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IMF Survey: How to Ensure Financial Stability After the Crisis

May 14, 2009

  • IMF-sponsored seminar examines future framework for mitigating systemic risks
  • Panelists explore how all systemic financial institutions should be regulated
  • Experts agree on need for systemic risk regulator at national level

Even as governments and international organizations seek to contain the current crisis, policymakers are debating how national frameworks for financial stability—including regulation and supervision of financial institutions—should change.

How to Ensure Financial Stability After the Crisis

Banks’ technology is fixed and “infinitely expandable across the customer base,” seminar hears (photo: Construction Photography/Corbis)


The goal of such change should be to “create a safer and sounder financial system for the future,” said José Viñals, Director of the IMF’s Monetary and Capital Markets Department.

Viñals moderated an IMF-sponsored symposium on April 25, 2009, that explored such issues as which institutions should be regulated, what policies are needed to mitigate systemic risk, whether there should be a single systemic risk regulator, and, if so, whether this should be the central bank.

A working paper by IMF economist Erlend Nier framed the symposium, which included four leading experts in banking and finance: Paul Volcker, chairman of the Group of Thirty; Andrew Crockett, president of JPMorgan Chase International; Richard Herring of the University of Pennsylvania’s Wharton School; and Willem Buiter of the London School of Economics.

Focus on banks?

Authorities must first determine whether an institution is systemically important and in need of “more stringent regulation and supervision,” Herring said.

Volcker suggested that supervision to contain systemic risk should be directed primarily at the banking system, not at all big financial institutions such as hedge funds or insurance companies. Because banks are at the heart of the financial system and its infrastructure, it is on banks that “regulation and supervision ought to focus,” Volcker said. Banks are essentially service organizations that ought not be taking risks that can “create conflicts of interest” and “may jeopardize their central function.” By contrast, big nonbank institutions operating in capital markets should not take the same degree of regulation, and policymakers should “try to avoid the presumption” that big nonbank institutions are going to be saved if they get into trouble.

Or include large nonbanks?

Crockett, on the other hand, said that although he did not dispute the centrality of banks to the functioning of the financial system, other large systemic financial institutions—interconnected by the financial markets—need the same type of strong regulatory oversight as banks.

Indeed, Crockett, former general manager of the Bank for International Settlements, said a single regulator with responsibility for the broad financial system might have been able to point out the growth of the shadow banking system—which encompasses such entities as investment banks, hedge funds, mortgage brokers, venture capital, and even credit rating agencies. The growth of the shadow banking system, which was largely outside anyone’s control, was a major source of the current crisis.

Buiter and Herring agreed with this assessment and suggested further that there would be little efficiency cost if those institutions considered “too big, too complex, and to interconnected to fail,” were forced to reduce their size and complexity. “Economies of scale are exhausted at about $100 billion,” Buiter said, and “growth beyond that size has other motivations—such as becoming too big to fail.”

However, Crockett, who represents one of the largest U.S.-based financial institutions, said there are efficiency gains that impel firms to grow larger. “About 40 percent of the cost of JPMorgan Chase is technology related,” Crockett said. This technology is fixed and “infinitely expandable across the customer base.”

Regulation versus resolution

Herring said giant financial institutions had developed “baroque international structures” that operate with little regard to borders, regulatory domains, or legal limits, partly to get around taxes and regulations.

However, to lessen the risks that very large institutions pose to systemic stability, regulation alone does not suffice. Herring said that to reduce the impact of systemic failures, special resolution regimes are needed to deal with insolvency of any systemically important institution, not only banks.

"Economies of scale are exhausted at about $100 billion, and growth beyond that size has other motivations"

In the United States, such a regime already exists for commercial banks, and it enabled the Federal Deposit Insurance Corporation to deal with the failures of several important banks, such as Wachovia and Washington Mutual. But such a special regime does not apply to bank holding companies, such as Citigroup, nor to nonbank financial institutions that can pose a systemic threat.

Herring said the lack of such a resolution framework was demonstrated in the cases of both investment bank Lehman Brothers and insurance giant AIG. The authorities’ decision to let Lehman fall into ordinary bankruptcy created substantial spillovers around the world. AIG was saved—two days later—because the perceived threat of disorderly bankruptcy was too great.

Herring said systemically important institutions should also be required to submit to their primary supervisor a plan for how they would wind down in a crisis. If the supervisor found the plan “implausible,” it would require the institution to “simplify its corporate structure, reduce its size, reduce its complexity, or reduce its geographic scope.”

Central banks as systemic risk regulators?

The panelists broadly agreed that a single agency should be given the responsibility and the authority to act as the systemic risk regulator, with a view to monitoring and devising policies to mitigate risks to the system as a whole. There was less agreement on which agency should assume this role.

Volcker, a former chairman of the U.S. Federal Reserve Board, said that when the financial stability framework is defined broadly to include monetary policy, regulatory policy, and supervisory policy, it followed that control of that framework should go to the central bank.

Crockett, while acknowledging the arguments for making the central bank the systemic risk regulator, said a number of factors led him to question that approach. One is that central banks—whose main role is assuring price stability—may lack the expertise to engage in supervision, where micro-knowledge, such as on accounting and legal issues, is required.

"Systemically important institutions should be required to submit to their primary supervisor a plan for how they would wind down in a crisis"

But more importantly, by taking on supervision and regulation, central banks would thrust themselves into an inherently political role—that of telling businesses what they can and cannot do. It would be difficult for them to maintain the independence from the political process that they require to conduct monetary policy.

But Buiter said that because central banks are in the business of providing liquidity to the financial system, their independence is already compromised. As liquidity providers they must be concerned about the solvency of financial institutions, implying a need to be involved in supervision. However, regulation and supervision of solvency is political and needs also to involve the Treasury. He concluded that it is impossible to maintain an independent central bank when either the central bank engages in liquidity support in crisis times or when the central bank assumes a role in solvency regulation.

Can they and should they?

As IMF economist Nier put it, there are two central issues: Can central banks do it? Do they have the expertise to become the systemic risk regulator? And, if so, should they do it?

Nier said he found fairly compelling the case for giving central banks responsibility for financial stability as well as price stability. Central banks are equipped to deal with financial stability because their macroeconomic perspective enables them to conduct macroprudential regulation. Their intimate knowledge of the payments and settlements infrastructure gives them an important ability to understand the impact of the failure of individual institutions on the financial system.

Central banks also have an incentive to maintain financial stability, as failure to do so jeopardizes both their independence and their ability to maintain price stability. The greatest danger to central bank independence lies in a financial crisis, he said, when “the central bank is dragged in by the treasury to do things it does not want to do.”

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