Rescue, Recovery and Reform

With foreclosures continuing to increase and unemployment rising ever higher, the Bank for International Settlements delivers an insightful post-mortem of the current crisis. Looking forward, it warns that reducing the size of the bloated financial industry should not be confused with a call for protectionism.

How could this happen?

No one thought that the financial system could collapse. Sufficient safeguards were in place.

There was a safety net: central banks that would lend when needed, deposit insurance and investor protections that freed individuals from worrying about the security of their wealth, regulators and supervisors to watch over individual institutions and keep their managers and owners from taking on too much risk.

And when an individual country faced a banking crisis, experts — feeling they knew better — would criticize the authorities for their mistakes. Prosperity and stability were evidence that the system worked.

Inflation was low, growth was high and both were stable. The policy framework, built on sound economic principles combined with a bit of learning, had delivered the Great Moderation in the industrial world. The developing world was wisely following the lead.

What a difference two years make. Since August 2007, the financial system has experienced a sequence of critical failures.

The financial system is the economy's plumbing. And like the plumbing in a house, it is taken for granted when it works, but when it doesn't, watch out.

In the same way that modern living depends on a reliable flow of water running through pipes, the modern economic system depends on a reliable flow of financing through intermediaries. On an average day, billions of individual payments are made, each requiring the transfer of funds.

But daily life is even more reliant on financial intermediation than this suggests. Many people in the industrial world own the home in which they live because they saved a portion of their income each month in a financial institution, and then combined those savings with a mortgage to purchase the home.

Obtaining the mortgage almost surely required obtaining fire insurance from an insurance company. The electricity, water and heating bills are probably paid each month using funds deposited automatically by the homeowner's employer into the homeowner's account at a commercial bank.

Traveling to work each day means either riding on public transport financed in part by bonds and taxes or driving in an insured car on a publicly or privately financed road. And that's really just the beginning.

Modern life requires the smooth operation of banks, insurance companies, securities firms, mutual funds, finance companies, pension funds and governments. These institutions channel resources from those who save to those who invest, and they are supposed to transfer risk from those who can't afford it to those who are willing and able to bear it.

Over the past few years, this essential and complex system of finance has been critically damaged. Evidence of serious trouble emerged when banks became less willing to lend to each other, because they were no longer sure how to value the assets held and the promises made — both their own and those of potential borrowers.

The modern financial system is immensely complex — possibly too complex for any one person to really understand. Interconnections create systemic risks that are extraordinarily difficult to figure out.

The fact that things apparently worked so well (up until the time that they did not) gave everyone a false sense of comfort. After all, when things are going well, why rock the boat? But this understandable complacency, born out of booms that make everyone better off, sows the seeds of collapse.

Hence, as we attempt to explain and fix what has failed, it is essential to keep in mind that the new financial system must take better account of our inherently limited ability to understand complex processes and to foresee their potential for failure.

A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires identifying and then treating the causes of the disease.

Looking at the past few years, we can divide the causes of the current crisis into two broad categories: macroeconomic and microeconomic.

The macroeconomic causes fall into two groups: problems associated with the build-up of imbalances in international claims and difficulties created by the long period of low real interest rates. The microeconomic causes fall into three areas: incentives, risk measurement and regulation.

Our analysis of the crisis leads to a variety of conclusions and highlights a number of risks for the financial system. In a modern financial system, bank-based finance and market-based finance should be viewed as complementary rather than as rivals or substitutes.

The crisis revealed that the presumed benefits of diversification derived from the creation of financial conglomerates — the hypermarkets of the financial system — were an illusion. When the crisis hit, all business lines were affected.

Similarly, the benefits of slicing risk into its smallest components through financial engineering were oversold.

However, reducing the size of the bloated financial industry should not be confused with a recommendation of financial autarky. The retreat of finance back inside national borders must be resisted. If left unchecked, the process would result in protectionism.

For industrial economies, a powerful interaction between the financial sector and the real economy began to take hold in the last quarter of 2008.

A dramatic loss of confidence was combined with the unwinding of imbalances that had built up on household, industrial and financial system balance sheets in the industrial economies since the beginning of the decade. The outcome has been a severe downturn in both real activity and inflation.

But since leverage has only begun to adjust — credit in both the financial and nonfinancial sectors of the economies that have had credit booms remains well above the level of only a few years ago — it is reasonable to anticipate both a protracted downturn and a slow recovery.

For the emerging market economies, circumstances are quite different — as they initially exhibited a great deal of resilience to the financial crisis.

The high degree of economic and financial integration that supported an extended period of rapid growth also left them exposed to sharp reversals in capital flows and declines in demand for their exports.

Countries that maintained prudent policies and low public debt, such as those in Asia and parts of Latin America, still have flexibility to respond. However, some countries with large current account deficits — and some where banks were making foreign currency loans — have run into external financing difficulties requiring external official assistance.

A healthy financial system is a precondition for a sustained recovery. Delaying financial repair risks hampering the efforts on other policy fronts. To speed economic recovery, authorities must act quickly and decisively in their efforts to repair the financial system, and must persevere until the job is done.

Officials will face a number of difficulties in exiting from the various crisis-related policy interventions. When real activity returns to normal, inflated central bank balance sheets will have to be slimmed down and policy interest rates raised in a timely way.

Public sector borrowing will have to be pulled back to a sustainable path. And the intermediation now being conducted by central banks will have to be returned to the private sector at the same time that the financial sector shrinks.

Ensuring financial stability requires a redesign of macroeconomic as well as regulatory and supervisory policies — with an eye to mitigating systemic risks.

For macroeconomic policies, this means leaning against credit and asset price booms. For regulatory and supervisory policies, it means adopting a macroprudential perspective.

Importantly, reform must focus on identifying systemic risks arising in all parts of the financial system — risks that arise from the complexity, opacity and ownership concentration of financial instruments; from the counterparty risk and margining practices in financial markets; from the risk of joint failure created by interconnections and common exposures; and from the pro-cyclicality that is inherent in financial institution management and can be compounded by microprudential regulation.

Editors note: This article is adapted from the 79th BIS Annual Report 2008/09.