Post on 15-Jul-2015
PREVENTING
THE NEXT CRISIS
The role of central banks and
financial institutions
Arnab Moitra
International Management Institute,
New Delhi
THE GAME CONTINUES...
We are in the fifth year of the latest financial crisis, and yet we are evidencing:
• It brought two pre-emptive bailouts: $125 billion to Spain's banks and 100 billion in England
Greek elections triggering a financial panic
• Fed chief Ben Bernanke announced QE4 at $85 billion a month for an extended period of time
Unemployment and problems of fiscal cliff stays high in the US
• The recent Libor, money-laundering scandals and the trading losses at JPMC
Criticism for the banking industry
GROWING CROSS-BORDER LINKS
Help diversify the risks that individual countries face
by reducing exposure to domestic financial system
shocks
Increase the risk of rapid and simultaneous shocks
between countries, with dramatic consequences for
economic conditions
THERE WILL ALWAYS BE A NEXT CRISIS
Financial innovators on the lookout…
They will look for flaws in the regulatory and supervisory apparatus
These reforms may have been necessary…
But we cannot stop tomorrow’s crises by looking backward
One reason is…
Tendency to look for systemic weaknesses unfolded by the recent ones
Crises continue to come…
Even with intense oversight by the authorities
IDENTIFYING SYSTEMIC CRISES
1982• Latin American debt crisis
1992/93
• European Exchange Rate Mechanism (ERM) crisis
Late 1990s
• Asian/Russian/Long Term Capital Management crises
2008• Global financial crisis
TRIGGERING THE DEBATE ON CENTRAL BANK
BEFORE:
Central banks
should primarily
target inflation
HOUSING BUBBLE &
CRASH:
Banks were heavily
implicated
CENTRAL BANKS
INVOLVED:
Provide liquidity to
banks as lender of
the last resort
Central Bank Independent Authority
United States, Italy, Portugal, New
Zealand, Netherlands, etc.
United Kingdom, Australia, Japan,
etc.
SUPERVISORY AUTHORITY
CENTRAL BANK AS A SUPERVISOR?
• Has expertise in evaluating the banking sector conditions, the payments
system, and capital markets
• Evaluation must be done quickly when financial stability is threatened
or when there is fear of the spread of problems
• Separation can lead them to ignore the impact of monetary policy on
banking system health
• Taking up credit risk as the lender of last resort and so complete
access to information about the borrower is needed
INFLATION TARGETING – RBI’S ONLY ROLE?
Inflation targeting is neither practical nor desirable in an emerging economy like
India because:
• Not practical to drive a single objective. Balance should be between
price stability, financial stability and growth
• Drivers of inflation often are from the supply side, which is beyond the
reach of monetary policy
• Problem of targeting a single representative index. We have one WPI
and four CPIs.
• Large and volatile capital flows have implications for liquidity and thus
for inflation, eroding RBI’s effectiveness
THE DESIGN OF FINANCIAL REGULATION
The design of financial regulation is not straight-forward
When everyone is baying for more, tougher regulation, it is not needed,
(because everyone is risk averse)
When such regulation is badly needed, no one wants it, (since the good times
are expected to roll on)
FINANCIAL REGULATION
FOCUSED & RULE-BASED
Discretion will be hard to use during periods of boom
TIME & STATE-VARYING
Light during normal periods, increasing as systemic threats build up
THE STRUCTURE OF FINANCIAL REGULATION
The recommendations are divided into four main headings:
GENERAL CAPITAL
LIQUIDITY OTHER
GENERAL RECOMMENDATIONS
• Requirements should be stated in terms of higher target levels of capital,
with statutory and forceful ladder of increasing sanctions
• A collapse of a financial institution causes risk spillovers. Effective
regulation must provide incentives to internalize such externalities
• Stress tests examine responses of banks to exogenous and not generally
endogenous risks. New techniques based on models (like CoVaR) need to
be devised
• Regulation (external intervention) should always be capable of
justification as a consequence of some specified market failure
CAPITAL REQUIREMENTS
• All systemic institutions should be subjected to micro-prudential
regulation (along the lines of Basel II), examining their individual risk
characteristics
• They should also be subjected to macro-prudential regulation, related to
their contribution to systemic risk
• Macro-prudential regulation should lean especially against bubbles
whose bursting can impair the financial intermediation sector
• Institutions highly leveraged with short-term debt and holding assets
with low market liquidity should have some constraints on their leverage,
maturity mismatch and credit expansion
LIQUIDITY
• A 'mark to funding' approach provides incentives for more long-term
funding
• Incentives to hold liquidity by interacting assessed liquidity with the
capital adequacy ratio
• To overcome debt overhang problems, the regulator should have the
authority to convert existing debt (such as tier-1 or tier-2 capital) into
equity
OTHER CONSIDERATIONS
• Support for the Counterparty Risk Management Policy Group (CRMPG) to
move systemically important derivative markets onto centralized clearing
houses
• Each "individually systemic" financial institution should be required to
provide annually a full contingency plan for dealing with its own
bankruptcy
• Crisis prevention should be done internationally. There needs to be
several proposals to reform the structure of the Financial Stability Forum
IS THIS THE ONLY WAY OUT?