82Lessons of the Financial Crisis for Future Regul

INTERNATIONALMONETARYFUNDLessonsoftheFinancialCrisisforFutureRegulationofFinancialInstitutionsandMarketsandforLiquidityManagementPreparedbytheMonetaryandCapitalMarketsDepartmentApprovedbyJaimeCaruanaFebruary4,2009ExecutiveSummaryThispaperseekstodrawlessonsforfinancialsectorregulationandsupervisionandcentralbankliquiditymanagementfromtheongoingcrisis,focusingprincipallyonimplicationsforthefutureratherthanonimmediatecrisismanagementpolicies.Inadequaciesinmacroeconomicpoliciesandthedesignoftheinternationalfinancialarchitectureexposedinthecrisiswillalsohavetobeaddressedtomakethesuggestedchangesintheregulatoryframeworkeffective.Thispaperdoesnotseektoprescribethespecificsofvariouspolicymeasures,sincethesewillneedtobedefinedbynationalregulatorsandinternationalstandardsetters.Nonetheless,theFund,givenitsuniquemandateandbroadmembership,iswellplacedtobothhelpdefineprioritiesandassistinimplementation,andthefollowingappeartowarrantparticularattention:•Institutingamacroprudentialapproachtosupervisionandassigningaclearmandatetoasystemicstabilityregulator.•Expandingtheperimeteroffinancialsectorsurveillancetoensurethatthesystemicrisksposedbyunregulatedorlessregulatedfinancialsectorsegmentsareaddressed.•Ensuringthatprudentialregimesencourageincentivesthatsupportsystemicstabilityanddiscourageregulatoryarbitrage,andassureeffectiveenforcementofregulation.•Addressingtheprocyclicalityofexistingcapitalrequirementsandotherprudentialnorms,preferablyinamannerthatisrulesbasedandcountersthecycle.•Fillingtheinformationgaps,especiallywithregardtolightlyregulatedfinancialinstitutionsand‘offbalancesheet’transactions,ensuringthatbothsupervisorsandinvestorsareprovidedmoredisclosureandahigherlevelofgranularityininformationprovided.•Resolvingthepoliticalandlegalimpedimentstotheeffectiveregulationofcross-borderinstitutions,developspecialinsolvencyregimestobeusedforlargecross-borderfinancialfirms,andharmonizeremedialactionframeworks.•Strengtheningthecapacityofcentralbankstoprovideliquidityandrespondtosystemicshocks.•Improvingthecapacityofnationalauthoritiestorespondtosystemiccrises,includingbyestablishingmechanismsforcoordinationbothwithinandacrossborders.•Establishingthebasisforfiscalsupportduringthecrisiscontainmentandrestructuringphase,andanexitstrategyforwithdrawingpublicsupportandforatransitiontoanewandmorestablefinancialmarketstructure.Principalcontributors:LuisCortavarria,SimonGray,BarryJohnston,LauraKodres,AdityaNarain,MahmoodPradhan,andIanTower.ContentsPageI.IntroductionandSummary................................................................................................3II.RethinkingthePerimeterofFinancialRegulation.............................................................8III.PoliciestoMitigateProcyclicality...................................................................................11IV.AddressingInformationGaps..........................................................................................15V.Cross-Border/Cross-FunctionalRegulation.....................................................................19VI.SystemicLiquidityManagement.....................................................................................21Boxes1.TheFinancialStabilityForumandItsResponsetotheFinancialCrisis...........................62.G20InitiativesonStrengtheningtheGlobalFinancialSystem........................................7Table1.UpdateofProgressofImplementationofFSFRecommendations.................................283I.INTRODUCTIONANDSUMMARY1.Sincethefinancialcrisisbegan,theFundhasworkedtoassesstheunderlyingcausesoftheturmoil,andtodrawtentativelessonstohelpinformoursurveillanceandtechnicalcooperationactivities.SomeofthisworkwaspresentedtotheIMFCaspartofthepaper“TheRecentFinancialTurmoil—InitialAssessment,PolicyLessons,andImplicationsforFundSurveillance.”1Inaddition,recentGlobalFinancialStabilityReportshaveprovideddetailedanalysisofthecrisisandofferedspecificpolicyrecommendationsonanumberoffronts.2.Thispaperextendsthisworkbyfocusingonfourkeyareasthatwarrantparticularattention.First,financialinstitutionsandotherinvestorswereexcessivelyoptimisticaboutassetpricesandrisk,lulledbyalowinterestrateenvironmentandchangesinthefinanciallandscapethatmaskedtheextentofleverageandmadetheserisksmoreopaqueandinterconnected.Second,neithermarketoversightnorprudentialsupervisionwereabletostemexcessiverisk-takingortakeintoaccounttheinterconnectednessoftheactivitiesofregulatedandnon-regulatedinstitutionsandmarkets.Thiswasdueinparttofragmentedregulatorystructuresandlegalconstraintsoninformationsharing.Third,oncethecrisishit,weaknessesanddifferencesinnationalandinternationalapproachestodealingwithcross-borderbankresolutionandbankruptcycametoahead.Andfinally,thecrisisdrovehomethelimitationsofexistingmechanismsforcentralbankliquiditysupportandtheneedforsignificantchangesinpracticeonthisfront.3.Thereisalsolittledoubtthatthecrisiswillrequirefar-reachingchangesintheshapeandfunctioningoffinancialmarkets,andthisevolutionhasalreadybegun.Amassivedeleveragingisalre