It was “no touch” regulation, not global imbalances, that got us into this mess

There are two main schools of thought about what caused the current banking and financial crisis.

First, there’s the “global imbalances” theory, in which investors’ and banks’ behaviour became distorted by the imbalances between heavily-indebted western nations and Asian nations with surpluses. Under this theory, it was the imbalances that prompted investors who were seeking yield to stoke up massive asset price bubbles.

The second view is that inadequate financial regulation, coupled with the actions of greedy and incompetent bankers was to blame.

Libertarians, free-marketeers and knee-jerk deregulatory thinkers, such as most of the editorial staff at The Economist, generally subscribe to the former view, perhaps because to subscribe to the latter would undermine their core beliefs.

Interestingly, however, the IMF on Friday plumped for blaming inadequate regulation coupled with poor market discipline. The fund explained its reasons in a must-read evaluation of the origins of the current financial and economic crisis (see IMF Urges Rethink on How to Manage Global Systemic Risk).

Among other things, the IMF report states: “Financial regulators were not equipped to see the risk concentrations and flawed incentives behind the financial innovation boom” and that “central banks focused mainly on inflation, not on risks associated with high asset prices and increased leverage.”

The report adds that there was “a general belief in light-touch regulation based on the assumption that financial market discipline would root out reckless behavior and that financial innovation was spreading risk, not concentrating it.”

The report also says: “A key failure during the boom was the inability to spot the big picture threat of a growing asset price bubble. Policymakers only focused on their own piece of the puzzle, overlooking the larger problem.”

“What is clear from the crisis is that the perimeter of regulation must be expanded to encompass systemic institutions and markets that were operating below the radar of regulators and supervisors.”

The study intended for the leaders due to attend the G20 summit in London on 2 April, mentions five key weaknesses that need to fixed.

The study identifies five key areas that need to be addressed:

(1) the regulatory perimeter, or scope of regulation, needs to be expanded to encompass all activities that pose economy-wide risks. Regulation should also remain flexible to keep up with innovation in financial markets, and it should focus on activities, not institutions. Risk concentrations should not be allowed to develop beyond the regulatory perimeter. Clarifying the mandate for oversight of systemic stability would be an important first step.

(2) Market discipline needs to be strengthened. The failures of credit rating agencies to adequately assess risk have been criticised by many, and initiatives to reduce their conflicts of interest and improve investor due diligence are underway. Other steps could include less reliance on ratings to meet prudential rules, and a differentiated scale introduced for structured products. Also, the resolution of systemic banks should include early triggers for intervention and more predictable arrangements for loss-sharing.

(3) Procyclicality in regulation and accounting should be minimized. Increasing the amount of capital required of banks during upswings would create a buffer on which banks can draw during a downturn. An international framework for provisioning is needed to reflect expected losses through-the-cycle rather than in the preceding period. Supervisors should also routinely assess compensation schemes to ensure they do not create incentives for excessive risk-taking. In addition, there is a strong case for improving accounting rules by acknowledging potential for mispricing in both good and bad times.

(4) Information gaps should be filled. Greater transparency in the valuation of complex financial instruments is needed. Improved information on off-market transactions and off-balance sheet exposure would allow regulators to aggregate and assess risks to the system as a whole. Such measures would also strengthen market discipline.

(5) Central banks should strengthen their frameworks for systemic liquidity provision. The infrastructure underlying key money markets should also be improved.

“What is clear from the crisis is that the perimeter of regulation must be expanded to encompass systemic institutions and markets that were operating below the radar of regulators and supervisors,” said Jaime Caruana, head of the IMF’s monetary and capital markets department, said. “We are suggesting a two-tiered approach to expand regulation: extending disclosure to provide enough information for supervisors to determine which institutions are big or interconnected enough to create systemic risk, and intensified functional regulation and oversight.”

This blog post was published on 9 March 2009