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Toto, we’re not in Kansas anymore: Exploring the Contours of the Financial System After the Tornado

Just as a tornado in Kansas transplanted Dorothy and, her dog, Toto, from familiar comforts to the unknown land of Oz, the global crisis has led many to wonder what has become of the global financial system and, more importantly, what will it look like next. Is the wicked witch of the West—excessive risk taking and leverage—really dead?

But now, as the storm subsides, there is time to speculate about what the future financial sector might look like. My IMF colleague, Aditya Narain, and I have done just that in a new Staff Position Note that attempts to discern the contours of this new financial landscape. What is clear is that the new landscape will be influenced by both the private and public sectors—their reactions to the crisis and to each other.

There are a multitude of possibilities between two extremes.

Neither outcome is desirable, so the note presents a base case between the two. What is needed is not more regulation, but sensible and better regulation. The attitude that “regulation never works, so why bother” misses two of the main lessons from the crisis. 

Although perfect regulation is the ideal, in the real world there is unlikely to be a perfect, gleaming Emerald City at the end of a yellow brick road. Nor is there a “great and all-powerful Oz” to devise and implement such regulation. Hence we look at the most likely set of reforms to be enacted—those that are perhaps the most politically feasible and globally acceptable—and their effects. We then speculate about what the main outcomes will be:

But what does this mean for the global financial system as a whole? In the short run, the system’s riskiness and size will likely continue to shrink alongside a prolonged period of deleveraging. In the medium term, the outcomes become less clear. If the largely bank-centric regulations currently on the drawing board come to pass, and the expanded nonbank activities are within a new regulatory perimeter, it could bring financial system risk back toward a healthier norm but, importantly, with less risk than in the pre-crisis period.

But, to get to a safer, sounder financial system, coordinated and consistent implementation of better, smarter regulation and oversight will be needed. We at Fund are working hard to put our relative strengths—namely our global vantage point, our extensive experience with financial sector reform, and existing partnerships with major international bodies, such as the Financial Stability Board, Basel Committee on Banking Supervision, International Organization of Securities Commissions, and the International Accounting Standards Board—to work in helping guide the development of the “just right” version of re-regulation. 

While a more holistic and coordinated approach across countries—with not too many countries jumping ahead nor lagging behind—is desirable, it is by no means assured. There is also a risk that, without buy-in from the private sector through “incentive compatible” regulation that encourages them to mitigate risks on their own, regulations put in place will be circumvented.

So, just as the scarecrow’s new brain and the lion’s new courage helped them guide Dorothy on her journey to find Oz, similar wisdom is needed in shaping the new financial system. It is critical that reforms are introduced with intelligence and foresight, as well as a firmness of purpose so that policymakers can navigate their way through the lessons from the crisis and we do not lose our way again. What do you think?

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