May, 2009 Miriam Bruhn, DECRG
On May 26, 2009, Stijn Claessens (IMF) and Asli Demirguc-Kunt (World Bank) jointly organized a one-day conference on “Managing Systemic Crises and Redesigning Financial Systems,” focusing on financial regulation, insolvency resolution and innovation and risk-taking.
SESSION 1: REFORMING REGULATION AND SUPERVISION
The first session, chaired by Michael Klein (Vice President, World Bank), featured a lively debate by Charles Calomiris (Columbia University) and Joseph Stiglitz (Columbia University, Chair of UN Commission of Experts) on “Reforming Regulation and Supervision”.
Both speakers agreed that regulatory failure regarding banks’ risk management was one of the main causes of the crisis and needs to be reformed, starting with the way in which risk-taking incentives are distorted and risk is measured. Importantly, they also pointed out that policy makers need to draw up a blueprint for restructuring too-big-to-fail banks in distress.
Somewhat more controversial, Stiglitz argued that the repeal of the Glass-Steagall Act in the U.S. led to a concentration of banking and thus to the creation of too-big-to-fail banks in the first place. Calomiris, on the other hand, claimed that since Glass-Steagall had nothing to do with mortgages, banks might have engaged in even more mortgage lending in the absence of its repeal. Instead, the repeal of Glass-Steagall allowed banks to diversify their business lines. This also helped with the resolution of the recent crisis since banks were better able to raise capital and acquire distressed investment banks.
Another key point of disagreement was that Stiglitz called for the creation of a global economic coordinating council to draft global regulation and to facility coordination in times of crisis. Calomiris, however, was concerned that political economy and coordination problems would likely make the implementation of such a global council impossible. He also argued that this was one of the reasons why the Basel banking supervision accord had failed. Stiglitz attributed this failure to the fact that the regulatory accords were created by bankers, which was bad governance.
Finally, both experts agreed that, when it comes to sensible and efficient regulation and crisis resolutions, developed countries can learn from a number of developing countries that have had to deal with financial crises in the past, such as Colombia and Malaysia.
SESSION 2: FINANCIAL CRISES AND THE RESTRUCTURING AGENDA
The second session of the conference focused on “Financial Crises and the Restructuring Agenda” and was chaired by Olivier Blanchard (Economic Counselor and Director, Research Department, International Monetary Fund).
In this session, Andrei Shleifer (Harvard University) presented his recent work on bankruptcy procedures around the world. This work finds that bankruptcy procedures are more efficient in high income countries than in middle and low income countries. In fact, the efficiency costs of bankruptcy are so high in developing countries that saving a company in distress is typically not a viable option. Shleifer thus suggested that, in times of crisis, the government should encourage and perhaps even subsidize private renegotiation of debt between firms and their creditors.
The other speaker in this session, Luigi Zingales (University of Chicago), however, did not think that this was a good idea since it could create big moral hazard and adverse selection problems among debtors. Shleifer was less preoccupied with these issues and emphasized that governments could feasibly only address the many challenges of a financial crisis by “muddling through,” which in his opinion would also include debt renegotiation.
In contrast, Zingales recommended that governments put in place a theoretical framework for crisis resolution to ensure consistency of decision making and to prevent vested interests from dominating policy making. He emphasized that the U.S. government had not been consistent in terms of which banks to rescue and which labor contracts to uphold, rendering it less credible and leading to uncertainty. He also argued that many recent policy decisions had not been optimal, but had rather been influenced by lobbying pressures.
Neither speaker was supportive of the way bankruptcies in the U.S. auto industry are being handled.
SESSION 3: FUTURE FINANCIAL REGULATION AND RISK MANAGEMENT
The final session of the conference was chaired by Justin Lin (Chief Economist and Senior Vice President, World Bank) and covered “Future Financial Regulation and Risk Management.”
The first speaker, Jagdish Bhagwati (Columbia University) started out by cautioning that we cannot rule out or regulate away all types of financial crises, but that we need to be prepared for them. He did not advocate excessive regulation, but rather appropriate regulation, which in his opinion had not been in place in the U.S., particularly regarding financial innovation.
Bhagwati said that financial innovation had progressed at such a fast pace that hardly anybody, not even policymakers, could keep up with understanding all the products and that regulating something you don’t understand is nearly impossible.
The second speaker, Daron Acemoglu (Massachusetts Institute of Technology), agreed with this assessment and also pointed out that Wall Street, having all the expertise regarding complex financial products, was being asked to advise the government on how to deal with its own problems, leading to conflicts of interest.
Both speakers suggested that the government build up a body of technocrats, dedicated to keeping up with Wall Street. They also advocated putting speed bumps in the path of financial innovation and providing consumers with financial education.
A second theme of this session was that the models used to assess the risk of different financial products are not adequate. Acemoglu pointed out that most risk models put a miniscule probability on tail events occurring, thereby understating the true risk.
Finally, neither of the two speakers saw the crisis as evidence that the free market system had failed. They argued that this system had worked well in the past and had led to unprecedented growth over the past decades. Moreover, Acemoglu stressed that crises also have a silver lining since they result in creative destruction, which, in the long-run, is a fundamental source of growth.
Background papers and presentations