentrated positions in illiquid structured products; ensure funding better reflects portfolio duration and liquidity. - Supervisors: - Encourage and assess more rigorous stress testing, especially in “good times,” and use results to inform supervisory practices. - Assess quality of risk management and governance to ensure senior management is well informed about risks. - Ensure supervisors have required skills and resources. - Structural considerations: - Risk management cannot be achieved solely by regulation; senior management retains primary responsibility for robust internal governance. - International dialogue and coordinated cross-border supervisory efforts are useful; the Senior Supervisors Group is a welcome development. - The future role of some structured credit products (e.g., ABS CDOs) requires scrutiny; these instruments are relatively opaque, illiquid, complex, and diminish signaling value—prudential or other measures may be needed if they remain significant in the financial landscape. Footnotes (as presented) - 1 Correlated loss assumptions are crucial for the rating analysis of structured credit products, especially for senior tranches. The shape of the loss distributions of CDO tranches, and therefore their ratings, depends critically on the correlations of default in the underlying asset pool–an element absent in bond ratings. In particular, an increase in default correlations shifts probability mass into the tails of the loss distribution, increasing the potential losses to the senior tranches. Nevertheless, it is difficult to estimate underlying default correlations, and they can be highly volatile over a business cycle. - 2 Some of the safeguards built into these vehicles and structures, such as asset quality tests, net cumulative outflow tests, and other performance, ratings, and market value triggers may have actually accelerated the pressure to unwind asset portfolios. While these automatic triggers protect senior investors and liquidity- and credit-enhancement providers during stable and relatively liquid markets, they create the potential for wide-spread selling pressure, depressing asset values further during times of market stress. ### Credit rating agencies (Section C) Findings - The crisis illustrated limitations of credit ratings for structured credit products, potential conflicts of interest at credit rating agencies (CRAs), and injudicious investor reliance on ratings. - CRA methodologies failed to capture complexity of structured instruments with multiple tranches and susceptibility to rapid, multiple-notch downgrades. - Investors relied too heavily on ratings, reinforced by investor mandates and regulatory requirements; downgrades were sluggish leading up to the crisis. - Existing CRA methodologies applied the same default-centered rating scale used for corporate debt, missing sensitivity to tail, market, and liquidity risks inherent in structured products. Recommendations - CRAs should improve methodologies and adopt differential ratings systems for structured instruments that better account for their distinct risk profiles. - Increase methodological transparency and disclosure, including disclosure of the stability and limitations of ratings for structured products. - Regulators should use approval and licensing procedures to reduce conflicts of interest and to spur improvements in transparency and disclosure of rating methodologies. - Review the use of ratings in prudential regulations to account for differential scales that would be applied to structured instruments. ### Valuation, disclosure, and accounting (Section summary) - Weaknesses in application of accounting standards and gaps in valuation and financial reporting for structured products contributed to the crisis. - Need further guidance on applying fair value accounting through the cycle, particularly when markets are illiquid. - Supervisors should ensure financial institutions develop robust pricing, risk management, and stress testing models, and collaborate with international standard setters for better cross-border convergence of accounting and disclosure practices. - Additional effort is needed to provide markets with accurate and timely reporting of exposures to structured credit products and other illiquid assets, and to disclose the valuation and accounting methodologies used. ### Central bank liquidity frameworks (Section summary) - The crisis revealed the need to adapt tools and practices for managing liquidity and cross-border differences in emergency liquidity frameworks. - Central banks may need to broaden the range of collateral and counterparties they can deal with and, given the level of cross-border finance, work to avoid significant differences in practice. ### Supervision and crisis management (Section summary) Findings - Supervisors did not adequately account for risks associated with new financial instruments; shortcomings existed in consolidated supervision and underwriting standards. - The experience highlights merits of Basel II’s more risk-sensitive approach, but regulators and supervisors need to re-consider capital and other buffers banks should hold, especially for illiquid structured products and off-balance-sheet activities. - Crisis management frameworks, including deposit insurance, have in some cases proved inadequate and need strengthening. Recommendations - Reconsider capital and buffer requirements with attention to illiquid structured products and off-balance-sheet activities. - Strengthen crisis management frameworks and deposit insurance arrangements. - Improve consolidated supervision and underwriting standards. ### Implications for Fund surveillance and concluding remarks (Section A and concluding material) - Integrating lessons into Fund surveillance will be a key challenge. - The Fund is contributing to an emerging consensus through collaboration with the FSF, regulators, standard setters, national authorities, and other bodies; this cooperative process should continue and be deepened. - The Fund is uniquely placed to: - Facilitate dissemination of lessons learned and best practice. - Monitor and evaluate policy implementation and its impact on the financial sector. - Provide feedback to member countries, standard setters, and other international bodies to drive further improvements. - The rest of the paper expands on preliminary views and recommendations in the five areas above and discusses implications for Fund surveillance. *Source: Executive Summary* ### 19. The impact that CRA ratings have on investor behavior and regulation may ### 040908 - 19. The impact that CRA ratings have on investor behavior and regulation may ### Impact of CRA ratings on investor behavior and regulation - Ratings provide a relatively low-cost mechanism for identifying and managing risk and can mitigate principal-agent problems (i.e., to prevent managers taking on greater risks than pension trustees and other principals would prefer). - The importance of ratings created incentives for financial engineering to obtain high ratings, leading the financial industry to design structures to increase the average rating of asset-backed securities. - Supervisory and regulatory incentives under the Basel II Accord and national insurance and pension fund regulations delegated a central role to CRAs in certifying asset quality, promoting use and creating a perception of CRA ratings as de facto regulatory instruments. - CRAs faced at least the appearance of conflict of interest: sponsors pay CRAs for being rated, and complexity of structured products led to pre-rating consultations on how structures would affect ratings. - These conflicts may have contributed to over-rating of some complex structured products (particularly those associated with sub-prime mortgages) and delays in downgrading when the U.S. housing sector deteriorated. ### Key lessons and recommendations on CRAs - Major global CRAs proposed changes to the IOSCO Code of Conduct for Credit Rating Agencies and instituted methodological revisions to: - Reduce conflicts of interest. - Improve quality and transparency of the rating process. - Strengthen investor education about the purposes and limitations of CRA ratings. - Methodological changes to date (e.g., Fitch’s simulation-based forward-looking indicator introduced in 2006, and proposals by Moody’s and Standard & Poor’s) focus mainly on parametric refinements of existing single-risk-focused methodologies (updating of input default probabilities, industry/obligor and geographic concentration, and recovery rates) rather than fundamentally incorporating multiple risk metrics for structured products. - Needed improvements: - Differentiate clearly between the credit risk ratings of structured products and of corporate and other debt. - Fully account for the multiple risk factors that influence structured credit product pricing. - Provide investors with more useful information on the sensitivity and stability of CRA ratings. - Scope exists to improve approval and licensing procedures to strengthen CRA industry integrity and diversity, boost transparency and disclosure of rating methodologies and processes, improve clarity on purposes and limitations of credit ratings, and reduce barriers to entry. - Caution against over-regulation: strengthening regulatory oversight may encourage reforms, but dictating rating methodologies, standards, and technical criteria could stifle innovation, exacerbate moral hazard, convey an impression of a public sector guarantee of ratings, and discourage proactive private-sector risk management. - Multilateral approaches to reform the role and use of credit ratings may be valuable, particularly for major financial standard-setters (especially the Basel Committee) to reconsider the prudential role given to credit ratings and how that role might be amended if a different rating system were to be applied to structured products. ### Valuation, disclosure, and accounting: weaknesses and causes - Weaknesses in applying accounting standards and gaps in valuation and disclosure of complex structured finance products contributed to the depth and duration of the crisis. - Governance and risk management within financial institutions need improvement; supervisors should scrutinize internal processes and controls, pricing and stress testing methodologies; prudential norms should be stiffened (e.g., increased capital and provision buffers) for new and complex instruments. - A key challenge: achieve better cross-border convergence of accounting and regulatory standards and disclosure practices. - Fair value accounting and procyclicality: - Structured products often classified in categories subject to fair value accounting.4 - During the upturn, booming demand boosted valuations, banks’ profits and equity; during the downturn, valuations became depressed as demand and liquidity evaporated, arguably meaning fair value accounting did not provide accurate information about banks’ true risk profile through the cycle. - Frequent incremental revisions in bank losses after the onset of turmoil further reduced market confidence. - Portfolio covenants or triggers amplified procyclicality by requiring sales, margin calls, or additional collateral as valuations declined, inducing forced sales and impairing liquidity. - Shortcomings in valuation models and practices: - Key assumptions proved inadequate, especially assumptions of single common factors and independence of default probabilities and recovery rates. - Practitioners relied on limited datasets to estimate default probabilities (notably for subprime mortgages with short histories). - Deficiencies in governance of valuations: senior management decisions to take risks to spur growth, lack of independent verification of valuations, and underestimation of contingent liabilities and liquidity risks associated with off-balance sheet entities. - Many conduits and SIVs should have been treated on a consolidated basis from the outset; banks were often forced to bring these claims back on balance sheet for reputational or contractual reasons. - Financial reporting shortcomings: - Inconsistent reporting of structured product holdings: few banks provided breakdowns by tranches; inconsistent reporting of net versus gross exposures; hedges not disclosed; limited disclosure of assets held by non-consolidated entities. - These shortfalls made it difficult to estimate actual and potential losses and exacerbated loss of market confidence. - Development of a consistent and standardized reporting template could help; supervisors and auditors can make disclosures more timely and consistent. ### Key recommendations on valuation, disclosure, and accounting - Apply fair value accounting better through the cycle to mitigate procyclicality; avoid changing accounting standards at the height of a crisis but provide more guidance on calculation and application of fair value rules, particularly for assets not actively traded. - Require specific disclosure of the origin of “write-ups” as well as “write-downs.” - Supervisors should: - Encourage development of more robust models addressing identified problems. - Require and review more prudent and reliable pricing assumptions and stress testing methodologies. - Monitor internal processes, models, and controls for managing risk and evaluate the rigor of institutions' fair value measurement practices and robustness of underlying risk management strategies, policies, and practices. - Encourage larger capital and provision buffers against such instruments where appropriate. - Accounting standard setters should work with supervisors and the industry to better account for financial stability implications of accounting standards and practices. - Standardize bank disclosure requirements to cover quantity and sensitivity of exposures to credit, market, foreign exchange, and liquidity risks; require separate disaggregated disclosure of off-balance sheet entities when material. - Address gaps in price discovery mechanisms: - Standardization of securitized instruments to enhance transparency, liquidity, and risk assessment. - A centralized over-the-counter (OTC) registry to collect and distribute transaction data would improve price discovery and capacity to develop accurate market-based valuations. ### Central bank liquidity frameworks: experience and lessons - Swift central bank liquidity support was critical to averting more severe interbank market disruption, but the crisis revealed shortcomings and cross-border differences in liquidity management. - Many central banks widened counterparties and acceptable collateral and improved cross-border cooperation, narrowing differences among facilities; this convergence is welcome but care is needed to avoid undue credit and counterparty risk. - Key challenges: sustain momentum from short-term necessity into longer-lasting cooperation and interoperability improvements. - Differences in central bank practices: - Variation in range and type of counterparties and collateral policies; differing capacities to address funding strains in international contexts (e.g., liquid foreign-exchange swap markets). - Changes in liquidity provision can confuse market participants about monetary policy intentions; sterilization of large-scale short-term injections can be difficult. - A “stigma” attaches to standing facilities, deterring stressed banks from accessing them and increasing interbank rate pressures and solvency risk. ### Key lessons and recommendations for central banks - Ensure ability to lend to a sufficiently broad set of counterparties; broadening counterparties can ease market strains when gaps occur in interbank networks. - Widen the range of eligible collateral; central banks with wider collateral definitions coped better, whereas narrower definitions required rapid operational adjustments. - Avoid “bad collateral driving out good” and excessive credit and counterparty risk: - Operating frameworks could limit placement of nontraditional and less creditworthy collateral via concentration limits and differential pricing. - Keep pricing and collateralization practices broadly in line with market practice to facilitate transparency and minimize central bank exposure. - Communicate early and often during stress to clarify how emergency liquidity operations relate to broader monetary policy stance and to explain objectives and implications for short-term interest rate objectives. - Enhance cross-border collaboration in liquidity provision; participation of the ECB and Swiss National Bank in the Federal Reserve’s TAF illustrated merits by allowing dollar provision to European banks without interfering with the Fed’s domestic liquidity management. - Consider establishing more permanent emergency swap lines modeled on recent procedures and broadened to other central banks to bolster market confidence in timely central bank action during global stress. - Examine ways to avoid stigma attached to use of standing facilities; instruments flexible enough to scale up in turmoil may be more effective than “emergency” bilateral facilities, while recognizing potential moral hazard trade-offs when broadening collateral pools or lending longer-term. ### Regulation, supervision, and crisis management (summary of shortcomings) - The crisis exposed shortcomings in regulatory, supervisory, and crisis management frameworks in mature market economies. - Shortcomings highlight merits of Basel II’s more risk-sensitive supervision, but transition to Basel II must be managed carefully; partial or incomplete implementation poses risks. - Need for effective consolidated supervision of off-balance sheet entities; minimum underwriting and consumer protection standards should extend to all financial intermediaries. - Strengthen resolution frameworks and deposit insurance systems and improve interagency coordination, ensuring central banks retain a key role for systemic stability and emergency liquidity provision. - Recent turmoil revealed weak implementation of consolidated supervision, supervisory frameworks that did not adequately capture risks of new instruments, and a deterioration in lending standards; supervisors did not sufficiently monitor bank exposures to structured debt or use of off-balance sheet conduits and SIVs. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_040908.pdf* ### 45. These shortcomings highlight the need for a more risk-sensitive approach to ### These shortcomings highlight the need for a more risk-sensitive approach to supervision ### Risk-sensitive supervision and Basel II (paras. 45, 47) - The Basel II framework will better align capital charges with the underlying risk that banks take on, and reduce the incentive for shifting assets off balance sheet. - The Basel Committee’s decision to review aspects of the Basel II framework in light of recent developments is appropriate. - Review priorities include: - the adequacy of capital charges, including those that apply to highly-rated CDOs and liquidity lines under Pillar 1; - the treatment of implicit support and reputational risk under Pillars 2 and 3; - managing the transition to Basel II and risks from “cherry-picking” elements of the framework. - Implementation guidance: - Supervisors should pay particular attention to impact analysis from the parallel run period and be prepared to extend the capital floors to longer periods, if warranted. - Use existing elements of Basel II to reduce its procyclicality; the calculation of risk factors and the calibration of rating systems should take into consideration at least a full cycle. - Banks should have strategic plans for raising sufficient capital in good times to endure a stressful economic environment when the cycle turns. - Countries with internationally active or sophisticated banks engaged in rapid innovation will need to move more quickly to Basel II, but only where supervisory capacity and other preconditions for effective application are in place. ### Crisis management, bank resolution, and supervisory capacity (paras. 46, 49–51, 55) - Identified deficiencies: - Weaknesses in supervisory authority, bank resolution and intervention frameworks, deposit insurance, and interagency and cross-border coordination. - More problematic where central banks do not have a central supervisory role. - Strengthening supervisory risk identification: - Risk-based supervisory approaches need recalibration in light of new transmission channels. - Outsourcing supervision to external auditors is an accepted practice in some countries, but must not compromise dialogue quality, understanding of activities, or timely preventive actions. - Consolidated supervision and prudential reporting: - Apply to off balance sheet entities associated with financial institutions and to loans sold with implicit or explicit recourse (e.g., SIVs and conduits). - Revisit presumptions that loans sold no longer pose a liability when the seller maintains any relationship with the purchaser. - Resolution framework recommendations: - Include specific triggers to initiate action; identify and correct banking stresses early. - Supervisors should have credible authority to intervene at the first sign of weakness; resolution action could commence at some positive level of risk-weighted capital. - Bank failures should be covered by specialized financial sector insolvency proceedings and dealt with by a specialized court or specialized agency. - Bankruptcy laws should clearly identify loss-sharing arrangements and facilitate transfer of control to an official administrator. - Receivers should have a broad range of instruments; supervisors’ actions should have finality and not be automatically suspended by the courts. - Supervisory powers and resources: - Remove ambiguity about mandates where institutions answer to multiple regulators; the lead agency must have full authority for enforcement and early remedial action. - Provide supervisors with sufficient resources—including staff—to carry out responsibilities given increasing business complexity. ### Consumer protection, underwriting standards, and monoline insurers (paras. 48, 54) - Minimum underwriting and consumer protection standards should apply to all financial intermediaries to limit excessive risk taking and regulatory arbitrage. - Particularly salient in the United States, where unregulated (or lightly regulated) institutions originate consumer credit products similar to those by regulated institutions. - Leveling the regulatory and supervisory playing field requires closer coordination of state and federal supervisors, such as recommendations from the President’s Working Group. - Monoline financial insurers: - Need reconsideration given their critical role in guaranteeing municipal and mortgage-backed securities and reliance on triple-A ratings. - These insurers have shown themselves to be thinly capitalized and vulnerable to market risk. ### Deposit insurance and central bank roles (paras. 52–53) - Deposit insurance system design: - Aim to limit the likelihood of retail depositor runs; include all deposit-taking institutions and cover adequately the large majority of retail depositors. - Have capacity to pay depositors quickly; public awareness of terms and coverage is critical. - Co-insurance arrangements need careful design. - Funding mechanisms should be in place to enable payouts; ex ante funding systems are more effective and less procyclical. - The role and function of deposit insurance must be unambiguous and have adequate authority and resources within the bank resolution framework. - Central banks: - Regardless of national supervisory arrangements, central banks need to play a central role given responsibilities for systemic stability and emergency liquidity provision. - Central banks should continuously monitor risk profiles of individual institutions, especially those material to payments systems and money and interbank markets. - Supervisory frameworks for group-wide risks need to be complemented with coordinated arrangements among agencies responsible for supervision, liquidity provision, and bank resolution. ### Implications for IMF surveillance (paras. 56–59) - The Fund’s role: - Contribute to the emerging consensus on causes of the financial market turmoil and lessons for policymakers. - Collaborate with the FSF and its working groups, private sector, regulators, national authorities, standard setters, and other bodies. - Share assessments and recommendations appropriately while remaining open to progress in other fora. - Surveillance sharpening through Article IV consultations and FSAP assessments: - Dialogue with supervisors and regulators to ensure adequacy of risk management, robustness of stress testing, and vigilance on liquidity, contingency planning, bank resolution, and deposit guarantee frameworks. - Assess cooperation between central banks and banking supervisors where central banks lack supervisory functions and evaluate provisions for emergency liquidity that balance access and central bank credit risk. - Pay special attention to emerging markets with large current account deficits financed by debt-creating capital inflows and/or financial sectors dominated by banks from mature markets—focus on authorities’ stress testing, bank resolution frameworks, and cross-border supervisory cooperation. - Provide capacity building to strengthen domestic policy frameworks. - Multilateral surveillance: - The April 2008 GFSR drew policy lessons and emphasized central bank liquidity frameworks and risk management. - Fund staff, encouraged by the G7, is coordinating closely with the Financial Stability Forum and other international organizations to forge a broad policy consensus and to discuss emerging issues in future multilateral consultations. *Source: IMF chapter/section (paras. 45–59).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_040908.pdf_