Toto, we’re not in Kansas anymore: Exploring the Contours of the Financial System After the Tornado

By Laura Kodres

Just as a tornado in Kansas transplanted Dorothy and, her dog, Toto, from familiar comforts to the unknown land of Oz, the global crisis has led many to wonder what has become of the global financial system and, more importantly, what will it look like next. Is the wicked witch of the West—excessive risk taking and leverage—really dead?

But now, as the storm subsides, there is time to speculate about what the future financial sector might look like. My IMF colleague, Aditya Narain, and I have done just that in a new Staff Position Note that attempts to discern the contours of this new financial landscape. What is clear is that the new landscape will be influenced by both the private and public sectors—their reactions to the crisis and to each other.

There are a multitude of possibilities between two extremes.

  • Having skirted systemic collapse—in part due to extraordinary official interventions—the difficult reform agenda could succumb to stiff private sector pushback, languishing and allowing vulnerabilities to become re-entrenched.
  • At the other extreme, the depth of the wounds inflicted by the crisis and resulting public outcry could lead to over-regulation, stifled creativity and innovation, and sluggish economic growth.

Neither outcome is desirable, so the note presents a base case between the two. What is needed is not more regulation, but sensible and better regulation. The attitude that “regulation never works, so why bother” misses two of the main lessons from the crisis. 

  • First, regulatory reforms are only part of a solution (and weak regulation was only part of the problem). A more macroprudential approach—more attention to the financial system as a whole rather than its individual parts—is needed.
  • Second, even when regulation is the right tool or is already in place, it is implementation that really matters. This in turn depends on strong supervision.

Although perfect regulation is the ideal, in the real world there is unlikely to be a perfect, gleaming Emerald City at the end of a yellow brick road. Nor is there a “great and all-powerful Oz” to devise and implement such regulation. Hence we look at the most likely set of reforms to be enacted—those that are perhaps the most politically feasible and globally acceptable—and their effects. We then speculate about what the main outcomes will be:

  • Banks will return to a more traditional function, faced with stricter regulations that limit the risks they can undertake and, as a result, their returns—making banking systems smaller overall.
  • Banking systems may look more segmented, with some banks returning to their deposit-taking/loan-making roots and other banks becoming more diversified and interconnected continuing to challenge the moniker of “too-important-to-fail.”
  • Nonbanks will fill the void left by banks. The diverse range of nonbank institutions will have a competitive advantage by both supplying credit and providing investors with much needed riskier investments to satisfy their retirement needs.
  • The regulatory perimeter will need to expand. Nonbank financial institutions—at least those seen as systemically important—should be covered. But the issue of exactly how to formulate regulations that mitigates the systemic risks they pose is going nowhere fast.
  • Market infrastructure, especially for markets thought to be susceptible to runs or contagion, will be improved by moving the “offending” instruments (either voluntarily or by mandate) to central counterparties where such risks can be partially mitigated.
  • More transparent and simpler instruments will be demanded, especially by those who lost money in the crisis on products that in hindsight were too complex to understand or price.

But what does this mean for the global financial system as a whole? In the short run, the system’s riskiness and size will likely continue to shrink alongside a prolonged period of deleveraging. In the medium term, the outcomes become less clear. If the largely bank-centric regulations currently on the drawing board come to pass, and the expanded nonbank activities are within a new regulatory perimeter, it could bring financial system risk back toward a healthier norm but, importantly, with less risk than in the pre-crisis period.

But, to get to a safer, sounder financial system, coordinated and consistent implementation of better, smarter regulation and oversight will be needed. We at Fund are working hard to put our relative strengths—namely our global vantage point, our extensive experience with financial sector reform, and existing partnerships with major international bodies, such as the Financial Stability Board, Basel Committee on Banking Supervision, International Organization of Securities Commissions, and the International Accounting Standards Board—to work in helping guide the development of the “just right” version of re-regulation. 

While a more holistic and coordinated approach across countries—with not too many countries jumping ahead nor lagging behind—is desirable, it is by no means assured. There is also a risk that, without buy-in from the private sector through “incentive compatible” regulation that encourages them to mitigate risks on their own, regulations put in place will be circumvented.

So, just as the scarecrow’s new brain and the lion’s new courage helped them guide Dorothy on her journey to find Oz, similar wisdom is needed in shaping the new financial system. It is critical that reforms are introduced with intelligence and foresight, as well as a firmness of purpose so that policymakers can navigate their way through the lessons from the crisis and we do not lose our way again. What do you think?

5 Responses

  1. As Milton Friedman wrote in his rather unorthodox earlier writing titled “A Fiscal and Monetary Framework for Economic Stability,” as proposed by the noted authors of the 1933 proposal called The Chicago Plan for Monetary Reform, and as again developed by the most esteemed authors of the paper titled “A Program For Monetary Reform,” linked below, there is only ONE major change to the entire economic-financial-monetary system that is necessary to prevent the next round of crisis. That is the SEPARATION of the private banking function of loans, deposits, and money management from the government function of the creation of a permanently adequate supply of the nation’s circulating medium. It’s really as simple as that, Laura.

    Check out this link to the long-lost paper by the six economists who wrote the 1939 Prpgram proposal, whose intention in so writing was ” ..To eliminate one recognized cause of Great Depressions, the lawless variability of our supply of circulating medium”. (i.e., financial instability).

    Otherwise, with all due respect, we are still in Kansas as far as our desire for financial and economic stability are concerned.

    Joe Bongiovanni
    Harborton, Virginia
    The Kettle Pond Institute

  2. You ask “Is the wicked witch of the West—excessive risk taking and leverage—really dead?” Of course I agree that the wicked witch of the West, the Basel Committee, authorized excessive leverages and which will have to come down, but… what is this about any “excessive risk taking”?

    The trillions lost were not lost laying railroads in Argentina but financing mortgages, in the safest country of the world, and in instruments rated AAA. That does not sound as excessive risk taking to me.

    No, I sure hope we get back some of that old fashioned good risk taking of lending to small businesses and entrepreneurs, those who will provide us with the next generation of jobs, and stop all this nonsense with the regulatory risk-aversion that sent the world off to swamps filled with Potemkin AAA rates.

  3. Sir / Madam
    Reading the enclosed and the line that the banks will return to more traditional function, these guys must be living on plant do-do. Do the people who wrote this item really think the banks are going to return to more traditional banking? Dream on people!

    When it comes to the banks, forget it, These banks do not, and never will, turn their backs on easy money–bailouts, over-charging, and, as long as they can, these banks will use every trick in the book to rake in as much profit as they can.
    Remember one thing people, these banks are not interested in what anyone might have to say as long as there are big profits to be made at the end of it.

    Philip j Carroll
    Dublin Republic of Ireland

  4. Dr. Laura Kodres’s blog note and her supporting papers on the current subject are on target and make a great deal of sense. Moreover, from the purely economic perspective, Dr. Kodres’s points are sound and hard to dispute; she does an excellent job of laying out the problem and useful solutions. It would be interesting, however, at least from a laymen’s point of view, to include a somewhat more explicit discussion of the policy and political elements necessary both to achieve and sustain the specific reforms and general future environment that Dr. Kodres foresees as necessary for future economic stability.

    In particular, what about the Munchkins? That is, what must be done to generate and maintain the political will among the populations involved to encourage still reluctant policy makers to implement and sustain the new regulatory environment that Dr. Kodres sees in our future? Of course, Dr. Kodres understands the political problem, and she describes the core economics of the issue better than I could hope to do.

    Still, perhaps most importantly, even if the “just right” levels of reforms to the system are achieved, what must be done to avoid a relapse? After all, to a certain extent we had regulations and safeguards in place, specifically many of those implemented following the great depression. Unfortunately, whether due to poor memories or some belief that we had all become so much smarter and thus less likely to repeat the actions that led to the depression we did, in fact, repeat many of our past mistakes and foolishly ignored or repealed many of the post-depression financial system safeguards that we had created. No regulatory design will work if it is not accompanied by the long term political will to maintain and live within the system.

    To be fair, Dr. Kodres acknowledges the political dimension of the problem and, of course, her’s and the fund’s recommendations are focused on the economic sphere, rather than the political one. Still, just looking at the United States as an example, while responsible policy makers move to fix the regulatory system there are those that seem to keep their heads in the sand and even suggest that their mission will be to repeal the new regulatory reforms as soon as they get the chance.

  5. I write in relation to these two items:

    • Market infrastructure, especially for markets thought to be susceptible to runs or contagion, will be improved by moving the “offending” instruments (either voluntarily or by mandate) to central counterparties where such risks can be partially mitigated.
    • More transparent and simpler instruments will be demanded, especially by those who lost money in the crisis on products that in hindsight were too complex to understand or price.

    I have yet to meet anyone who does not now agree, after disagreeing, say, a couple of years ago, that a large factor in precipitating the crisis to which your post refers, Laura, was grossly improvident trading in derivatives and especially synthetic derivatives backed by market-makers’ (in some cases in serious of conflicts of interest) and improvident insurers.

    While many like Dorothy might bemoan the need for derivative speculation, anyone reading this post knows that speculative trading has become, from the point of view of the economy as a whole, essential to establishing prices for decision-makers in the non-derivative, i.e. “real” economy. More mature Dorothies, such as we participating in this forum, must surely now be wondering whether people like George Soros and Warren Buffett, might be expressing some wisdom in suggesting that market oversight authorities distinguish between speculative transactions that are very likely to be dysfunctional for the economy as a whole and other speculative transactions which would, in contrast, be serving the need for pricing certainty by actors in the real economy.

    When one talks with lesser luminaries in the trader-investor community than Soros and Buffett, one frequently meets with the presumption that no such distinctions can be rationally made. In fact one manager of traders at a Canadian bank seemed to want to bet me a sum of money that it couldn’t be done, until I asked him to put his money where his mouth was, at which point he decided his money was better NOT put on the table between us.

    While it is true that short-term speculations serve to make price discoveries, these discoveries are of no value to the real economy in most goods; they are only of self-erotic value to traders addicted to trading and to their less scrupulous sponsors. By contrast, speculations with a term having meaningful relationship to the planning horizons of real economy actors ARE of real value to the economy as a whole. It follows therefore that contract term is of some predictive value as to whether any contemplated speculative transaction is likely to be of value to the real economy.

    Why then are the papers coming out of the offices of authorities worried about regulation of the market not calling loudly and insistently for institution of some tax calibrated to contract term on derivative speculations? Have I missed them? That’s possible: I’ve not spent my life studying such papers.

    I don’t therefore have an answer to this question. Does anyone?

    What I do have is a paper entitled “Beyond Stress Tests & the Dodd-Frank Bill: Why a ‘Calibrateable dsFTT’ Makes Sense”. This paper explores how a tax, differentiated by contract term and the real economy good on which derivative contracts are based, and periodically calibrated by a modestly democratic means in which the needs of the whole economy are weighed might work to get us a little closer to Oz.

    You can find it at:

    Angus Cunningham
    (Angus operates an executive coaching practice in Toronto. He was educated at Cambridge and Wharton).

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