Zeroing in on systemic risks

One of the lessons from the recent global financial turmoil has been the lack of timely recognition of the build-up of systemic risks emanating from the sub-prime mortgage market, particularly in the US. Second, the linkage of the sub-prime market with the money and credit markets was not clearly understood. Third, the extent of contagion across the US' borders to advanced and emerging markets was unexpected. And fourth, the potential impact of all these in real economic activity across regions was underestimated.

Despite all these limitations, a significant outcome of the crisis has been the extraordinary cooperation across various jurisdictions to bring financial markets back to normalcy and the medium-term plan to strengthen regulation and supervision of both markets and institutions at country and multilateral levels.

Role of IMF

At the multilateral level, the role of the International Monetary Fund (IMF) has become central in initiating further steps towards crisis prevention. The IMF has been closely helping the recently constituted Financial Stability Board and has also been providing technical papers to the G-20, which has replaced G-7 as the watchdog for monitoring the progress with resolutions towards strengthening regulation and supervision at the membership level.

The IMF has also been engaged in improving its internal governance arrangements and introducing changes to its surveillance procedures and mechanisms.

In the above context, the recent report of the IMF's Independent Evaluation Office (IEO) on the Bretton Woods institution's role in the run-up to the crisis makes a candid assessment of the failure of the multilateral body's surveillance mechanism at the time of the crisis.

The IMF Managing Director, Mr Dominique Strauss-Kahn, has indicated that the recommendations of this report will go a long way to enhance the efforts towards better surveillance. In substance, the important recommendations are:

(i) create an environment that encourages candour and diverse and dissenting views;

(ii) strengthen incentives to speak truth to power;

(iii) better integrate financial sector issues into macroeconomic assessments;

(iv) overcome silo behaviour and mentality; and

(v) deliver a clear, consistent message to the membership on global outlook and risks.

All these are well said, but the outcome has to be watched and seen over time. Since the power centre has shifted from G-7 to G-20, there is some hope that there will be improvements in these directions.

Financial Sector Surveillance

One of the ways in which surveillance is done is through financial sector assessments by the IMF and the World Bank at discrete intervals. This has now been made mandatory for 25 systemically important countries.

The financial sector assessments are more in the nature of snapshots at a point of time at discrete intervals. This cannot be adequate to capture the build-up of risks in some institutions or/and markets within a country or across regions. Therefore, the strategy should be to strengthen the regular surveillance work — both bilateral and multilateral — with particular reference to financial institutions and markets.

Better integration of financial sector issues with macroeconomic assessments through the World Economic Outlook (WEO) and the Global Financial Stability Report (GFSR) is, therefore, a crucial recommendation. It must be noted that the WEO is more backward-looking, but the GFSR is forward-looking.

The latter, on different occasions before the crisis, brought out insightful analysis of risks emerging in international financial centres and how OTC products such as credit default swaps and other credit derivatives were non-transparent and lacked any regulation or supervision, posing systemic threats.

Also, it described how the risks were centred in the banking system first, then spread to insurance and later to households themselves. It is clear from the IEO report that there were no more such warnings from GFSR after 2005. GFSR became more technical and academic and the intricate assessment of systemic risks was lacking.

Furthermore, as an earlier IEO report on surveillance observed, both WEO and the GFSR have come to be viewed simply as sources of public information rather than as building blocks for multilateral discussions. In particular, more than 90 per cent of the staff surveyed responded that the WEO and the GFSR were for policymakers and public sector economists. While some 50 per cent also included academics and research institutes, almost no one referred to the private sector.

What is needed

What is needed, therefore, is timely recognition of the systemic risks, supported by mechanisms for sharing information with the governments concerned, in particular the regulatory authorities, in time and issuing early warnings to crucial market agents to correct behaviour that could destabilise markets.

Recently, the IMF has identified about 25 market agents as systemically important at the global level. If there is a will, there is definitely a way to recognise the build-up of systemic risks in time.

This will make it easier to take corrective action and prevent or reduce the contagion and spillover of the order experienced during the recent financial crisis at enormous economic and social cost.

(The author is Director, EPW Research Foundation. The views are personal. blfeedback@thehindu.co.in )

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