Lessons from the Recent Financial Crisis and the Role of the Fund, A Keynote Address by Saleh M. Nsouli, Director, Offices in Europe, International Monetary Fund at the International Arab Banking Summit 2008

June 26, 2008

A Keynote Address by Saleh M. Nsouli1
Director, Offices in Europe, International Monetary Fund
At the International Arab Banking Summit 2008
Paris, June 26, 2008

During the last several months we have witnessed one of the most trying times for financial markets in several decades, perhaps since the 1930's Great Depression. I need not repeat in detail, for this audience, the litany of events that have led up to the present. As you all well know, the originators of lower quality mortgages in the United States had strong incentives to meet a constant and, indeed, increasing demand for securitized products of some form or another. There was little incentive to originate good loans or monitor the borrowers' creditworthiness. Additionally, the high demand for other types of structured credit products, such as those formed from commercial real estate, leveraged loans, and some other types of consumer credit, meant that these sectors also witnessed weakened credit standards. In these categories, the after-effects are just now becoming visible.

Let me focus my remarks on two broad and key areas. First, what are we learning from the events that have unfolded so far? And second, what can the International Monetary Fund do to make the global financial markets a safer place in which to ensure sustainable global growth?


There are several lessons we can now draw for the private and public sector related, in one way or another, to how various incentives have played out in the run-up to the crisis. Let me, in the first instance, highlight four key lessons for the private sector.

The first is that originators need to be "incentivized" to make loans to high-quality borrowers and to monitor loan performance more carefully. While end-investors are now more demanding of the originators, there are currently several regulatory initiatives that have been taken or are being considered to help make the various links in the originate-to-distribute chain stronger and more transparent. The US federal bank regulators have issued tighter guidance over how riskier mortgage borrowers are to be qualified for loans and this has been emulated by both state bank regulators and Fannie Mae and Freddie Mac in their procedures for purchasing riskier mortgages. As a result, hybrid subprime loans with teaser rates are no longer being made. In addition, the Fed has issued draft regulation to tighten the lending standards for higher-risk mortgages under Federal law while Congress is considering ways to regulate mortgage brokers in the US for the first time.

The second lesson is that the governance structure of the risk management system needs to be improved in financial firms in which the incentives are biased toward returns rather than the risks involved in attaining them. Compensation schemes in many organizations focus on returns and, for the most part, ignore the risk taken to obtain such returns. The risk managers, because they are not profit centers and do not sell products or write trading tickets, tend to be ignored when profits are up. Indeed, many of them apparently did sound the alarm bells before the crisis set in and were often disregarded as too out-of-touch with new structural trends, though not all firms downplayed the advice of their risk managers. The key is to ensure that top management hears both sides at equal volume, choosing the risk-return combination which best represents the risk appetite of the firm.

The third lesson is that the incentives to use credit rating agencies and the incentive structures within credit rating agencies themselves need to be reexamined. In the run-up to the crisis, the practices (including incentives) and modeling approaches of rating agencies were generating a large proportion of AAA-rated structured credit products. The credit rating agencies are considering how best to handle these issues. The International Organization of Securities Commissions (IOSCO) has recently published its code of conduct for ratings agencies and the U.S. Securities Exchange Commission has also weighed in with its guidance.

The fourth lesson is that investors need to perform their own due diligence and ask the right questions about the riskiness of the securities they are purchasing. While ratings agencies are clearly an important and valuable part of our financial system, how the ratings are interpreted by end-users is also part of equation—and part of what has caused the structured products market to collapse. Again, incentives in the upswing of a cycle were such that this "search-for-yield" in a low interest rate environment outweighed careful risk analysis.

Let me now turn to the public sector, which certainly shares some of the responsibility. Two key lessons emerge.

First, there is a need to refine the regulatory framework to avoid distorted incentives. The desires of private sector investors and the actions of the intermediaries were indeed influenced by the regulations they faced. Probably the most widely cited problem to be uncovered is that capital regulations applied to banks encouraged them to store some of the new credit-related products in off-balance sheet vehicles. The maturity mismatch and the lack of transparency about the type of assets in these off-balance sheet vehicles started what has become a severe and chronic funding shortage.

Second, supervisors and regulators need to have the incentives and resources to look hard and deep at possible flaws in the risk management systems of the institutions they oversee. Often, stress tests did not stress the right areas or not enough; funding liquidity risks received inadequate attention; and holistic views across credit, market, and funding risks were not emphasized in part because of the recent and constant attention on Basel II regulations, covering primarily credit risk.

An important third set of lessons relates to how to cope with the outcomes of crises of this new type. Bank resolution and deposit-insurance frameworks need to be strengthened and interagency coordination needs to be more effective. Central banks should remain well-informed and involved in the ongoing analysis of risks of the major financial institutions in their economies. In the area of central banking, the lessons are particularly relevant, since how central banks respond can affect outcomes in the real economy. Without doubt, we can see that there were shortcomings in the existing emergency liquidity frameworks. Obsolete tools and operational procedures have been replaced with others that are aimed at fixing the low volumes in interbank markets and getting these markets going again. Yet we still see that interbank and money markets more generally are not recovering as quickly as we had hoped. The evaluation of the set of new facilities and how well they have served their desired purposes is ongoing. Issues of moral hazard are also at the heart of the problem.

The Role of the Fund

Let me now turn to the role of the Fund in fostering a stable financial system.

First, the Fund can use its surveillance tools to monitor the situation as it evolves. As part of our multilateral surveillance, we can point to cross-border channels and linkages that may be difficult for the authorities in individual countries to see. Based on our work, we can provide an assessment of the situation and recommendations. In fact, we have provided a first set of policy responses to the issues raised in the crisis in our latest Global Financial Stability Report and in our report to the International Monetary and Financial Committee, one our main decision-making bodies at the Fund.

Second, the Fund regularly shares its analyses and assessments with our international counterparts, such as the Financial Stability Forum, the Basel Committee, and the Bank of International Settlements, contributing to a better understanding of the challenges confronting the international financial system.

Third, because of our wide membership, we can act as an effective conduit in transferring the lessons learned in the crisis, where appropriate, to other countries and regions. We can alert them to vulnerabilities they face, including any potential contagion effects that may come their way.

Fourth, through our Financial Sector Assessment Programs we have an opportunity to observe and evaluate financial sectors of individual countries and their linkages across countries as well as their ability to absorb various macroeconomic shocks. Part of the assessment is based on a set of stress tests, in which various specific vulnerabilities are highlighted. Another is spent tracking where a given country stands relative to its peers on several dimensions, such as banking supervision (through the Basel Core Principles), securities market regulation (through the IOSCO Core Principles) and so on. We can use these evaluations, as well as any new guidance following the crisis from other standard setters, to encourage countries to adopt best practices.

Fifth, the Fund provides a venue for members to exchange ideas and views regarding how to mitigate the types of problems we are facing today. Last fall, for instance, we held a Financial Stability Workshop with the FSF and BIS as co-sponsors focusing on the events that had then unfolded. Going forward, the Fund will be unveiling a Financial Stability Portal on its website soon, where our own current research and that of others, as well as policy discussions about financial stability can be posted and links to other sites can be found.


In summary, while the crisis is not over yet, we certainly hope the worst is behind us. Corrective action is still needed and the lessons we are learning are ongoing. That said, we have learned, in fact re-learned, that while crises may manifest themselves in different ways, with new instruments, in new markets, and sometimes in newly created types of institutional frameworks, one of the items that remains the same is that "incentives" are often at the root of a crisis. Often altering incentives is a difficult job as market participants and the official sector have gotten comfortable in their various roles, rules, and regulations. But it is time to re-evaluate how incentives altered the buildup to the latest crisis and its aftermath and how they can be redirected to reinforce self-corrective forces in financial markets rather than destructive ones. The Fund can play a role in putting forth possible options, joining with various international organizations and standard setters to discuss them, and acting as a focal point for such discussions, and can help disseminate the new best practices or rule-making throughout its membership to foster a more secure global economic and financial environment.

1 The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its Management.


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