Lessons from Global Credit Crisis:The IMF published the first detailed study of the crisis in Washington DC on Friday afternoon and recommends a worldwide rethink of how to handle systemic risk management. The Fund accepts its surveillance either missed or underestimated risks, while complacency was encouraged by its optimistic bottom-line assessments and hedged messages. It lists the causes of the crisis as, first, failure of market discipline, then failure of regulation, and then macro economy conditions, where big surpluses in Asia, were matched by big deficits, in particular in the US. Government debt is expected to rise by about 15% of GDP for rich G20 countries in 2008/2009, and this is the largest increase in any 2 years since the end of the second world war, in 1945.

“To look past blame in this crisis, it is useful to ask why policymakers failed to heed the looming threat,” the report said. “If there is an underlying theme to the lessons here, it is of failing to come to grips with fragmentation.”

The IMF’s work, initially requested by its policy steering committee, the International Monetary and Financial Committee, will feed into the work of the Group of 20 (G-20) leading economies to come up with a blueprint for reforming the way financial markets are regulated and for making international financial institutions, such as the IMF and the World Bank, more effective. The G-20 leaders will meet in London on April 2, 2009. In its discussion of the analysis, the IMF’s Executive Board stressed“the need for remedial actions across a broad front and at many levels, implying an ambitious agenda for policymakers and the need for coordinated action.”

Why the crisis happened

The IMF says understanding what went wrong is key to restoring stability to the global economy, which is suffering the worst recession since the Second World War. “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,” Reza Moghadam, head of the IMF’s Strategy, Policy and Review Department said.

The IMF’s analysis points to failures at three different levels:

• 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.

Light-touch regulation failed to spot risk

The IMF study on financial regulation notes how, over the past decade, the financial system expanded massively and created new instruments that appeared to offer higher rewards at lower risk. This was encouraged by 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.

"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."

The study identifies five key weaknesses that need to be fixed:

• First, the regulatory perimeter, or scope of regulation, needs to be expandedto 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.

Macroeconomic policies did not target systemic risks

The crisis was preceded by a long period of robust global growth and low interest rates. This encouraged investors to seek higher returns, fueling demand for the riskier products generated by financial innovation. “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,” Olivier Blanchard, Economic Counsellor and Director of the IMF’s Research Department, said. “With large failures in regulation and supervision, this fuelled high leverage and build-up of risky assets.”

"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."

While monetary and fiscal policies did not play a major role in the run up to the crisis, the crisis still holds a number of lessons for policymakers on the macroeconomic level.

• First, monetary policy should respond to the buildup of systemic risk.The IMF said policymakers should focus on macro-financial stability and pay greater attention to the buildup of systemic risk. Of course, how to identify and then to react to an inflating bubble is difficult. Typically, monetary policy will be too blunt an instrument to deal with asset price and credit booms: the response has to be found mainly in prudential regulation. But that first line of defense has failed in the past, and did so again recently. So there is a case for expanding the mandate of monetary policy to explicitly include macro-financial stability, not just price stability.

• Second, fiscal policy should be put on a stronger footing in good times.Fiscal policy did not play a major role in the run up to the crisis, but many countries failed to pay down public debt and reduce deficits during good times. As a result, these countries now find themselves limited in their ability to stimulate their way out of the crisis. Tax policy also encouraged debt financing in recent years. Such tax rules could usefully be changed. The IMF says it has developed detailed analysis of available fiscal space in key countries, how to design effective stimulus packages, and how to ensure fiscal solvency over the medium term, in light of the increase of debt and contingent liabilities.

• Third, while international capital flows are on the whole beneficial, global imbalances have to be addressed.Policymakers should use macroeconomic and structural policies to rebalance savings and investment in their own economies. They should also use regulation to help reduce systemic risk stemming from capital flows, for example by imposing constraints on the foreign exchange exposure of domestic financial institutions and other borrowers.

Failures of international cooperation

Despite the growing threat, the IMF and other institutions failed to send a strong wakeup call to policymakers and achieve a collaborative policy response. To be fair, some warnings were issued, the Fund says. For example, the IMF and others warned about risk concentrations in the financial sector and the prospects of disorderly adjustment from global imbalances. But the warnings, which were given fell on deaf ears, partly reflecting their lack of urgency and specificity.

There was also a lack of commitment on the part of policymakers for coordinated policy action in response to global threats. For instance, as the crisis unfolded, the initial policy response was a rush to protect local banks, at the risk of causing runs elsewhere.

"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."

The IMF says the national deposit insurance schemes are just one example of the many unintended consequences of countries undertaking unilateral policy actions, which then cause problems for other countries, magnifying the impact of the problem.

The bottom-line is that the crisis has underlined the need for clearer policy messages and for more, not less, international cooperation across a range of economic and financial issues. According to the IMF’s analysis, action is needed in four areas.

• Policy warnings should be more focused and specific.The IMF is working with the Financial Stability Forum (FSF) on a new early warning exercise that will bring together scattered macro-financial expertise and drill down on key threats. More generally, the IMF’s challenge will be to piece together macroeconomic and financial sector developments into a big picture scenario that also takes into account cross-country spillover effects.

• Leadership is needed in responding to systemic global risks.A range of organizations can claim a leadership role, including the IMF, the G-7 and G-20, the FSF, and the OECD, but none has been effective. The IMF has the mandate, near universal membership, and a blend of macroeconomic and financial expertise that makes it particularly well-suited to assume leadership on global risks, but its bureaucratic ways and rigid power structures has shifted the policy debate towards smaller, more flexible groups, including to the G-20 and the FSF. Yet these smaller groups have their own problems of legitimacy and capacity for follow-up. A satisfactory global solution would bring together expertise, legitimacy, and effectiveness, and provide a forum for engagement among high-level policy makers. The IMF can be this solution, but this will require a further rebalancing of voice and representation among its members, to make its decision-making more accurately reflect today’s global economic landscape.

• Rules for cross-border financial sector resolution are neededto encourage collaboration rather than solutions that minimize the burden on the local taxpayer with potential beggar-thy-neighbor effects.

• A credible global liquidity framework is needed.Access to large-scale financing or insurance remains an issue for most emerging market countries. The IMF is reviewing its lending framework to make sure it is well-suited to members’ needs. If the Fund cannot provide the needed insurance, countries may in future seek to rely on self-insurance through surpluses and reserve accumulation, which could distort global trade for years to come.

The way forward

The IMF says implementing its recommendations, will be difficult both politically and technically. However, the sheer scale of today’s crisis provides clear evidence of the importance of learning from past mistakes. The Fund says one also should not underestimate the momentum today toward decisive action and lasting solutions. The summit of G-20 leaders on April 2, 2009 will be the first opportunity to make real progress.

“The reform agenda is huge, and people come to it with sometimes very different perspectives, but we see a genuine desire to find common solutions. We hope that the IMF’s analysis will be helpful in helping build consensus on how to tackle these shared problems,” Moghadam said.