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?