## _020409

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### Executive Summary — Purpose, scope, and priorities
- Purpose:
  - Draw lessons for financial sector regulation and supervision and central bank liquidity management from the ongoing crisis, focusing on implications for the future rather than immediate crisis management policies.
  - Note that inadequacies in macroeconomic policies and the design of the international financial architecture exposed in the crisis will have to be addressed to make suggested changes in the regulatory framework effective.
  - The Fund is positioned to help define priorities and assist implementation; specifics to be defined by national regulators and international standard setters.
- Four key problem areas identified:
  - Excessive optimism about asset prices and risk, fostered by a low interest rate environment and financial innovations that masked leverage and increased opaqueness and interconnectedness.
  - Market oversight and prudential supervision failed to curb excessive risk-taking and did not adequately account for interconnectedness across regulated and non-regulated institutions and markets; fragmented regulatory structures and legal constraints on information sharing contributed.
  - Weaknesses and differences in national and international approaches to cross-border bank resolution and bankruptcy were exposed.
  - Limitations of existing mechanisms for central bank liquidity support became evident, indicating need for significant changes in practice.
- Expected post-crisis adjustments:
  - Massive deleveraging driven by large losses and sharp reductions in counterparty risk exposures.
  - Likely features: lower levels of leverage; reduced funding mismatches (maturity and currency); less exposure to counterparty risk; greater transparency regarding financial instruments.
  - Institution-type, size, and cross-border exposures that survive will likely differ considerably from pre-crisis structures; consolidation among banks underway.
  - Surviving business models will need substantially stronger risk management; some business models may disappear.
- Principal priorities for action (policy implications and recommendations):
  - Institute a macroprudential approach and assign a clear mandate to a systemic stability regulator.
  - Expand the perimeter of financial sector surveillance; consider differentiated layers allowing institutions to graduate from disclosure to prudential oversight as systemic contribution increases.
  - Ensure prudential regimes discourage regulatory arbitrage and adopt a broad concept of ‘systemic’ risk factoring in leverage, funding, and interconnectedness.
  - Address procyclicality of capital requirements and other prudential norms with preferably rules-based countercyclical measures; develop methodology to link cycle stage to capital requirements non-discretionarily.
  - Fill information gaps on lightly regulated institutions and off-balance sheet transactions through enhanced disclosure and granularity.
  - Resolve political and legal impediments to cross-border regulation and resolution; develop special insolvency regimes for large cross-border firms and harmonize remedial action frameworks.
  - Strengthen central bank capacity to provide liquidity and respond to systemic shocks; consider greater flexibility and focus on credit and asset booms.
  - Improve national mechanisms for coordination within and across borders.
  - Establish basis for fiscal support during crisis containment: enhanced depositor protection and government guarantees for certain wholesale liabilities; bank recapitalization; in some cases direct purchase by government or central bank of bank and other assets.
  - Design clear exit strategies for withdrawing public support and transitioning to a more stable financial market structure.
- Role of international fora:
  - Coordinated work by the Financial Stability Forum (FSF), national authorities, standard setters, and G-20 Working Groups; caution against a “rush to regulate.”
  - Emphasis on tackling legal and institutional hurdles to cross-border cooperation.

### Applicability of lessons and IMF implications (content unit: 8.)
- Applicability:
  - Most immediately applicable to advanced economies presently in crisis, but relevant to emerging market and developing economies.
  - Emerging markets are beginning to face strains from spillover effects and exposure to asset price inflation, financial innovation, funding and currency mismatches, and weak risk management.
  - Even resilient economies can adapt lessons with flexible implementation.
- IMF role and engagement:
  - IMF’s near universal membership and macro-financial stability mandate position it to facilitate, promote, and coordinate national and multilateral responses.
  - Current engagement: bilateral surveillance, FSAP assessments, programs, technical assistance; multilateral surveillance via World Economic Outlook and Global Financial Stability Report; active engagement with other international organizations and standard setters.
  - Purpose of paper: offer specific suggestions where the Fund could provide additional impetus to an effective crisis response.
- Paper structure (signposted):
  - Section II: perimeter of regulation.
  - Section III: information gaps and improved data collection.
  - Section IV: procyclicality and regulation.
  - Section V: cross-border and cross-functional coordination.
  - Section VI: central bank operations and liquidity support.

### Rethinking the perimeter of financial regulation (Section II)
- G20 call (November 15 communiqué): review scope of financial regulation with “a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring that all systemically-important institutions are appropriately regulated.”
- Need for a macroprudential approach:
  - Prudential regulation instruments: minimum capital and liquidity requirements, supervisory inspection, early intervention mechanisms, deposit insurance, insolvency and resolution mechanisms.
  - Assign clear national mandate to agency best placed to monitor systemic risk.
- Scale of activities outside the perimeter:
  - For the United States, total assets of the “shadow banking system” were roughly US$10 trillion in late 2007—about the same size as the banking system.
  - Some entities were regulated mainly for investor protection and business conduct, not integrated with prudential oversight.
- Flaws in explicit public-policy arguments for a narrow perimeter revealed by crisis:
  - Market discipline ineffective for nonbanks; unregulated entities assumed credit and significant liquidity risks funded short-term with high leverage.
  - Systemic importance of some nonbanks was under-appreciated (examples cited: Lehman Brothers, two Bear Stearns hedge funds).
  - Regulation failed to account for systemic risks from interactions between regulated and unregulated institutions (off-balance sheet vehicles, monoline insurers, weak-underwriting loan originators).
  - Limited regulation and weak market discipline fostered risky innovation (securitization); investors relied excessively on credit ratings focused on default risk.
  - Public agencies supporting securitization (e.g., U.S. GSEs) were weakly supervised, undercapitalized, and burdened with public policy objectives undermining financial position.
- Steps to strengthen regulation within the perimeter:
  - Clearer and more stringent rules on consolidation; effective supervision of activities, entities, and risks of financial groups, especially bank-sponsored off-balance sheet activities.
  - Effective frameworks for solo and consolidated prudential supervision of regulated securities and insurance companies.
  - Strengthened oversight of counterparty risk management in regulated institutions to contain exposure to unregulated companies.
- Rationale and design for extending the perimeter:
  - Objective: ensure all activities that may pose systemic risks are overseen.
  - Broaden systemic significance to include market disruption, loss of confidence, interconnectedness, size, leverage, and funding mismatches.
  - Envisaged two-tiered perimeter:
    - Outer perimeter: all financial institutions have disclosure obligations to allow authorities to assess systemic potential.
    - Inner perimeter: institutions of systemic importance (nonbanks and banks), identified by broadly agreed and disclosed parameters, subject to higher prudential oversight.
  - Authorities must decide on central bank liquidity access for non-depository institutions; haircuts and pricing crucial to minimize moral hazard.
  - Prudential requirements should differ by institution or activity, allow rapid corrective action, and use incentives (capital charges) to favor safer trading environments and robust clearing systems.
- Consider extending regulation of products and markets:
  - Consider regulation for complex, information-asymmetric, or systemically important products used by widely dispersed users outside the perimeter.
  - Examples highlighted: collateralized debt instruments and credit default swaps.

### Policies to mitigate procyclicality and prudential proposals (Section III preview and specifics)
- Concerns:
  - Loan loss provisioning rules are too short-term and backward-looking, recognizing risks too late.
  - Enhanced risk-sensitivity in Basel II capital requirements could exacerbate procyclicality.
- Countercyclical approach:
  - Supplement monetary and fiscal policy with countercyclical regulatory policies; prefer rules-based, non-discretionary measures where feasible.
  - Reforms should be comprehensive and gradual to avoid exacerbating banking system difficulties.
  - Maintain risk-sensitivity while encouraging earlier recognition of risks in upswings to build buffers.
- Specific proposals:
  - Capital regulation:
    - Include incentives and guidance for accumulation of additional capital buffers in good times.
    - Increase minimum regulatory capital during upswings to allow buffer accumulation for downturns.
    - Prefer non-discretionary, rules-based countercyclical measures built into capital requirements.
    - Develop robust metrics linking capital requirements to indicators of cyclical pressure; the Fund could help develop globally applicable indices.
    - Example indicators: deviation between actual and potential GDP; deviations between smoothed or average credit growth and current credit growth.
  - Loan-loss provisions:
    - Reflect expected losses through the cycle; allow banks to provision during upswings and draw down in downturns.
    - Current accounting requiring incurred losses restricts recognition of expected losses; need an international framework permitting forward-looking provisioning.
    - ‘Dynamic provisioning’ models in some jurisdictions cited as starting points.
  - Re-calibrate risk weights to better capture through-the-cycle effects and tail risks.
  - Introduce a supplementary leverage ratio akin to the equity/asset ratio with enhanced sensitivity to off-balance sheet exposures as an upper bound to constrain excessive leverage.
  - Allocate valuation reserves for trading-book assets:
    - Maintain Fair Value Accounting (FVA) as benchmark and full transparency.
    - Supervisors could require (and accounting standards should allow) “valuation reserves” when market prices deviate rapidly from trend or estimated underlying value.
  - Adopt more conservative collateral valuations where valuations are highly uncertain; adjustments should be forward-looking and based on measurable indicators (e.g., estimates of mean-reversion of prices).

### Liquidity risk mitigation proposals
- Liquidity risk features and drivers:
  - Procyclical linkages to market and credit risks and “accelerator” factors (mark-to-market effects).
  - Structural reliance on short-term wholesale funding (including securitization) raised sensitivity to procyclical influences.
- Regulatory policy considerations:
  - Reflect the true price of funding liquidity, including a liquidity risk premium, to reduce excessive reliance on central bank emergency support.
- Areas to consider:
  - Improved funding risk management:
    - Strengthen governance and controls; make stress tests and estimates of liquid assets, cash flows, and funding costs sensitive to firms’ credit ratings, collateral triggers, correlated credit events, and funding market breakdowns.
    - Supervisors must ensure adherence.
  - A minimum quantitative funding liquidity buffer:
    - Require a stock of high-quality liquid assets less prone to illiquidity in extreme events.
    - Apply to systemically-important institutions, widely defined, and account for balance sheet structure (liability stability).
  - Incentive-based mechanisms:
    - Introduce regulatory charges for institutions presenting higher-than-average liquidity risk instead of blunt mandatory holdings.
    - Tailor pricing of central bank liquidity access to encourage holding better-quality collateral.

### Information importance, critical gaps, and proposals (paras. 28–33 and bullets)
- Importance:
  - Adequate coverage and quality of information critical for markets, policy makers, and financial authorities to assess risks and vulnerabilities.
- Critical coverage gaps revealed by the crisis:
  - On- and off-balance sheet exposures:
    - Supervisors and analysts underappreciated systemic risks posed by off-balance sheet entities (SIVs, SPVs) sponsored by banks and systemically important NBFIs.
    - On-balance sheet risks, including bank trading books, underappreciated and/or underreported due to product complexity and lack of granularity and consistency in disclosures.
  - Complex structured products:
    - Asset valuation techniques and risk models insufficient to capture tail loss distributions and price correlations; model calibration and back testing were not rigorous enough.
  - OTC derivatives:
    - Insufficient information on prices, traded volumes and concentration inhibited assessment of liquidity and market risk.
  - Leverage:
    - Monitoring systemic leverage difficult due to off-balance sheet vehicles and growth of leverage among systemically important NBFIs.
  - Cross-border and counterparty exposures:
    - Crisis revealed large exposures of non-U.S. banks to U.S. sub-prime market and to Lehman Brothers; underlying vulnerabilities under-appreciated.
- Limitations of early warning frameworks:
  - Standard FSIs useful but limited as leading indicators.
  - Some FSIs (e.g., CAR) depend on underlying asset-quality assessment and understated risks associated with complex structured products and off-balance sheet transactions.
  - Market indicators like distance to default were driven by contemporaneous information and failed to provide early indications.
- Proposals to strengthen information for macro-financial analysis (five main categories):
  1) Strengthen public disclosure practices of systemically-important financial institutions:
     - Large banks: frequent reporting covering market positions, exposures by economic sector, large counterparties, countries, and off-balance sheet activities; use a common reporting template to permit aggregation and cross-country comparison.
     - Systemically important NBFIs: report indicators on leverage and exposures in formats comparable to banks.
     - Coordination among supervisors, central banks, market participants, the IMF and other international organizations to promote enhanced disclosures.
  2) Revamp and broaden FSIs:
     - Re-prioritize and improve FSIs; expand coverage to include systemic NBFIs and enhanced coverage of sectoral risk exposures (households and corporates), including in foreign exchange where appropriate.
  3) Strengthen disclosure of valuation models and risk management practices:
     - Large banks, systemic NBFIs and credit rating agencies should disclose main characteristics of model valuation techniques, datasets used to calibrate risk parameters and stress tests, and links of risk models to macroeconomic conditions.
  4) Translate disclosures into effective assessments (role of financial stability departments):
     - Financial stability departments should lead in translating disclosures into assessments; oversight to ensure disclosures produce clear messages and actionable recommendations; disseminate assessments to relevant domestic and international agencies.
  5) Improve transparency and coverage of OTC derivatives information:
     - BIS could enhance its OTC derivatives database (geographical and instrument coverage; frequency; granularity; focus on exposures).
     - Disclosure of CDS transactions improved by coordination of clearing house developments; extend clearing and settlement platforms to other OTC instruments.
  6) Enhance transparency of credit ratings methodologies:
     - National authorities should ensure credit rating agencies provide more information on methodologies for structured credit products and sensitivity of ratings to shocks.
     - Consider adopting a different rating scale for such instruments to encourage more prudent assessments.

### Cross-border and cross-functional regulation and supervision (paras. 34–40)
- Progress and remaining gaps:
  - Progress toward cross-border cooperation (FSF proposals for colleges of supervisors and supervisory MoUs), but significant improvements still needed.
  - Authorities were not effective in sharing information or identifying vulnerability buildups in globally active and systemically important institutions; examples: AIG, Lehman Brothers, three Icelandic banks.
  - Legal impediments: lack of an international legal framework for fair resolution of global firm failures and imprecise domestic legislation constraining information flow.
  - Risk of national responses discouraging financial globalization and resorting to ring-fencing and discriminatory resolution practices in stress.
- Policy suggestions for improving cross-border/cross-functional regulation (para. 38 bullets):
  - Compatible bank resolution and information-sharing legislation converging home and host country banking legislation on:
    - early corrective actions with common criteria on triggers and timing of resolution or bankruptcy procedures for a global firm;
    - resolution tools to allow quick, synchronized cross-country action to preserve franchise value and ensure fair treatment of creditors;
    - depositor and investor protection schemes ensuring coverage by scheme prevailing in each jurisdiction, regardless of subsidiary or branch status (branches would have to join local scheme);
    - free exchange of information and cooperation by regulators with local and foreign counterparts, including possible joint inspections;
    - loss sharing arrangements measured on objective criteria (example: level of unprovisioned non-performing loans of each location to total equity).
  - Compatible minimum supervisory practices for cross-border firms:
    - Appoint a lead regulator (in principle home authority) by the college of regulators responsible for mapping risk concentration and firm-level strengths and vulnerabilities.
    - Harmonize key information and reporting to facilitate aggregation and comparability across countries and encourage single firm-wide definitions of risk concentration.
    - Define minimum permissible activities between lead and other supervisors (lead regulator capacity for direct contact, request examinations, participate in joint exams, access inspection reports and risk concentration databases).
    - Enhance coordination among national supervisors; adopt colleges of supervisors and lead supervisor approach; seek higher compatibility in Core Principles across functional regulators.
  - Broader recommendations:
    - Make minimization of systemic risk the main mission of financial supervisors to force full coordination with counterparts.
    - Address budgetary constraints that impede hiring/retaining well-trained supervisory staff.
  - Multilateral mechanisms:
    - Develop more active and effective multilateral mechanisms for cross-border supervision, building on FSF, Basel Committee, and other standard setters.
    - IMF (in consultation with the World Bank and Basel Committee) could develop guidelines for cross-border supervision and resolution addressing best practices (including triggers and depositor protection).
    - FSAP assessments could evaluate adequacy of countries’ oversight of cross-border financial firms and transactions.

### Systemic liquidity management and limitations of central bank actions (paras. 41–42 and following)
- Central bank actions and scale:
  - Major central banks injected liquidity by expanding lending perimeters to broader collateral, lengthened terms, broadened counterparties, and introduced U.S. dollar swap lines with several central banks.
  - Central bank balance sheets increased massively; some have more than doubled since September 2008.
- Limitations observed:
  - Central bank intervention has not restarted active interbank trading because underlying counterparty risk concerns remain.
  - Central bank liquidity substantially substituted for market liquidity in advanced economies.
  - In some emerging markets, providing liquidity to support domestic markets posed tradeoffs with risk of facilitating capital flight.
  - Footnote: Bagehot’s Lombard Street recommendation to lend freely but at a high cost in the case of liquidity crisis provoked or accompanied by capital outflows remains appropriate here.
- Lessons for redesigning central bank liquidity frameworks:
  - In crises and market dysfunctionality, targeting a single short-term market rate may be inappropriate; central banks may need to consider a broader range of short rates and their impact on term rates and the macro-economy.
  - Breakdown in normal transmission mechanism points to need for better understanding of how central banks can underpin functioning in unusual times—perhaps through term transactions.
  - Operational adjustments may be required: vary balance between short- and medium-term open market operations; broaden counterparties; review definition and pricing of acceptable collateral.
  - Governance and moral hazard: balance flexible crisis response against moral hazard risk; acceptance of wider collateral lists weakens incentives to hold high-quality paper and needs mitigation via governance and haircut/pricing reviews.
- Term lending, guarantees, and asset swaps:
  - Term lending eased balance sheet adjustment but has not restarted interbank or commercial lending.
  - Government guarantees of commercial bank liabilities useful as short-term palliative in severe dislocation but can distort funding allocation.
  - Asset swaps (central bank provides liquid government security for illiquid private credit instruments) may better support money market functioning; unclear impact on lending spreads or credit channel restoration.
- Quasi-fiscal measures and central bank balance sheets:
  - Quasi-fiscal instruments go beyond normal monetary policy; they can muddy policy signals if prolonged and increase central bank balance sheets, potentially taking years to unwind.
  - Early transfer of such operations and resulting balance-sheet items to fiscal authorities is needed.
  - Fiscal authorities should bear primary responsibility for addressing banking sector balance-sheet weaknesses, including direct recapitalization and/or restructuring.
  - Footnote: The Fed’s recent efforts to purchase mortgage securities appear to have impacted price, if not volume, of mortgage lending.
- Repo market infrastructure and leverage:
  - Strengthen repo infrastructure: introduce central clearing counterparty (CCCP) services (already widely used in Europe).
  - Provide stronger incentives and guidance by public authorities where markets are unlikely to act given public-good nature of infrastructure.
  - Better measure and avert risks of excessive leverage via repo operations, including regulatory limits.
- Bank regulation and liquid collateral:
  - Institutions undervalued social benefit of liquidity; policy option to enhance liquid asset requirements within a defined framework for assessing institutional and systemic risk consistent with central bank liquidity approach.
- Cross-border liquidity and central bank coordination:
  - Need better mechanisms for providing cross-border liquidity, including permanent arrangements.
  - Major central banks—especially the U.S. Federal Reserve—established swap lines that effectively addressed cross-currency pressures; such measures are palliative rather than solutions to broader structural and macroeconomic issues.
- Exit strategies and policy coherence:
  - Early consideration of exit strategies needed to avoid undermining incentives or exposing central banks to excessive policy/balance-sheet risks.
  - As conditions normalize: official interest rates should incentivize markets to reduce transactions with the central bank; eligible collateral lists and relative pricing should be reviewed.
  - Ensure coherence where overlapping policy measures, including fiscal measures, have been introduced.

### Table 1 — Selected highlights: Update of Progress of Implementation of FSF Recommendations (status as of September 15, 2008; updates noted)
- 1. The capital framework:
  - January 2009: BCBS issued consultative papers proposing (i) an incremental risk capital charge (IRC) and a stressed value-at-risk (VaR) requirement for trading book exposures; and (ii) enhancements to all three Pillars of the Basel II framework including increased capital charges for re-securitizations and ABCP liquidity lines.
- 2. Liquidity risk management and regulation:
  - September 2008: BCBS published Principles for Sound Liquidity Risk Management and Supervision; implementation monitored by its Working Group on Liquidity with a first review slated for second half of 2009.
- 3. Review of risk management:
  - January 2009: BCBS issued a consultative document aimed at strengthening risk management through Pillar 2.
- 4. Operational infrastructure for OTC derivatives:
  - October/November 2008: market participants and authorities committed to building stronger OTC derivatives infrastructure, development of CDS central counterparties, and an MOU among national agencies.
- 5. Risk disclosures:
  - BCBS consultative package on Basel II (January 2009) aims to strengthen Pillar 3 disclosure standards; IASB proposed enhanced disclosure requirements for valuations and liquidity risk (October 2008).
- 6. Accounting standards for OBSEs:
  - December 2008: IASB proposed revised standards for consolidation of OBSEs and disclosure of related risk exposures; derecognition proposals planned by March 2009.
- 7. Valuation:
  - October/November 2008: IASB finalized guidance on valuation of complex securities; BCBS released a consultative paper Supervisory Guidance for Assessing Banks’ Financial Instrument Fair Value Practices.
- 8. Credit Rating Agencies:
  - IOSCO to publish an Implementation Report on the IOSCO CRA Code of Conduct and develop regulatory inspection modules and oversight approaches for globally active CRAs; Joint Forum concluded a stocktaking of ratings use.
- 9. Strengthening authorities’ responsiveness to risk:
  - FSF developed protocols for supervisory colleges; colleges exist for most large complex financial institutions identified by the FSF; a review will be undertaken in 2009.
- 10. Central Bank Operations:
  - CGFS followed up on international distribution of liquidity focusing on (i) inter-central bank swap lines; and (ii) acceptance of cross-border collateral; CPSS finalized (December 2008) a report on operational arrangements for central banks to provide cross-border liquidity.
- 11. Dealing with weak banks:
  - BCBS’ Cross Border Resolution Group completed a preliminary assessment and is examining individual failures; IADI Core Principles for Effective Deposit Insurance to be finalized for publication in March or April; FSF sub-group on cross-border crisis management to publish high-level principles in March 2009.

*Source: Executive Summary and selected sections of IMF content unit _020409.*

### Executive Summary

### Executive Summary

### Purpose and scope
- Seeks to draw lessons for financial sector regulation and supervision and central bank liquidity management from the ongoing crisis, focusing principally on implications for the future rather than on immediate crisis management policies.
- Notes that inadequacies in macroeconomic policies and the design of the international financial architecture exposed in the crisis will have to be addressed to make suggested changes in the regulatory framework effective.
- Does not prescribe specific policy measures; national regulators and international standard setters will need to define specifics.
- States the Fund, given its unique mandate and broad membership, is well placed to help define priorities and assist in implementation.

### Four key problem areas identified
- Excessive optimism about asset prices and risk, fostered by a low interest rate environment and financial innovations that masked leverage and increased opaqueness and interconnectedness.
- Market oversight and prudential supervision failed to curb excessive risk-taking and did not adequately account for interconnectedness across regulated and non-regulated institutions and markets; fragmented regulatory structures and legal constraints on information sharing contributed to this failure.
- Weaknesses and differences in national and international approaches to dealing with cross-border bank resolution and bankruptcy were exposed once the crisis hit.
- Limitations of existing mechanisms for central bank liquidity support became evident, indicating a need for significant changes in practice.

### Expected post-crisis financial system adjustments
- A massive deleveraging is underway driven by large losses and sharp reductions in counterparty risk exposures.
- Likely characteristics of the post-crisis period include:
  - Lower levels of leverage.
  - Reduced funding mismatches (both in terms of maturity and currency).
  - Less exposure to counterparty risk.
  - Greater transparency regarding financial instruments.
- Institution-type, size, and cross-border exposures that survive will likely differ considerably from pre-crisis structures.
- Consolidation among banks is already underway; push to reduce counterparty risk and improve transparency is significant.
- Some business models may disappear; surviving models will need substantially stronger risk management.

### Principal priorities for action (policy implications and recommendations)
- Institute a macroprudential approach to supervision and assign a clear mandate to a systemic stability regulator.
- Expand the perimeter of financial sector surveillance to ensure systemic risks posed by unregulated or less regulated financial sector segments are addressed; consider differentiated layers allowing institutions to graduate from simple disclosure to higher levels of prudential oversight as their contribution to systemic risk increases.
- Ensure prudential regimes encourage incentives that support systemic stability, discourage regulatory arbitrage, and adopt a broad concept of ‘systemic’ risk that factors in leverage, funding, and interconnectedness.
- Address procyclicality of existing capital requirements and other prudential norms, preferably in a manner that is rules based and counters the cycle; develop a methodology to link the stage in the cycle to capital requirements in a non-discretionary way and to accommodate accounting and prudential standards.
- Fill information gaps, especially with regard to lightly regulated financial institutions and ‘off balance sheet’ transactions; ensure supervisors and investors are provided more disclosure and a higher level of granularity in information provided; consider costs and benefits of enhanced information collection and disclosure, especially additional information regulators require.
- Resolve political and legal impediments to effective regulation of cross-border institutions; develop special insolvency regimes for large cross-border financial firms and harmonize remedial action frameworks to improve cross-border crisis management.
- Strengthen capacity of central banks to provide liquidity and respond to systemic shocks; consider greater flexibility for central banks to provide liquidity and focus greater attention on credit and asset booms; better understand the monetary policy transmission mechanism, including whether central banks should support liquidity in term markets.
- Improve capacity of national authorities to respond to systemic crises by establishing mechanisms for coordination both within and across borders; address instances where actions appeared piece-meal and uncoordinated.
- Establish the basis for fiscal support during the crisis containment and restructuring phase, including:
  - Enhanced depositor protection and government guarantees for certain wholesale bank liabilities.
  - Bank recapitalization.
  - In some cases direct purchase by government or the central bank of bank and other assets.
- Design a clear exit strategy for withdrawing public support and transitioning to a new and more stable financial market structure; requires careful planning and international cooperation to avoid market distortions and promote a revival of markets at a reasonable level of systemic risk.

### Role of international fora and coordination
- Notes coordinated work by the Financial Stability Forum (FSF), national authorities, standard setters, and recently constituted G-20 Working Groups to address deficiencies. FSF and G-20 workstreams are contributing to the design of reforms.
- Emphasizes need to avoid a “rush to regulate” that could impose excessive and inefficient regulation and stifle innovation.
- Highlights the importance of tackling legal and institutional hurdles to improving cross-border cooperation in regulation and resolution of troubled institutions.

### Selected contextual details and timelines cited
- FSF established a senior working group in October 2007 to examine causes and weaknesses producing the crisis and set out recommendations (FSF report published in April 2008).
- G20 Leaders issued a declaration following their summit in Washington DC in November 2008 committing to implement policies consistent with common principles; set a list of immediate actions to be taken by March 31, 2009 and medium term actions.
- G20 set up four working groups whose reports will be discussed by the G20 Deputies in their March 2009 meeting and whose outcome will be reflected in the April 2009 meeting of the G20 Leaders.

### Institutional and coordination details (boxes)
- Box 1 summarizes the FSF mandate and lists associated workstreams addressing procyclicality, provisioning practices, valuation and leverage, compensation, financial crisis management, and supervisory colleges; several FSF workstreams started in 2008 and feed into the G20 November 2008 Action Plan.
- Box 2 summarizes the G20 membership (19 countries and the European Union) and the four G20 Working Groups’ mandates:
  - WG I: enhancing sound regulation and strengthening transparency.
  - WG 2: reinforcing international cooperation and promoting integrity in financial markets.
  - WG3: reforming the IMF.
  - WG4: reforming the World Bank and multilateral development banks.

### Contributors
- Principal contributors: Luis Cortavarria, Simon Gray, Barry Johnston, Laura Kodres, Aditya Narain, Mahmood Pradhan, and Ian Tower.

*Source: Executive Summary*

### 8.      These lessons are most immediately applicable to the advanced economies that

### _020409 - 8.      These lessons are most immediately applicable to the advanced economies that

### Applicability of lessons
- Most immediately applicable to the advanced economies presently in crisis, but with broader relevance to emerging market and developing economies.
- Emerging market and developing economies are beginning to face strains due to:
  - spillover effects; and
  - experience with asset price inflation, financial innovation, funding and currency mismatches, and weak risk management.
- Even resilient economies can adapt lessons learned by crisis-hit countries, with flexibility in implementation.

### Implications for the Fund (IMF)
- The IMF, with near universal membership and a mandate encompassing macro-financial stability, is uniquely placed to facilitate, promote, and coordinate national and multilateral responses to the crisis.
- Current Fund engagement includes:
  - bilateral surveillance, FSAP assessments, programs, and technical assistance;
  - multilateral surveillance through the World Economic Outlook and Global Financial Stability Report;
  - active engagement with other international organizations and standard setters.
- Recent summaries and proposals referenced:
  - “Integrating Financial Sector Issues and FSAP Assessments into Surveillance—Progress Report” (summary of recent efforts);
  - a companion Board paper detailing proposals for new Fund roles in the evolving financial architecture.
- Purpose of this paper: to offer specific suggestions where the Fund could provide additional impetus to an effective crisis response.

### Paper structure (as signposted)
- Section II: overview and analysis of the perimeter of regulation.
- Section III: reviews information gaps and the need for improved data collection.
- Section IV: addresses procyclicality and regulation.
- Section V: reviews cross-border and cross-functional coordination.
- Section VI: discusses central bank operations and liquidity support.

### Rethinking the perimeter of financial regulation (Section II)
- G20 call (November 15 communiqué): review scope of financial regulation with “a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring that all systemically-important institutions are appropriately regulated.”
- Need for a macroprudential approach:
  - Prudential regulation aims to ensure safety and soundness by minimizing risks of failure of institutions and settlement systems critical for financial stability.
  - Instruments include minimum capital and liquidity requirements, supervisory inspection, early intervention mechanisms, deposit insurance, insolvency and resolution mechanisms.
  - A clear national mandate should be assigned to the agency best placed to monitor systemic risk.
- Scale of activities outside the regulatory perimeter:
  - For the United States, total assets of the “shadow banking system” were roughly US$10 trillion in late 2007—about the same size as the banking system.
  - Some entities in that total were subject to regulation focused on investor protection and business conduct, not integrated with broader prudential oversight.
  - Underscores need for better enforcement of regulations.
- Explicit public policy arguments for a narrow perimeter included:
  - reliance on market discipline and self-regulation;
  - belief that only certain institutions (notably banks) could create systemic risk;
  - expectation that bank regulation would control risks from lending to entities outside the core;
  - concern that broader regulation would be too costly, reduce innovation, and potentially increase systemic vulnerabilities.
- Crisis experience indicates these policy considerations were flawed:
  - Market discipline was ineffective in constraining risk-taking outside banking; some unregulated entities assumed credit and significant liquidity risks, funding long-term securities with short-term borrowings and high leverage.
  - Systemic importance of some nonbanks was under-appreciated (e.g., Lehman Brothers, two Bear Stearns hedge funds).
  - Regulation did not adequately account for systemic risks from interactions between regulated and unregulated institutions (e.g., off-balance sheet vehicles, monoline insurers, loan originators with weak underwriting).
  - Limited scope of regulation and weak market discipline fostered risky innovation (e.g., securitization) at high cost.
  - Investors relied too heavily on credit ratings focused on default risk and subject to conflicts of interest in structured products.
  - Public agencies supporting securitization (e.g., the U.S. GSEs) were weakly supervised, undercapitalized, and burdened with public policy objectives that undermined financial position.
- Steps being taken to strengthen regulation within the perimeter:
  - Clearer and more stringent rules on consolidation, and more effective supervision of activities, entities, and risks of financial groups, especially bank-sponsored off-balance sheet activities.
  - Effective frameworks for both solo and consolidated prudential supervision of regulated securities and insurance companies, given systemic repercussions from failures.
  - Strengthened oversight of counterparty risk management in regulated institutions to contain exposure to unregulated companies (approach analogous to post-LTCM measures), noting practical difficulties in applying prudential regulation directly to hedge funds.
- Rationale for extending the regulatory perimeter:
  - Key objective: ensure all financial activities that may pose systemic risks are appropriately overseen.
  - Broaden understanding of systemic significance to include disruption to key markets, loss of confidence, interconnectedness, size, leverage, and funding mismatches.
  - Envisaged two-tiered perimeter:
    - Outer perimeter: all financial institutions would have disclosure obligations allowing authorities to assess systemic potential.
    - Inner perimeter: institutions of systemic importance (nonbanks and banks), identified by broadly agreed and disclosed parameters, subject to higher prudential oversight.
    - Authorities must decide whether central bank liquidity access should remain limited to depository institutions; if access is expanded, haircuts and pricing of liquidity will be crucial to minimize moral hazard.
  - Prudential requirements should differ by institution or activity, allow rapid corrective action, and use incentives (e.g., capital charges) to favor safer trading environments and robust clearing systems.
- Consider extending regulation of products and markets:
  - Consider regulation for particularly complex, information-asymmetric, or systemically important products or those used by widely dispersed users outside the perimeter.
  - Examples: collateralized debt instruments and credit default swaps, given systemic risks observed in the recent crisis.

### Policies to mitigate procyclicality (Section III preview)
- Crisis sparked calls to re-examine regulatory and institutional practices to avoid procyclical impetus.
- Concerns:
  - Loan loss provisioning rules are too short-term and backward-looking, recognizing risks too late and allowing excessive risk-taking in upswings.
  - Enhanced risk-sensitivity in Basel II capital requirements could exacerbate procyclicality.
- Countercyclical regulatory policies are being considered as a supplement to monetary and fiscal policies.

### Balancing objectives and implementation
- Reforms must balance reducing procyclicality with reflecting current risks; prudential regulation should remain risk-sensitive.
- Earlier recognition of risks during upswings can moderate excesses and build buffers when profits and capital availability are higher.
- Reforms should be comprehensive and gradual to avoid exacerbating banking system difficulties (e.g., raising capital requirements should wait until recovery is underway).
- Need to avoid unintended consequences across sectors; maintain balance between rules-based and discretionary prudential policymaking:
  - Benefits to rules-based approaches and automatic stabilizers through the cycle.
  - Supervisors should retain discretion and accountability to act when vulnerabilities are identified.

### Specific proposals for prudential regulation, valuation, and accounting
- Capital regulation:
  - Include incentives and guidance for accumulation of additional capital buffers in good times.
  - Increase minimum regulatory capital during upswings to allow buffer accumulation for use in downturns.
  - Prefer non-discretionary, rules-based countercyclical measures built into capital requirements.
  - Develop robust metrics linking capital requirements to indicators of cyclical pressure; the Fund could help develop globally applicable indices for the economic cycle.
    - Examples of possible indicators: deviation between actual and potential GDP; deviations between smoothed or average credit growth and current credit growth (or similarly for provisions).
- Other regulatory areas to re-examine:
  - Loan-loss provisions:
    - Should reflect expected losses through the cycle.
    - Banks should have ability and incentives for greater provisioning during upswings (drawn down in downturns).
    - Current accounting that requires incurred losses restricts recognition of expected losses; need an international framework permitting forward-looking provisioning.
    - ‘Dynamic provisioning’ models in some jurisdictions provide a starting point.
  - Re-calibrate risk weights and related parameters to better capture ‘through the cycle’ effects and tail risks.
  - Introduce a supplementary leverage ratio:
    - A measure akin to the equity/asset ratio with enhanced sensitivity to off-balance sheet exposures as an upper bound to constrain excessive leverage in upswings.
  - Allocate valuation reserves for trading book assets:
    - Maintain Fair Value Accounting (FVA) as benchmark and full transparency.
    - Supervisors could require (and accounting standards should allow) “valuation reserves” when market prices deviate rapidly from trend or estimated underlying value, building buffers in upswings to draw down in downturns.
    - This aims for more accurate depiction of fair value consistent with good risk management.
  - Adopt more conservative collateral valuations:
    - Where valuations for provisions and capital buffers are highly uncertain, rely less on contemporaneous market prices and include a buffer to withstand normal cyclical downward movements.
    - Adjustments should be forward-looking and based on measurable indicators (e.g., estimates of mean-reversion of prices).

### Proposals to mitigate liquidity risk
- Liquidity risk can be procyclical via links to market and credit risks and “accelerator” factors (mark-to-market effects).
- Structural reliance on short-term wholesale funding (including securitization) increased banks’ sensitivity to procyclical elements (credit ratings, market liquidity, aggregate liquidity).
- Regulatory policies should reflect the true price of funding liquidity (including a liquidity risk premium) to reduce excessive reliance on central bank emergency support.
- Areas to consider:
  - Improved funding risk management:
    - Strengthen governance and controls; make stress tests and estimates of liquid assets, cash flows, and funding costs more sensitive to firms’ credit ratings, collateral triggers, correlated credit events, and funding market breakdowns.
    - Supervisors must ensure adherence to such practices.
  - A minimum quantitative funding liquidity buffer:
    - Require a stock of high-quality liquid assets less prone to illiquidity in extreme events.
    - Apply to systemically-important institutions, widely defined, and account for balance sheet structure (e.g., liability stability).
  - Incentive-based mechanisms:
    - Instead of blunt mandatory liquidity holdings, introduce regulatory charges for institutions presenting higher-than-average liquidity risk.
    - Tailor pricing of central bank liquidity access to encourage holding better-quality collateral.

*Source: IMF content unit _020409 - 8.      These lessons are most immediately applicable to the advanced economies that*

### 28.      For markets, policy makers and financial authorities, including the IMF,

### _020409 - 28.      For markets, policy makers and financial authorities, including the IMF,

### Information importance and crisis lessons (paras. 28–30)
- Appropriate coverage and quality of information are critical for markets, policy makers and financial authorities to assess risks and vulnerabilities (para. 28).
- Investors and counterparties should have sufficient information to assess investment and counterparty risks; policy makers and financial authorities should have sufficient information to formulate macro-financial policies to prevent or mitigate crises (para. 28).
- The recent crisis exposed significant gaps in information: large on- and off-balance sheet risk exposures were unappreciated or unreported; pricing and design of complex structured credit products were opaque to many investors; lack of transparency in some OTC derivatives markets caused uncertainties about counterparty risk (para. 29).
- More granular disclosure about risks, exposures, and risk management could improve market discipline; proprietary information should not be public but must be collected and possibly acted upon by systemic risk monitors (para. 29).
- A multilateral, internationally cooperative approach is needed to fill information gaps, especially to measure cross-border exposures and potential cross-border spillovers; the IMF is enhancing collaboration with national authorities for financial stability assessments to identify relevant information and cooperation areas (para. 30).

### Specific critical coverage gaps revealed by the crisis (para. 31)
- On- and off-balance sheet exposures:
  - Supervisors and analysts appear to have been unaware of, or paid inadequate attention to, systemic risks posed by off-balance sheet entities (SIVs, SPVs, etc.) sponsored by banks and other systemically important nonbank financial institutions (NBFIs).
  - Even on-balance sheet risks, including bank trading books, appear to have been underappreciated and/or underreported due to product complexity and lack of granularity and consistency in disclosures, reflecting insufficient data and understanding of size, concentration, and interlinkages across borders and markets.
- Complex structured products:
  - Asset valuation techniques and risk models were insufficiently developed to capture tail loss distributions and price correlations.
  - Model calibration and back testing were not rigorous enough, relying on an unusually benign credit cycle; price distributions and cross-correlations of structured products had not been tested by a downturn until the crisis.
- OTC derivatives:
  - Insufficient information on prices, traded volumes and concentration in OTC traded instruments inhibited assessments of liquidity and market risk.
- Leverage:
  - Monitoring and management of systemic leverage proved difficult because of increased use of off-balance sheet vehicles, growth of leverage among systemically important NBFIs, and complex webs of exposures to other financial institutions.
- Cross-border and counterparty exposures:
  - The crisis revealed surprisingly large exposures of non-U.S. banks to the U.S. sub-prime market and to Lehman Brothers, suggesting underlying vulnerabilities were under-appreciated by bank risk managers and supervisors.

### Limitations of early warning frameworks (para. 32)
- Standard indicators of financial soundness (FSIs) are useful but limited as leading indicators of vulnerability.
- Some FSIs, such as capital adequacy ratios (CAR), depend on underlying asset-quality assessment and understated risks associated with complex structured products on banks’ trading books and off-balance sheet transactions in the run up to the crisis.
- Market indicators and measures of institution soundness, such as distance to default, were driven largely by contemporaneous information and failed to provide early indications of stress.
- Conclusion: existing indicator sets need supplementation when designing early warning systems of the future.

### Proposals to strengthen information for macro-financial analysis (paras. 33–33, bullets)
- Goal: strengthen information to support macro-financial analysis and complement other institutional initiatives. Proposals fall into five main categories (para. 33) and include the following measures:

1) Strengthen public disclosure practices of systemically-important financial institutions
- Large banks:
  - Reporting should be frequent and cover market positions as well as exposures by economic sector, large counterparties, and countries.
  - Off-balance sheet activities should be covered.
  - Reporting should follow a common reporting template to permit aggregation, identification of network linkages and exposures, and cross-country comparison for macro-prudential assessment needs (para. 33, First → Large banks).
- Systemically important NBFIs (e.g., insurance companies and large investment funds):
  - Should report information, including indicators on leverage and exposures, in a format consistent and comparable to that for banks (para. 33, First → Systemically important NBFIs).
- Coordination:
  - Supervisors, central banks, market participants, the IMF and other international organizations will be required to promote and support enhanced bank and systemic NBFI disclosures (para. 33, First).

2) Revamp and broaden the coverage of FSIs
- FSIs should be re-prioritized and improved; the IMF is well placed to promote and guide this work (para. 33, Second).
- Specific FSI changes recommended:
  - re-prioritized for banks, especially their CAR, liquidity, and leverage measures;
  - expanded to include systemic NBFIs;
  - enhanced coverage of sectoral risk exposures (households and corporates), including in foreign exchange where appropriate (para. 33, Second).

3) Strengthen disclosure of valuation models and risk management practices
- Large banks, systemic NBFIs and credit rating agencies should disclose more complete and standardized information, including:
  - main characteristics of model valuation techniques and risk management practices, including characteristics of datasets used to calibrate main risk parameters and stress tests as well as credit and liquidity risk management methodologies;
  - linkages of risk models and parameters to macroeconomic conditions (para. 33, Third).

4) Translate disclosures into effective assessments (role of financial stability departments)
- Financial stability departments of central banks and supervisory authorities should lead in translating disclosures into assessments of institutional and systemic risk.
- Oversight of reporting institutions is required to ensure disclosures become clear messages for policymakers and actionable recommendations.
- Assessments should be disseminated to all relevant domestic and international agencies that need them for financial stability and early warning systems (para. 33, Fourth).

5) Improve transparency and coverage of OTC derivatives information
- While comprehensive OTC derivatives data will remain challenging, recommended actions include:
  - The BIS could take the lead in enhancing its OTC derivatives database by considering geographical and instrument coverage; frequency of reporting; granularity regarding instruments, counterparties, and market concentration; and shifting the focus from volumes to exposures (para. 33, Fifth; footnote: This BIS has already established a task force to address many of these issues).
  - Disclosure of CDS transactions would be enhanced by coordination of clearing house developments; clearing and settlement platforms could be extended to other OTC traded instruments (para. 33, Fifth).

6) Enhance transparency of credit ratings methodologies
- National authorities should ensure credit rating agencies provide more information on methodologies for structured credit products and on sensitivity of ratings to shocks.
- Adopting a different rating scale for such instruments could help encourage more prudent assessments of vulnerability to multiple-notch downgrades (para. 33, Sixth).

### Cross-border and cross-functional regulation and supervision (paras. 34–40)
- Progress has been made toward improving cross-border and cross-functional cooperation among supervisors, including FSF proposals for colleges of supervisors and supervisory MoUs (para. 34).
- However, significant improvements remain needed: authorities were not effective in sharing information or identifying vulnerability buildups in globally active and systemically important institutions; AIG and its CDS market implications, and responses to Lehman Brothers and three Icelandic banks illustrate insufficient cross-functional cooperation and home/host coordination (para. 35).
- Legal impediments hinder better coordination: lack of an international legal framework for fair resolution of global firm failures and imprecise domestic legislation constrain information flow even within jurisdictions (para. 36).
- Risk: without cooperation, national authorities may discourage financial globalization in tranquil times and resort to ring-fencing and discriminatory resolution practices in stress (para. 37).

Policy suggestions for improving cross-border/cross-functional regulation and supervision (para. 38)
- Compatible bank resolution and information-sharing legislation, converging home and host country banking legislation on:
  - early corrective actions, including common criteria on triggers and timing of resolution or bankruptcy procedures of a global firm;
  - resolution tools to allow quick, synchronized cross-country action to preserve franchise value and ensure fair treatment of creditors;
  - depositor and investor protection schemes ensuring coverage by the scheme prevailing in each jurisdiction, regardless of subsidiary or branch status (branches would have to join the local scheme);
  - free exchange of information and cooperation by regulators with local and foreign counterparts, including possible joint inspections;
  - loss sharing arrangements measured on objective criteria (for instance the level of unprovisioned non-performing loans of each location to total equity) (para. 38, bullets).
- Compatible minimum supervisory practices for cross-border firms, potentially established as a core set of principles, including:
  - Appointing a lead regulator (in principle the home authority) by the college of regulators, responsible for mapping risk concentration and firm-level strengths and vulnerabilities;
  - Harmonizing key information and reporting to facilitate aggregation of risk and comparability across countries and encourage single, firm-wide definitions of risk concentration;
  - Defining minimum permissible activities between lead and other supervisors (lead regulator capacity to keep direct/regular contact with regulatory teams; request examination of items; participate in joint examinations; obligations regarding counterparts; presentation of periodic detailed progress reports; free access to inspection reports and database of risk concentrations);
  - Enhancing coordination among national supervisors, adopting colleges of supervisors and lead supervisor approach in local regimes, and seeking higher compatibility in application of Core Principles across functional regulators (including addressing differences in capital definitions, ensuring consolidated supervision across securities and insurance, and harmonizing risk concentration definitions) (para. 38, bullets).
- More broadly:
  - Make minimization of systemic risk the main mission of financial supervisors to force full coordination with counterparts;
  - Address budgetary constraints in supervisory agencies that impede hiring/retaining well-trained staff (para. 39).
- Multilateral mechanisms:
  - Develop more active and effective multilateral mechanisms for cross-border supervision, building on FSF, Basel Committee, and other standard setters; the IMF (in consultation with the World Bank and the Basel Committee) could develop guidelines for cross-border supervision and resolution addressing best practices (including triggers and depositor protection).
  - FSAP assessments could evaluate adequacy of countries’ oversight of cross-border financial firms and transactions (para. 40).

### Systemic liquidity management (para. 41)
- Major central banks successfully injected liquidity and staved off financial-system collapse by expanding central bank lending perimeters to broader collateral, lengthened terms, new counterparties, and introducing U.S. dollar swap lines with a number of central banks.
- Central bank balance sheets increased massively; some have more than doubled since September 2008 (para. 41).

*Source: IMF content unit _020409 - 28.      For markets, policy makers and financial authorities, including the IMF.*

### 42.      At the same time, the limitations of these actions have become apparent. In

### At the same time, the limitations of these actions have become apparent.

### Limitations of central bank interventions
- Central bank intervention has not been able to restart active interbank trading because these actions cannot address the underlying concerns about counterparty risk.
- Central bank liquidity has substantially substituted for market liquidity in the advanced economies.
- In some emerging markets, providing liquidity to support domestic markets has posed a difficult tradeoff with the risk of facilitating capital flight.
- Footnote: 11 Bagehot’s Lombard Street recommendation to lend freely but at a high cost in the case of a liquidity crisis provoked or accompanied by capital outflows remains appropriate here.

### Lessons for redesigning central bank liquidity frameworks
- In crises and periods of market dysfunctionality:
  - Targeting a single short-term market rate may no longer be appropriate.
  - Central banks may need to consider a broader range of short rates and their impact on term rates and the macro-economy.
  - A breakdown in the normal transmission mechanism points to a need for a better understanding of how central banks can underpin its functioning in unusual times—perhaps through term transactions.
- Operational adjustments in crises:
  - Significant and rapid adjustments to operational frameworks may be needed (example: the Federal Reserve’s establishment of a legal basis for remunerating reserves).
  - Other adjustments include varying the balance between short- and medium-term open market operations, broadening the range of counterparties, and reviewing the definition and pricing of acceptable collateral.
- Governance and moral hazard:
  - Changes must balance a flexible and decisive crisis response against the risk of moral hazard, particularly during prolonged emergency measures.
  - Accepting a wider range of collateral weakens market incentives to hold high-quality paper; these concerns need alleviation via appropriate governance structures and regular review of pricing and incentives (e.g., haircuts).

### Term lending, guarantees, and asset swaps
- Term lending and interbank guarantees:
  - Term lending has helped ease balance sheet adjustment but has not restarted interbank or commercial lending.
  - Government guarantees of commercial bank liabilities can distort funding allocation and are principally useful as a short-term palliative in severe market dislocation.
- Asset swaps:
  - Asset swaps (central bank provides liquid government security in exchange for illiquid private credit instruments) may be more effective in supporting money market functioning.
  - It is not yet clear that asset swaps substantially reduce lending spreads or re-establish a normal credit channel.

### Quasi-fiscal measures and central bank balance sheets
- Quasi-fiscal instruments used by central banks (supporting specific markets or borrower groups) go beyond normal monetary policy and liquidity management.
- While they can provide credit, they risk muddying the policy signal if prolonged and can substantially increase central bank balance sheets in ways that could take years to unwind.
- Early efforts are needed to transfer such operations and resulting balance sheet items to the fiscal authorities.
- Fiscal authorities should shoulder primary responsibility for addressing banking sector balance sheet weaknesses, including direct re-capitalization and/or restructuring.
- Footnote: 12 The Fed’s recent efforts to purchase mortgage securities do appear to have had an impact on the price, if not the volume, of mortgage lending.

### Repo market infrastructure and leverage
- The smooth functioning of money market repo operations calls for forceful action to strengthen underlying infrastructure.
- Recommended actions:
  - Introduce central clearing counterparty (CCCP) services (already widely used in Europe).
  - Provide stronger incentives and guidance by public authorities where markets are unlikely to act, given the public good element in this infrastructure.
  - Better measure and avert risks of excessive leverage via repo operations, including through regulatory limits.

### Bank regulation and liquid collateral
- Crisis lesson: banks and other institutions undervalued the social benefit of liquidity, leaving the system vulnerable to liquidity shocks that can become wide-spread solvency problems.
- Policy option:
  - Enhance liquid asset requirements within a well defined framework for assessing institutional and systemic risk, consistent with the central bank’s approach to liquidity management.

### Cross-border liquidity and central bank coordination
- Critical need for better mechanisms for providing cross-border liquidity, including permanent arrangements.
- Major central banks—especially the U.S. Federal Reserve—have established swap lines that effectively addressed cross-currency pressures.
- Such measures are palliative rather than solutions to broader structural and macroeconomic issues.

### Exit strategies and policy coherence
- Early consideration of exit strategies is needed to avoid measures that:
  - Unduly prolong market breakdown by undermining incentives.
  - Expose central banks to excessive policy or balance sheet risks.
- As conditions normalize:
  - Official interest rates should be set to provide incentives for markets to reduce transactions with the central bank.
  - Eligible collateral lists and relative pricing of different types of collateral should be reviewed.
- Care is required to ensure coherence where overlapping policy measures, including fiscal measures, have been introduced.

### Table 1 — Update of Progress of Implementation of FSF Recommendations (select highlights)
- Status as of September 15, 2008 (updates noted below in source text):
  - 1. The capital framework:
    - January 2009: BCBS issued consultative papers proposing (i) an incremental risk capital charge (IRC) and a stressed value-at-risk (VaR) requirement for trading book exposures; and (ii) enhancements to all three Pillars of the Basel II framework including increased capital charges for re-securitizations and ABCP liquidity lines.
  - 2. Liquidity risk management and regulation:
    - September 2008: BCBS published Principles for Sound Liquidity Risk Management and Supervision; implementation monitored by its Working Group on Liquidity with a first review slated for second half of 2009.
  - 3. Review of risk management:
    - January 2009: BCBS issued a consultative document aimed at strengthening risk management through Pillar 2.
  - 4. Operational infrastructure for OTC derivatives:
    - October/November 2008: market participants and authorities committed to building stronger OTC derivatives infrastructure, development of CDS central counterparties, and an MOU among national agencies.
  - 5. Risk disclosures:
    - BCBS consultative package on Basel II (January 2009) aims to strengthen Pillar 3 disclosure standards; IASB proposed enhanced disclosure requirements for valuations and liquidity risk (October 2008).
  - 6. Accounting standards for OBSEs:
    - December 2008: IASB proposed revised standards for consolidation of OBSEs and disclosure of related risk exposures; derecognition proposals planned by March 2009.
  - 7. Valuation:
    - October/November 2008: IASB finalized guidance on valuation of complex securities; BCBS released a consultative paper Supervisory Guidance for Assessing Banks’ Financial Instrument Fair Value Practices.
  - 8. Credit Rating Agencies:
    - IOSCO to publish an Implementation Report on the IOSCO CRA Code of Conduct and develop regulatory inspection modules and oversight approaches for globally active CRAs; Joint Forum concluded a stocktaking of ratings use.
  - 9. Strengthening authorities’ responsiveness to risk:
    - FSF developed protocols for supervisory colleges; colleges exist for most large complex financial institutions identified by the FSF; a review will be undertaken in 2009.
  - 10. Central Bank Operations:
    - CGFS followed up on international distribution of liquidity focusing on (i) inter-central bank swap lines; and (ii) acceptance of cross-border collateral; CPSS finalized (December 2008) a report on operational arrangements for central banks to provide cross-border liquidity.
  - 11. Dealing with weak banks:
    - BCBS’ Cross Border Resolution Group completed a preliminary assessment and is examining individual failures; IADI Core Principles for Effective Deposit Insurance to be finalized for publication in March or April; FSF sub-group on cross-border crisis management to publish high-level principles in March 2009.

*Source: Financial Stability Forum.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/np/pp/eng/2009/_020409.pdf_