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The International Financial Crisis: Have the Rules of Finance Changed?

September 2009, Asli Demirgüç-Kunt and Ouarda Merrouche, DECRG-FP

A two-day conference (September 24-25)  co-organized by the Federal Reserve Bank of Chicago and the World Bank brought together a distinguished list of academics, policymakers and practitioners to discuss the causes and consequences of the financial crisis.

The first session focused on the causes of the crisis. Speakers emphasized that a combination of macro environmental contributors such as loose monetary policy and global imbalances and wrong micro incentives were necessary to create this severe crisis.  They mentioned the decline in mortgage lending standards and the failures of regulation, as well as interest rates that were kept too low.

In the second session, Containing a systemic crisis: Is there really no playbook?  there was agreement that a playbook has to follow three principles: (1) it has to be simple; (2) it has to follow existing rules; (3) it has to be implemented.  Overall, the message of the session was that there is a playbook for crisis resolution (as written by Bagehot long time ago) but that it has not been applied consistently and fairly in the latest crisis. Hence the speakers agreed that the toolkit needs improvement along at least two fronts: (1) the resolution regime; (2) contingency plans.

The next session on the role of the state during crisis focused on the social contract linking banks and the state and how crises often change the terms of the contract by expanding the safety net in size and scope. Presentations illustrated central bank interventions in money markets during the crisis and their effectiveness in narrowing interbank spreads.  Speakers also questioned the handling of the crisis after the failure of Bear Stearns. Overall there was agreement that the role of the state can be harmful or helpful and that regulation cannot prevent all future crises although it should make them less frequent and costly.

The session on what to do about bubbles: monetary policy and macroprudential regulation.  emphasized the failure of macroeconomic models to build a link between financial system and the real sector.  Speakers discussed if a less procyclical financial system is achievable and the role of financial regulation in this process. It was clear systemic regulation faces the problem of identifying systemic tier of institutions which is difficult, though cross-border financial institutions are certainly in this tier.

Speakers in the session, Dealing with the crisis in a globalized World: Challenges and solutions, agreed that the financial turmoil has revealed gaps in the crisis resolution framework at the global level and lack of coordination and harmonization in accounting, regulation, and supervision.  Some of the options to address cross-border issues discussed are to adopt an international bank charter or to create a World Financial Authority  (a world financial regulator/supervisor).  A more realistic option that was mentioned is to work towards promoting convergence within existing agencies.

The last session focused on regulatory governance and agency design, on how to make regulators and government more accountable.  Speakers discussed that safety-net subsidizes create moral-hazard, underlining the importance of incentives.  Going forward it is important to define and enforce duties of loyalty, competence and care;  continually adapt surveillance systems to counter innovative regulatee efforts; propose new rules and discipline rule-breakers;  and plan and train for crisis. A successful regulatory authority is more likely in political systems that are subject to more checks and balances and in systems which make greater use of markets to discipline banks and endow their institutions with greater discretion and independence. 

The conference concluded with a panel discussion on proposals going forward.  Eliminating the too big to fail ( TBTF) and addressing the regulatory gap in the field of consumer protection were deemed essential.  Several proposals to curb excessive risk-taking in booms were discussed: raising the capital requirement based on proportion of short term debt, illiquidity and bank size; use of convertible debt issuances; and mandatory living wills to ease the unwind of TBTF institutions; subordinated debt to enhance market discipline;  and the need to limit deposit insurance.  It was also emphasized that measures for developing countries may be different than those for developed countries, and reforms should not be copied and implemented without serious consideration.


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