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Heavy consequences of a light touch

Heavy consequences of a light touch
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First Published: Mon, Feb 14 2011. 08 54 PM IST
Updated: Mon, Feb 14 2011. 08 54 PM IST
A key element of the post-crisis management of the global financial system has been the focus on effective regulatory oversight. This was prominently reflected in the leaders’ declaration at the end of the Group of Twenty (G-20) summit in Seoul last year. The declaration spelt out the core elements of a new financial regulatory framework, including measures to better regulate systemically important financial institutions, complemented by more effective oversight and supervision. These measures were seen as sine qua non for a more resilient system that would rein in past excesses of the financial sector and better serve the needs of major economies.
Policymakers have focused on elements of a regulatory framework, but little thought has been given to the institutions that would help implement these regulations. This lacuna has been exposed by two recent reports that point to the failure of some of the major institutions responsible for surveillance of the financial system to anticipate crises. One, the Financial Crisis Inquiry Commission (FCIC), set up by the US government to “examine the causes of the current financial and economic crisis”, has concluded inter alia that in the face of a financial tsunami, “widespread failures in financial regulation and supervision proved devastating” to the stability of the country’s financial markets. And two, the Independent Evaluation Office (IEO) of the International Monetary Fund (IMF), which has assessed the performance of the organization’s surveillance systems in the run-up to the crisis, has commented, “IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak.”
FCIC has pointed out that the failure of financial regulation and supervision in the US occurred through a combination of two factors—systematic deregulation by dismantling some of the time-tested instruments, and a series of regulatory captures, manifest in lawmakers’ disinclination to adopt new regulations or challenge the industry on the risks of new instruments being introduced as a part of so-called financial innovation. These developments were in keeping with the philosophy espoused by the then chairman of US Federal Reserve Board, Alan Greenspan. In short, Greenspan argued that markets do not need regulation, they invariably self-regulate; it is the self-interest of market participants that generates private market regulation. Clearly, Greenspan was against government rules, which he believed “may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation”.
Greenspan’s faith in the market meant that systemic risks were never addressed at a time when the financial sector was developing new and risky instruments. The evidence unearthed by FCIC shows that too many financial institutions acted recklessly: taking on too much risk, with too little capital, and with excessive dependence on short-term funding. What is most galling is that US regulators did see these telltale signs of an impending blowout of the financial system, but all they did was to take small steps to restrain the growth of an asset bubble. Once the bubble burst, they used all available tools to stabilize the markets. The moral hazard was all too evident in this approach—financial institutions were allowed to cover their downside risk using support provided by the government. The most blatant display of this occurred when US authorities used the argument “too big to fail” to prop up market manipulators.
One of the most disturbing features of the latest financial crisis was that the regulatory institutions displayed a “herd instinct”. As IEO has since found out, IMF at the time believed that because of innovation, large financial institutions were in a strong position, and that financial markets in advanced countries were, therefore, fundamentally sound. Not surprisingly, IMF praised the US for its “light-touch regulation and supervision”, which permitted the rapid financial innovation that ultimately contributed to the problems in the financial system. Perhaps more damning are IEO’s observations that even after the financial crisis broke out, IMF believed that it would remain contained because the large financial institutions could weather the severest stress.
What should worry the global financial community the most is IEO’s finding that the institution responsible for multilateral surveillance failed to anticipate the impending crisis even as late as 2006. In doing so, IMF repeated its failure to anticipate the Asian financial crisis. Even two months before the onset of the crisis in July 1997, IMF was bullish about the prospects of a clutch of newly industrializing economies.
Interestingly, on both occasions, IMF failed because it gave little consideration to deteriorating financial sector balance sheets, financial regulatory issues, the possible links between monetary policy and the global imbalances, and the credit boom and emerging asset bubbles.
The institutional deficit that caused the crisis must be the central focus of initiatives being taken now to develop a framework for managing the financial sector. Whether the existing institutions are good enough to respond to emerging challenges is really the moot point.
Biswajit Dhar is director general at Research and Information System for Developing Countries, New Delhi
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First Published: Mon, Feb 14 2011. 08 54 PM IST
More Topics: G20 | FCIC | IMF | IEO | Financial Crisis |