Reforming the Financial Landscape After the Crisis

Today we have released the three analytical chapters in our upcoming Global Financial Stability Report. These chapters cover some of the most relevant areas facing policymakers as they devise financial reforms that address the systemic risks that arose during the crisis and deal with potential forthcoming vulnerabilities.

Chapter 1 comes out next week. Chapter 2, published today,  focuses on two questions facing policymakers attempting to reform the financial landscape. One, whether systemic risk would be reduced by placing all regulatory functions under the purview of one entity—be that a single agency or an overseeing council? And two, if we were to use capital surcharges on financial institutions to try to limit the systemic risk associated with domino-like failures, how would we construct such surcharges?

Let us stress that, we do not have “the” answer to these difficult questions, but we think we have been able to frame the debate in a constructive way and provide guidance to policymakers on these important issues. For instance, we do not necessarily see a capital surcharge on systemically important institutions as the only way to reduce systemic risk, but as one method of a multipronged approach. There is a need to examine a number of approaches to see which one or which combination will do the job best.

Chapter 3 takes a slightly different tack by delving into how we can improve market infrastructure to help limit systemic risk. As you are aware, the over-the-counter derivatives market has been under scrutiny since problems in the credit default swap market arose with Lehman’s bankruptcy and AIG’s near miss. The IMF looks closely at the how central counterparties for clearing these contracts can be a shock-absorber in the financial system.

Chapter 4 looks ahead to the vulnerabilities that may be building up in some countries partly as a result of the low interest rates and ample liquidity that has characterized the main advanced economies’ current monetary policy stances. The chapter documents that global liquidity plays a role in capital inflows to emerging and some other advanced countries where interest rates are higher and growth prospects are stronger.

Certainly, an increase in capital inflows is a positive development following their dramatic decline during the height of the crisis, but they can be too much of a good thing if they add to inflation pressures or asset price bubbles.

The chapter looks closely at the policy options that liquidity receiving economies can use. It suggests that, as a first-best solution, macroeconomic policies, including flexible exchange rates, and enhanced prudential regulations for the financial sector, can go a long way in managing a surge of capital inflows. It also reviews the international experience with capital controls.

2 Responses

  1. It is most remarkable that any “systemic risk” of the “financial system” avoids any mention of national, public, sovereign or government debt. See

    Anybody vaguely trained in systems thinking would differentiate three levels of the financial system:

    1. the issuers of CURRENCY, i.e. nation states and central banks

    2. the issuers of CREDIT, i.e. banks and financial institutions

    3. the users of MONEY, i.e. Cash and Credit.

    Governments have successively issued less and less interest-free Cash, while central banks have ensured that virtually all money in circulation is now “central bank” or “broad” money rather than “state” or “narrow” money.

    Furthermore, successive governments have created budget deficits, thus contributing to the need for borrowing.

    Could any thinking person please answer “who creates the INTEREST necessary to pay for credit?”

    No, for the creators of money as debt aka credit are happy to benefit of legally enforceable interest payments. Everybody else doesn’t bother to question what is going on, let alone think about the mathematics of exponential growth, the practice of usury or the philosophy of making money out of money, without any reference to money as a medium of exchange for the real economy.

    NO regulator has looked into the Cash : Credit ratio so far. Why would any ONE regulator do better?

    More on

  2. For those of us who believe that the financial regulations are the least probable to do harm when they are totally transparent and understandable to all market participants (including the regulators themselves), Chapter 2 on “Systemic Risk and the redesign of financial regulation” provides for some truly scary reading.

    It does not even mention the need of simplifying or eliminating the current capital requirements structure and which by discriminating arbitrarily between risks so utterly confused the capital markets and exploded the AAA-bomb. Instead it describes many other ways of digging us even deeper in the hole.

    Honestly, the idea of having to put some regulators in straitjackets is becoming more plausible by the hour when they so stubbornly refuse to accept that they themselves could very well be the biggest source of systemic risk.

    Who allowed the banks to hold zero capital when lending to Sovereigns rated AAA to AA? The regulator!

    Who allowed the banks to hold only 1.6 percent in capital on claims on Corporations rated AAA to AA? The regulator!

    Who then discriminated against the unrated businesses or entrepreneurs; those from a societal point of view conforms a bank’s most important clients, demanding that banks were to hold 8 percent when lending to these? The regulator!

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