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INTERNATIONAL MONETARY FUND Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management Prepared by the Monetary and Capital Markets Department Approved by Jaime Caruana February 4, 2009 Executive Summary This paper seeks to draw lessons for financial sector regulation and supervision and central bank liquidity management from the ongoing crisis, focusing principally on implications for the future rather than on immediate crisis manage
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  INTERNATIONAL MONETARY FUND Lessons of the Financial Crisis for Future Regulation of Financial Institutions andMarkets and for Liquidity Management Prepared by the Monetary and Capital Markets DepartmentApproved by Jaime CaruanaFebruary 4, 2009 Executive Summary This paper seeks to draw lessons for financial sector regulation and supervision and central bank liquiditymanagement from the ongoing crisis, focusing principally on implications for the future rather than onimmediate crisis management policies. Inadequacies in macroeconomic policies and the design of theinternational financial architecture exposed in the crisis will also have to be addressed to make the suggestedchanges in the regulatory framework effective.This paper does not seek to prescribe the specifics of various policy measures, since these will need to bedefined by national regulators and international standard setters. Nonetheless, the Fund, given its uniquemandate and broad membership, is well placed to both help define priorities and assist in implementation, andthe following appear to warrant particular attention: ã   Instituting a macroprudential approach to supervision and assigning a clear mandate to a systemicstability regulator. ã   Expanding the perimeter of financial sector surveillance to ensure that the systemic risks posed byunregulated or less regulated financial sector segments are addressed. ã   Ensuring that prudential regimes encourage incentives that support systemic stability and discourageregulatory arbitrage, and assure effective enforcement of regulation. ã   Addressing the procyclicality of existing capital requirements and other prudential norms, preferably ina manner that is rules based and counters the cycle. ã   Filling the information gaps, especially with regard to lightly regulated financial institutions and ‘off  balance sheet’ transactions, ensuring that both supervisors and investors are provided more disclosureand a higher level of granularity in information provided. ã   Resolving the political and legal impediments to the effective regulation of cross-border institutions,develop special insolvency regimes to be used for large cross-border financial firms, and harmonizeremedial action frameworks. ã   Strengthening the capacity of central banks to provide liquidity and respond to systemic shocks. ã   Improving the capacity of national authorities to respond to systemic crises, including by establishingmechanisms for coordination both within and across borders. ã   Establishing the basis for fiscal support during the crisis containment and restructuring phase, and anexit strategy for withdrawing public support and for a transition to a new and more stable financialmarket structure.  Principal contributors: Luis Cortavarria, Simon Gray, Barry Johnston, Laura Kodres, Aditya Narain,Mahmood Pradhan, and Ian Tower.   Contents   PageI. Introduction and Summary................................................................................................3II. Rethinking the Perimeter of Financial Regulation.............................................................8III. Policies to Mitigate Procyclicality...................................................................................11IV. Addressing Information Gaps..........................................................................................15V. Cross-Border/Cross-Functional Regulation.....................................................................19VI. Systemic Liquidity Management.....................................................................................21Boxes1. The Financial Stability Forum and Its Response to the Financial Crisis...........................62. G 20 Initiatives on Strengthening the Global Financial System........................................7Table1. Update of Progress of Implementation of FSF Recommendations.................................28  3 I. I NTRODUCTION AND S UMMARY   1. Since the financial crisis began, the Fund has worked to assess the underlyingcauses of the turmoil, and to draw tentative lessons to help inform our surveillance andtechnical cooperation activities. Some of this work was presented to the IMFC as part of the paper “ The Recent Financial Turmoil—Initial Assessment, Policy Lessons, and  Implications for Fund Surveillance.” 1 In addition, recent Global Financial Stability Reports  have provided detailed analysis of the crisis and offered specific policy recommendations ona number of fronts.2. This paper extends this work by focusing on four key areas that warrantparticular attention. First, financial institutions and other investors were excessivelyoptimistic about asset prices and risk, lulled by a low interest rate environment and changesin the financial landscape that masked the extent of leverage and made these risks moreopaque and interconnected. Second, neither market oversight nor prudential supervision wereable to stem excessive risk-taking or take into account the interconnectedness of the activitiesof regulated and non-regulated institutions and markets. This was due in part to fragmentedregulatory structures and legal constraints on information sharing. Third, once the crisis hit,weaknesses and differences in national and international approaches to dealing with cross- border bank resolution and bankruptcy came to a head. And finally, the crisis drove home thelimitations of existing mechanisms for central bank liquidity support and the need for significant changes in practice on this front.3. There is also little doubt that the crisis will require far-reaching changes in theshape and functioning of financial markets, and this evolution has already begun. Amassive deleveraging is already being forced by large losses coupled with sharp reductions incounterparty risk exposures, and it is likely that the post-crisis period will be characterized bya financial system that has lower levels of leverage, reduced funding mismatches (both interms of maturity and currency), less exposure to counterparty risk, and greater transparencywith regard to the financial instruments that are used. Moreover, it is likely that the type, size,and cross-border exposures of institutions and markets that will survive the crisis will beconsiderably different than before. Consolidation among banks is already underway, andthere is already a significant and welcome push to reduce counterparty risk and to improvetransparency. Some business models could disappear while others will have to considerablystrengthen their risk management in order to survive.4. But further substantial adjustments will have to take place, including on theregulatory front. Market failures that emerged as a result of financial innovationundermined the effectiveness of a regulatory model that rested, at least in large part, ontransparency, disclosure, and market discipline to curb excessive risk taking. Reform of both 1 www.imf.org/external/np/pp/eng/2008/040908.pdf   4regulation and supervisory structures is needed to reduce the scope and incentive for regulatory and tax arbitrage, while encouraging continued innovation and the neededrestructuring of institutions and markets in a manner that is consistent with strengthenedsystemic stability.5. The challenge is to ensure that measures taken in the heat of a crisis aredesigned in manner that supports rather than hinders the needed restructuring. Difficult questions still need to be answered about the likely (and appropriate) shape of the post-crisis financial system, with the thorniest issue the extent to which markets and policymakers will support global, universal banks, or prefer smaller and narrower institutions. Consideration may have to be given to whether mega- institutions should bediscouraged, for example, through additional capital requirements proportional to their contribution to systemic risk or through stricter prudential oversight. Nonetheless, it is probably more important to ensure that the crisis response—including decisions on how todeal with weak institutions and efforts to re-start credit—does not foreclose or undulyincrease the cost of the needed transformation. Still, policy responses will have to beconsistent with the long-term view of the financial system without exacerbating the presentcrisis.6. The specifics of the policy response are already being debated and developed in arange of fora . Coordinated by the Financial Stability Forum (FSF), the Fund, nationalauthorities, and standard setters are already working to address deficiencies revealed inexisting arrangements through the deliberations of the FSF Working Groups and the recentlyconstituted G-20 Working Groups (see following Boxes 1 and 2). The Fund is represented inthese groups and staff views have benefited from these discussions. These bodies arecognizant of the need to mitigate systemic risk    while avoiding a “rush to regulate” that couldimpose excessive and inefficient regulation and stifle financial innovation. Moreover, these bodies are also attempting to tackle difficult legal and institutional hurdles to improvingcross-border cooperation in regulation and the resolution of troubled institutions.7. This paper aims not at defining the specific policy response, which is more thepurview of these other bodies, but focuses on defining priorities for action : ã   The perimeter of financial sector surveillance needs to be expanded to a wider range of institutions and markets, possibly with differentiated layers to allowinstitutions to graduate from simple disclosure to higher levels of prudential oversightas their contribution to systemic risk increases. Mechanisms also are needed to allowfor the assessment of, and the response to, systemic risks posed by unregulated or lessregulated financial sector segments. ã   Prudential regimes should encourage incentives that support systemic stability;discourage regulatory arbitrage; and adopt a broad concept of ‘systemic’ risk,factoring in the effects of leverage, funding, and interconnectedness.
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