The global financial crisis: Let good sense prevail
Monday, 27 October 2008
Zahid Hussain
Financial crisis is nothing new. The world has experienced hundreds. Understandably, interest in learning from past crises mounts when another crisis occurs. The sort of crisis the world is experiencing now has systemic roots. Corrupt acts of a few greedy individuals or isolated regulatory failures rarely cause financial crisis. Had that been the case, crisis would have been the rule rather than the exception because corruption bred by greed and regulatory errors, and even malfeasance, have always been there and, for sure, will always be there.
This is not the first time financial institutions have engaged in reckless risk-taking by exploiting regulatory loopholes. Such behaviour is easier to disguise when a bubble or boom is on. Economic boom and assets bubbles have often preceded financial crises. Financial market historians have noted that the likelihood of crisis increases the stronger and the longer are economic booms. In the midst of such booms, crises are often triggered by shocks in output, assets prices, terms of trade, and interest rates.
Financial deregulation has been blamed for causing the current crisis. That can at best be a part of the story. It ignores the role of deficient oversight and suggests that rules, not incentives, are at fault. Financial crises are often driven by breakdowns in arrangements designed to take advantage of loopholes in a country's regulatory restraints on risk-taking and risk-shifting behavior. The meltdown that began in 2007 is rooted in institutions abusing derivative instruments that were rationalized as vehicles to diversify and hedge risk and, instead, ended up magnifying risk.
This has led some to interpret recent events as evidence that market discipline is not reliable. They focus on designing new rules. Others are not so convinced. They suggest public supervision should focus on generating and using better market signals. A more balanced view says that the current crisis epitomizes the power of government-induced incentive distortions as well as the limits of market discipline. Financial engineers shifted risk to unwary investors. Financial globalization enabled corporations and financial institutions to bypass burdensome regulations in the resident countries by strategically booking their business offshore. Government supervisors failed to challenge decisions made by credit rating organizations. All these went on unabated because of the prevalence of perverse incentive systems that govern the ways in which financial institutions, regulators, and politicians interact.
It is easy to blame market failure for the securitization meltdown. As several analysts have pointed out, market failures were embedded in a parallel oversight failure on the part of public regulatory institutions. Federal supervisors in the U.S. failed to take on the political and practical challenge to establish and maintain their ability to detect and discipline complicated risk exposures. Consequently, investors were fed overly optimistic assessments of the quality of the products they purchased. The breakdown of public supervision in the most highly developed countries shows that incentive alignment is critical. Bad incentives generate misinformation which in turn creates painful losses. This is a key lesson that all crises impart.
Moving forward, it is dangerous to set aside long-term perspectives even at the peak of a financial crisis. Short-sighted approach to crisis resolution garners the expectation that they will be used again in the next crisis, thus undermining market discipline and future financial stability. Historians observe that blanket guarantees, open-ended liquidity support, and regulatory forbearance increase the ultimate fiscal cost of resolving a crisis. Providing liquidity support to distressed institutions prolongs a crisis by distorting incentives for risk-taking so much that prudent investments and healthy exits are delayed. Authorities routinely prefer to treat the troubled institutions generously, claiming that they must minimize potential short-term contagion at all cost. Bona fide reform must address the contradictory bureaucratic and political incentives to attempt to resolve the crisis in undesirable ways.
A recent IMF study of 42 systemic banking crises across the world provides evidence on how different crises were resolved. They find that in 32 of the 42 cases there was government financial intervention of some sort. Only in 10 cases systemic banking crises were resolved without any government financial intervention. Among the 32 cases where the government recapitalized the banking system, only seven included a program of purchase of bad assets/loans (like the one initially proposed by the US Treasury). In 25 other cases there was no government purchase of such toxic assets.
In the Scandinavian banking crises (Sweden, Norway, Finland) that are considered models of how a banking crisis should be resolved there was no government purchase of bad assets. Most of the recapitalization occurred through various injections of public capital in the banking system. In most cases in which purchase of toxic assets were used, the fiscal cost of the crisis became much higher (as in Japan and Mexico).
The lessons of the crisis for regulation and supervision are equally relevant for developing countries. In all countries, good regulatory design requires attention to proper alignment of incentives, in both the public and private arena, with the objectives of financial regulation. Developing countries have an additional problem in that their financial systems cannot count on generous bailouts because their governments are financially too weak to cope. (The author is Senior Economist at the World Bank Dhaka office. The views expressed are the author's own, not that of the World Bank.)
Financial crisis is nothing new. The world has experienced hundreds. Understandably, interest in learning from past crises mounts when another crisis occurs. The sort of crisis the world is experiencing now has systemic roots. Corrupt acts of a few greedy individuals or isolated regulatory failures rarely cause financial crisis. Had that been the case, crisis would have been the rule rather than the exception because corruption bred by greed and regulatory errors, and even malfeasance, have always been there and, for sure, will always be there.
This is not the first time financial institutions have engaged in reckless risk-taking by exploiting regulatory loopholes. Such behaviour is easier to disguise when a bubble or boom is on. Economic boom and assets bubbles have often preceded financial crises. Financial market historians have noted that the likelihood of crisis increases the stronger and the longer are economic booms. In the midst of such booms, crises are often triggered by shocks in output, assets prices, terms of trade, and interest rates.
Financial deregulation has been blamed for causing the current crisis. That can at best be a part of the story. It ignores the role of deficient oversight and suggests that rules, not incentives, are at fault. Financial crises are often driven by breakdowns in arrangements designed to take advantage of loopholes in a country's regulatory restraints on risk-taking and risk-shifting behavior. The meltdown that began in 2007 is rooted in institutions abusing derivative instruments that were rationalized as vehicles to diversify and hedge risk and, instead, ended up magnifying risk.
This has led some to interpret recent events as evidence that market discipline is not reliable. They focus on designing new rules. Others are not so convinced. They suggest public supervision should focus on generating and using better market signals. A more balanced view says that the current crisis epitomizes the power of government-induced incentive distortions as well as the limits of market discipline. Financial engineers shifted risk to unwary investors. Financial globalization enabled corporations and financial institutions to bypass burdensome regulations in the resident countries by strategically booking their business offshore. Government supervisors failed to challenge decisions made by credit rating organizations. All these went on unabated because of the prevalence of perverse incentive systems that govern the ways in which financial institutions, regulators, and politicians interact.
It is easy to blame market failure for the securitization meltdown. As several analysts have pointed out, market failures were embedded in a parallel oversight failure on the part of public regulatory institutions. Federal supervisors in the U.S. failed to take on the political and practical challenge to establish and maintain their ability to detect and discipline complicated risk exposures. Consequently, investors were fed overly optimistic assessments of the quality of the products they purchased. The breakdown of public supervision in the most highly developed countries shows that incentive alignment is critical. Bad incentives generate misinformation which in turn creates painful losses. This is a key lesson that all crises impart.
Moving forward, it is dangerous to set aside long-term perspectives even at the peak of a financial crisis. Short-sighted approach to crisis resolution garners the expectation that they will be used again in the next crisis, thus undermining market discipline and future financial stability. Historians observe that blanket guarantees, open-ended liquidity support, and regulatory forbearance increase the ultimate fiscal cost of resolving a crisis. Providing liquidity support to distressed institutions prolongs a crisis by distorting incentives for risk-taking so much that prudent investments and healthy exits are delayed. Authorities routinely prefer to treat the troubled institutions generously, claiming that they must minimize potential short-term contagion at all cost. Bona fide reform must address the contradictory bureaucratic and political incentives to attempt to resolve the crisis in undesirable ways.
A recent IMF study of 42 systemic banking crises across the world provides evidence on how different crises were resolved. They find that in 32 of the 42 cases there was government financial intervention of some sort. Only in 10 cases systemic banking crises were resolved without any government financial intervention. Among the 32 cases where the government recapitalized the banking system, only seven included a program of purchase of bad assets/loans (like the one initially proposed by the US Treasury). In 25 other cases there was no government purchase of such toxic assets.
In the Scandinavian banking crises (Sweden, Norway, Finland) that are considered models of how a banking crisis should be resolved there was no government purchase of bad assets. Most of the recapitalization occurred through various injections of public capital in the banking system. In most cases in which purchase of toxic assets were used, the fiscal cost of the crisis became much higher (as in Japan and Mexico).
The lessons of the crisis for regulation and supervision are equally relevant for developing countries. In all countries, good regulatory design requires attention to proper alignment of incentives, in both the public and private arena, with the objectives of financial regulation. Developing countries have an additional problem in that their financial systems cannot count on generous bailouts because their governments are financially too weak to cope. (The author is Senior Economist at the World Bank Dhaka office. The views expressed are the author's own, not that of the World Bank.)