The International Monetary Fund blames the policymakers and financial regulators for the global economic downturn.
“At the root of the crisis was the optimism that was brought about by a long period of prosperity. This optimism led to risks in the global economy not being assessed as carefully as they should have been," says the IMF survey.
To put it simply, the policymakers forgot what goes up must come down.
“A key failure 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,” said Reza Moghadam, head of the IMF’s Strategy, Policy and Review Department.
The IMF is urging governments to tighten financial regulation and adopt a "binding code of conduct across nations" to coordinate how and when they would intercede in troubled firms, and how to share losses from major financial institutions that operate across borders, reports the Wall Street Journal.
The IMF is calling for greater transparency in the financial system. Strengthen public disclosure of important financial institutions, it says, and calls for greater transparency in the valuation of complex financial instruments.
According to the IMF, inadequate financial regulation and not global imbalances caused the crisis.
But the banks would not have gone overboard and lent heavily and created risky financial instruments unless a glut of money from countries with high savings rates, such as China and the oil-producing states, came flooding into America, says the Economist. The bankers were merely meeting market demands. Asian and Middle Eastern sovereign wealth funds even invested in banks that were already in trouble such as Citigroup and UBS. British banks went into the subprime market.
The IMF does say: "While international capital flows are on the whole beneficial, global imbalances have to be addressed. Policymakers
should… rebalance savings
and investment in their own economies."
The IMF survey, which can be downloaded from the IMF website, says:
- Financial regulators were not equipped to see the risk concentrations and flawed incentives behind the financial innovation boom. Neither market discipline nor regulation were able to contain the risks resulting from rapid innovation and increased leverage, which had been building for years.
- Policymakers failed to sufficiently take into account growing macroeconomic imbalances that contributed to the buildup of systemic risks in the financial system and in housing markets. Central banks focused mainly on inflation, not on risks associated with high asset prices and increased leverage. And financial supervisors were preoccupied with the formal banking sector, not with the risks building in the shadow financial system.
- International financial institutions were not successful in achieving forceful cooperation at the international level. This compounded the inability to spot growing vulnerabilities and cross-border links.
The IMF prescription
As to what needs to be done, the survey says:
First, 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.
Second, market discipline needs to be strengthened. The failures of credit rating agencies to adequately assess risk have been criticized 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.
Third, 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.
Fourth, 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.
Fifth, central banks should strengthen their frameworks for systemic liquidity provision. The infrastructure underlying key money markets should also be improved.
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