Containing a Systemic
Risk :
Is There a Playbook?
Masahiro Kawai (ADB Institute)
Michael Pomerleano (World Bank)
“The International Financial Crisis:
Have the Roles of Finance Changed?”
Federal Reserve Bank of Chicago and World Bank
Chicago, 24-25 September 2009
Outline
1. Introduction
2. The Global Financial Crisis of
2007-2009
3. Crisis Prevention, Management
and Resolution
4. Recent Regulatory Reforms to
Address Systemic Risk
5. Conclusions
1. Introduction
• Failure to predict the current global financial
crisis and to assess the severity of its impact
• Is there a playbook to contain a systemic
financial crisis?
• All the crises in the past had major policy
mistakes, leading to structural vulnerabilities
and systemic risk, and were slow to unfold.
They could have been “spotted” in early
stages
• What is needed to make a playbook, if there
is one, effective?
Why do we care? Output losses and fiscal
costs are staggering. A crisis lasts long.
2. Global Financial Crisis, 2007-09
2.1 Policy mistakes behind the crisis
• Failure of macroeconomic policy,
particularly monetary policy, to contain the
build up of domestic financial
vulnerabilities and systemic risk
• Flaws in financial regulation and
supervision
• Weak global financial architecture
IMF, “Initial Lessons of the Crisis for the Global
Architecture and the IMF” (February 2009).
Major policy mistakes led to this crisis:
rapid credit growth, housing bubbles, etc.
• Bernanke: “The Fed cannot reliably identify
bubbles in asset prices…”
- “Aftermath: Implications for Monetary Policy,” NBER
Working Paper 8992, June 2002
• The Taylor rule ignored:
“Getting off Track: How Government Actions and
Interventions Caused, Prolonged, and Worsened the
Financial Crisis
• Greenspan’s belief that monetary policy
should not prick asset price bubbles, but
should respond to the bursting of the
bubble to mitigate its negative impact
What went wrong in financial regulation?
• Several excellent reviews of what went wrong in
financial regulation and how to remedy the
situation:
- Group of Thirty Report on Financial Reform
- Geneva Report No. 11, Fundamental Principles of
Financial Regulation
- de Larosiere Group, Report on Financial Supervision
• Supervisors/examiners were “mis-educated”:
“A key failure during the boom was the inability to spot the
big picture threat of a growing asset price bubble.
Policymakers only focused on their own piece of the puzzle,
overlooking the larger problem.” (IMF, 2009)
• Financial regulation has been founded on a fallacy
of composition—assumption that making each
bank safe makes the system safe
• This explains how global finance has become so
fragile without sounding regulatory alarm bells
Weak global financial architecture
• Failure of global institutions (IMF, BIS, FSF) to
conduct effective macro-financial
surveillance of systemically important
economies (US, UK, the euro zone) and
provide compelling warnings
• The discussion of “global payments
imbalances” diverting attention away from the
build up of US domestic financial vulnerabilities
(towards China’s exchange rate policy)
• Ineffectiveness of fragmented international
arrangements for regulation and supervision
(and resolution) of internationally active
financial institutions and markets
2.2 Crisis management not always
effective
• Collapse of Lehman Brothers
• Troubled Asset Relief Program (TARP)
• Blanket protection of deposits and guarantees of
interbank loans
• Asset stress tests of US financial institutions
• Public-Private Investment Program (PPIP)
2.3 Consequences of crisis
•
•
•
•
•
Financial sector impact
Output and employment losses
Central bank balance sheets
Fiscal costs
Moral hazard issues
3. Crisis Prevention, Management
and Resolution
3.1 Containing systemic risk
• Systemic risk: the potential for an event or
shock triggering a loss of economic value or
confidence in a substantial portion of the
financial system (through contagion effects),
with resulting major adverse effects on the real
economy
• The strategy to contain systemic risk involves
oversight of the financial system as a whole,
and not just its individual components, as
potential events or shocks can affect the
economy as a whole
Principles of crisis containment
• Crisis prevention is better than cure
- establishment of effective framework of macroprudential surveillance that monitors, and
triggers action to reduce, economy-wide risk
- consolidated supervision of all systemically
important financial institutions
• Effective crisis management can minimize
economic and fiscal costs of the crisis
• Crisis resolution: The development of an
orderly resolution mechanism, nationally and
internationally, of systemically important banks
and nonbank financial institutions is essential
Table 5. Summary of Policy Lessons
from the Global Financial Crisis
Objective
Preventing
or reducing
the risk of
systemic
crises
National Measures
Global Measures
Regional Measures
Establish effective financial regulation & supervision to monitor and act on economy-wide
systemic risk
Establish a national systemic stability regulator
or council in charge of containing systemic risk
Improve information transparency and
disclosure in financial & corporate sectors
Strengthen macro-prudential supervision with
focus on consolidated supervision of systemically
important institutions
Improve monitoring of household and corporate
sectors
Reduce pro-cyclicality of regulation
Strengthen capacity, resources and
effectiveness of FSB to promote
global systemic stability
Support implementation of
international standards and codes,
and best-practice corporate
governance
Agree on regulations over rating
agencies, hedge funds,
remunerations, etc
Establish a regional systemic
stability council, such as the
European Systemic Risk Board
and the proposed Asian Financial
Stability Dialogue
Strengthen regional monitoring of
financial markets
Develop regional early warning
systems
Adopt sound macroeconomic management (monetary, fiscal, exchange rate, and public debt)
Pursue non-inflationary monetary policy
Maintain sound fiscal policy
Manage public debt prudently
Avoid large current account deficits
Use monetary policy to head off excesses,
booms and asset price bubbles
Strengthen IMF surveillance and
early earning systems, with focus on
systemically important economies
Utilize private-sector monitoring
agencies
Strengthen regional
macroeconomic policy dialogue
and monitoring
Develop regional early warning
system
Maintain sustainable current account positions
Avoid excessive currency overvaluation
Avoid persistent current account deficits and
heavy reliance on ST capital inflows
Authors’ compilation
Coordinate policies to avoid
unsustainable global payments
imbalances
Expand regional demand where
savings rates are exceptionally
high
Table 5. (continued)
Managing
crises
Provide timely liquidity of sufficient magnitude
Restore market confidence through consistent policy
packages
Reduce moral hazard problems
Strengthen IMF liquidity support,
including the new Flexible Credit Line
Strengthen a regional
liquidity support facility to
contain crises and contagion
Support the financial sector within a consistent framework
Extend guarantees of bank obligations
Conduct stress tests to identify losses and capital
needs of financial institutions
Establish a consistent framework for NPL removal and
recapitalization
Establish a common international rule
for public sector interventions in the
distressed financial system
Avoid financial protectionism
Harmonize national
interventions in the financial
system—such as bank
deposit guarantees—at the
regional level
Adopt appropriate macroeconomic policies to mitigate the adverse feedback loop between financial
and real sectors
Adopt an appropriate monetary and fiscal policy mix
contingent on the specific conditions of the economy
Be prepared for extraordinary policies
Resolving
systemic
crises
Streamline IMF conditionality
Design international fiscal support
programs for fiscally constrained
economies
Strengthen regional capacity
to formulate conditionality
Create regional fiscal support
systems
Establish frameworks for resolving financial institutions’ impaired assets and corporate & household
debt
Establish frameworks for resolving bad assets of
financial institutions
Introduce legal and out-of-court procedures for
corporate debt workouts
Harmonize national frameworks for
resolving bad assets of financial
institutions
Provide international support
Finance regional programs to
help accelerate bank and
corporate restructuring
Introduce rules for exit of non-viable financial institutions
Establish clear procedures for exits of financial
institutions, and rehabilitation
Establish legal & formal procedures for corporate
insolvencies and workouts
Harmonize national resolution regimes
for non-viable financial institutions
Harmonize insolvency
procedures by adopting good
practices
Introduce international insolvency mechanisms for resolving internationally active fin. institutions
Strengthen national insolvency procedures of banks,
non-bank financial institutions and corporations
Introduce international procedures for
cross-border insolvencies
Develop regional insolvency
procedures to support the
global effort
3.2 Crisis prevention
• Establish effective financial regulation and
supervision to monitor and act on economywide systemic risk
- focus on not only financial institutions, but also
corporations and households (and their links with
the financial system)
• Adopt sound macroeconomic management
(monetary, fiscal, exchange rate, and public
debt)
- be ready to use monetary policy to reduce macrofinancial instability
• Maintain sustainable current account position
Macro-prudential surveillance
• A methodology that aims to preserve systemic
financial stability by identifying vulnerabilities in a
country’s financial system and triggering policy
and regulatory actions in a timely and informed
manner to prevent crises from occurring
• The focus is the system and therefore includes
corporations and households, and does not rule
out contained failures of individual institutions
• It is a “top-down” approach that focuses on the
environment (e.g., macroeconomic, regulatory,
legal) in which financial systems operate and
helps assess sources of risks and incentives
• Micro-prudential supervision is a “bottoms-up”
approach that focuses on the health and stability
of individual institutions
3.3 Crisis management
• Provide timely liquidity of sufficient
magnitude (to individual institutions and
the market)
• Support the financial sector within a
consistent framework of supporting viable
institutions (NPL removal,
recapitalization, etc.) and allowing exit of
nonviable institutions
• Adopt appropriate macroeconomic policies
to mitigate the adverse feedback loop
between the financial system and the real
sector
3.4 Crisis resolution
• Build consistent frameworks for resolving
financial institutions’ impaired assets and
corporate and household debt
- a need for a coordinated approach to
bank and corporate restructuring
• Establish orderly exit rules for nonviable
financial institutions
• Introduce international insolvency
mechanisms for resolving internationally
active financial institutions
3.5 Systemic stability regulator
• Clear regulatory objectives and mandates
(crisis prevention, management and
resolution)
• Effective regulatory structure (a single
agency vs. a council)
• Sufficient regulatory resources (political
backing, and legal, human and financial
resources)
• Effective regulatory implementation
(instruments and tools)
Clear objectives and mandates of a
systemic stability regulator
• Monitoring systemic risks—such as large or growing credit
exposure to real estate—across firms and markets
• Assessing the potential for deficiencies in risk-management
practices, broad-based increases in financial leverage, or
changes in financial markets/products, creating systemic risk
• Analyzing possible spillovers between financial firms or
between firms and markets—for example through the mutual
exposures of highly interconnected firms
• Identifying possible regulatory gaps, including gaps in the
protection of consumers and investors, that pose risks for the
system as a whole
• Curtailing systemic risks across the entire financial
system—through legislative action, prudential measures,
advising on monetary policy, intervention in individual
institutions
• Issuing periodic reports on the stability of the financial
system
Effective organization of a
systemic stability regulator
• Independent, credible and transparent
- Nick Stern: “Any forthright, disinterested assessment of
the global economic system’s stability requires two sorts
of independence.. must not have anything other than its
own reputation riding on its assessment… It must be
independent of the G-7.”
-The systemic stability regulator should complement, not
displace, micro-prudential supervision
• A single agency approach
- a fully consolidated model (Singapore, pre-1998 Japan)
- a central bank-led model
- a new national agency in charge of systemic stability
• A “council” approach: a coordinated
framework with the central bank, financial
regulator(s) and supervisor(s), and finance
ministry, supported by a powerful working group
Sufficient regulatory resources to
fulfill responsibilities
• Adequate authority and powers backed up by
legal and legislative support
• Staffing
– Requires knowledge and experience across a wide range of
financial institutions and markets to offer a comprehensive and
multi-faceted approach to systemic risk
– Substantial analytical resources to identify the types of
information needed and to analyze the information obtained, and
– Supervisory expertise to develop and implement the necessary
supervisory response
• Broad authority to obtain information
– Rely on the information, assessments, and supervisory and
regulatory programs of existing financial supervisors and
regulators whenever possible; however,
– Broad authority to obtain information—through data collection
and reports, or when necessary, examinations—from a range of
financial market participants, including banking organizations,
securities firms, and key financial market intermediaries
Effective implementation by a
systemic stability regulator
• Macro-prudential measures
- Warnings of signs of built-up vulnerabilities
- Sector targeted tools (tightening loan and
underwriting standards, limiting loan-to-value ratios,
limiting debt-to-income ratios)
- Stress tests
- Higher capital ratios and provisioning
• Monetary policy as a last-resort tool against
a build up of systemic risk through the
market (in a non-inflationary environment)
• Legislative initiatives such as insolvency
regimes for non-viable banks and nonbank
financial institutions
Stress testing & scenario analysis
• Stress testing is a technique to assess the
vulnerability of the financial system (and
macro “top-down” on the entire economic
system) to exceptional but plausible
shocks
• Stress tests impose a coherent structure in
which to discuss risks and can add rigor to
systemic analyses
4. Recent Regulatory Reforms to
Address Systemic Risk
4.1 Global financial architecture
• With sweeping mandates, can the FSB be
effective?
- weak political commitments by the G20 to make
the FSB a credible and powerful global institution
- lack of capacity to provide “high-powered”
analytical surveillance
• What can be done to make the FSB
effective?
- need for a full support by the US & UK in
expanding the number of experts, providing
independent assessment, and compelling
member countries to take necessary actions
Financial Stability Board: Mandate
• Assess vulnerabilities affecting the financial system;
• Identify and oversee action needed to address them;
• Promote coordination and information exchange
among authorities responsible for financial stability;
• Monitor and advise on market developments and their
implications for regulatory policy;
• Advise on and monitor best practice in meeting
regulatory standards;
• Undertake joint strategic reviews of the policy
development work of the international standards
setting bodies;
• Set guidelines for and support the establishment of
supervisory colleges;
• Manage contingency planning for cross-border crisis
management; and
• Collaborate with the IMF to conduct Early Warning
Exercises
4.2 National efforts to establish a
systemic stability regulator
US stability reform plan
• The Federal Reserve would become the nation’s most
powerful financial overseer.
• The Fed would win power to monitor risks across the
financial system, and sweeping authority to examine any
firm that could threaten financial stability, even if the Fed
wouldn't normally supervise the institution.
• The nation’s systemically important financial institutions
(“Tier 1 institutions”), whether or not they are banks in the
old-fashioned sense, will be more tightly regulated by the
Fed.
• A proposed “rapid resolution plan” requires systemically
important financial companies to regularly file a “funeral
plan”: a set of instructions for how the institution could be
quickly dismantled should the need to do so arise.
• A new insolvency regime will cover all such firms, modeled
on the scheme run by the FDIC for ordinary banks
UK stability reform plan
• Supervision will be top-down “macro-prudential”,
i.e., monitoring the financial system as a whole, as
well as bottom-up “micro-prudential”, i.e., keeping
an eye on individual firms.
• The Financial Services Authority (FSA) will be in
charge of macro-prudential regulation and address
systemic risks such as rapid credit surges, for
example by requiring more bank capital
• FSA will also have the micro-prudential
supervisory powers over banks
• The Bank of England (BOE) will have statutory
responsibility for financial stability, and will be
given new powers to deal with troubled banks
• But the BOE objects that it does not have the tools
it needs, leading to open confrontation between
King and Darling
Global practices of central banks in
regulation and financial stability
• Of the 84 economies listed in Table 6, 30 have an
integrated prudential supervision, 20 have
supervisory agencies in charge of two types of
financial intermediaries, and 34 have multiple
sectoral supervisors
• The central banks of 48 countries (57% of the
total) have the authority of banking supervision
• In countries with multiple sector supervisors,
central banks tend to have the banking
supervision authority
• In all G20 countries, the central bank is in charge
of price stability and payment system stability
• Most of the central banks publish financial
stability reports, while close to half have
financial stability committees (Table 7)
Table 6. Economies with Single, SemiIntegrated, and Sectoral Prudential
Supervisory Agencies, 2009
Single Prudential Supervisor
for the Financial System
(year of establishment)
Australia (1998)
Austria (2002)
Bahrain* (2002)
Belgium (2004)
Bermuda* (2002)
Cayman Islands* (1997)
Denmark (1988)
Estonia (1999)
Germany (2002)
Gibraltar (1989)
Guernsey (1988)
Hungary (2002)
Iceland (1988)
Ireland* (2002)
Japan (2001)
Kazakhstan* (1998)
Korea, Rep. (1997)
Latvia (1998)
Maldives* (1998)
Malta* (2002)
Netherlands* (2004)
Nicaragua* (1999)
Norway (1986)
Singapore* (1984)
South Africa* (1990)
Sweden (1991)
Taipei,China (2004)
United Arab Emirates*
(2000)
United Kingdom (1997)
Uruguay (1993)
Total - 30
Agency Supervising Two
Types of Intermediaries
Banks
and
securities
firms
Banks and
insurers
Finland
Luxembourg
Mexico
Switzerland
Uruguay
Total - 5
Canada
Columbia
Ecuador
El Salvador
Guatemala
Malaysia*
Peru
Venezuela, Rep.
Bolivarian
a de
Total - 8
Securities
firms and
insurers
Bolivia
Bulgaria*
Chile
Jamaica*
Mauritius*
Slovak Rep.*
(b)
Ukraine*
Total - 7
Multiple Sectoral
Supervisors
(at least one each for
banks, securities
firms & insurers)
Albania*
Argentina*
Bahamas, The*
Barbados*
Botswana*
Brazil*
Croatia*
Cyprus*
Czech Republic (b)
Dominican Rep*
Egypt*
France *
Greece *
Hong Kong SAR *
India *
Indonesia *
Israel *
Italy *
Jordan*
Lithuania*
New Zealand*
Panama
Philippines*
People’s
Republi
c of
China
(PRC)
Poland*
Portugal*
Russia*
Slovenia*
Sri Lanka*
Spain *
Thailand *
Tunisia *
Uganda *
United States
*
Total - 34
Table 7: Mandates for the Major Central Banks
De jure
independence
Price
stability
Country/Region
Financial system stability
Payment
system
regulation &
supervision
Regulation and supervision of
Banking
Securities
Insurance
Macro
prudential
surveillance
Financial
stability
committee
Financial system
stability
analysis/report
Argentina
Yes
Yes
Yes
Yes
--
--
---
--
Yes
Australia
Yes
Yes
Yes
--
--
--
--
Yes
Yes
Brazil
Yes
Yes
Yes
Yes
Yes
--
--
--
Yes
Canada
No
Yes
Yes
--
--
--
--
--
Yes
China (PRC)
No
Yes
Yes
--
--
--
--
Yes
Yes
Euro Zone
Yes
Yes
Yes
--
--
--
--
Yes****
Yes
Hong Kong
No
Yes
Yes
Yes
--
--
--
Yes****
Yes
India
No
Yes
Yes
Yes
Yes
Yes
--
Yes***
Yes
Indonesia
Yes
Yes
Yes
Yes
--
--
--
--
Yes
Japan
Yes
Yes
Yes
Yes*
--
--
--
--
Yes
Malaysia
No
Yes
Yes
Yes
Yes
Yes
--
--
Yes
Mexico
Yes
Yes
Yes
--
--
--
--
--
Yes
Philippines
Yes
Yes
Yes
Yes
--
--
--
Yes
--
Russia
Yes
Yes
Yes
Yes
--
--
--
Yes****
--
Saudi Arabia
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Singapore
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
South Africa
Yes
Yes
Yes
Yes
--
--
--
--
Yes
South Korea
Yes
Yes
Yes
--
--
--
--
--
Yes
Switzerland
Yes
Yes
Yes
Yes**
Yes**
--
--
--
Yes
Thailand
No
Yes
Yes
Yes
Yes
Yes
--
Yes***
--
Turkey
Yes
Yes
Yes
--
--
--
--
--
Yes
United Kingdom
Yes
Yes
Yes
--
--
--
--
Yes
Yes
United States
Yes
Yes
Yes
Yes
--
--
--
Yes****
--
The “council” approach to systemic
stability regulation
• US, UK and Japan: possible to expand the existing
framework of crisis management to broader crisis
containment, including crisis prevention
• UK government’s proposal to create a “Council for
Financial Stability” to bring together the BOE, FSA
and HM Treasury
• Australia: Council of Financial Regulators, with
RBA as chair, APRA, ASIC and Treasury
• Korea: Financial policy coordination by the Finance
Ministry as chair, BOE and Financial Supervisory
Commission
• For the council approach to be successful, it needs
- clear mandates and division of labor
- analytical resources and capacity collectively
- all the necessary macro-prudential tools
Table 8. Existing Framework of
Systemic Crisis Management
United States
United Kingdom
Japan
Key
Processes
The following approvals
are required to apply
the systemic risk
exceptions:
 2/3 of the FDIC Board
 2/3 of the Board of
Governors of the Fed
 Treasury Secretary after
consulting with the
President
Based on the MOU, HM
Treasury, the FSA, and the
BoE shall take coordinated
actions for crisis
management.
 HM Treasury has the
authority to nationalize
banks.
 HM Treasury shall provide
blanket guarantee of
deposits, based on the
common law power
The Prime Minister shall
decide if the systemic
risk exception (Article
102, Deposit Insurance
Law) should be applied,
after consulting with the
Financial Crisis
Management Council
(members listed below).
Members
 Treasury Secretary
 Chairman of the Federal
Reserve
 Head of FDIC
 Chancellor of Exchequer
 President of the Bank of
England (BoE)
 Chairman of the Financial
Services Authority (FSA)
 Prime Minister (Chair)
 Chief Cabinet Secretary
 Minister of Financial
Services
 Commissioner of FSA
 Minister of Finance
 Governor of the BOJ
4.3 Regional initiatives
European Union reforms
• European macro-prudential surveillance:
European Systemic Risk Board to watch for the
build-up of financial risk and sound the alarm over
the build-up of risk. To be headed by ECB president
• Europe-wide bank oversight: European System of
Financial Supervisors in charge of coordinating
national supervisors and monitoring large crossborder financial institutions
• Europe-wide bank restructuring. EU’s weak
cross-border framework for crisis management and
for the resolution of cross‐border banks
–
–
–
–
Risk of asset grab impeding information sharing & collaboration
Legal form not functioning
Multiple (conflicting) proceedings and competencies
Existing resolution tools not effective at crisis time
Asian Financial Stability Dialogue
• Initially a forum for information exchange
and policy dialogue among Asia’s finance
ministries, central banks and financial
regulators/supervisors
• To strengthen the current ASEAN+3
finance ministers process, and may have
an expanded membership
• To work with the CMIM (a future AMF) for
Asian financial stability
• To evolve into a more systematic body,
like an Asian FSB in the future
4.4 An international framework for
the 21st century
Who is going to do the heavy-lifting?
• The present voluntary cooperative efforts at the
international level are not adequate
• The FSF (FSB) and IMF have done little more than
issue statements of principles since the start of the
crisis
• The Westphalian principles governing international
financial oversight (sovereignty of states) are not
suited to address today’s global financial system
• The international financial community needs to
make progress with a binding global financial order.
5. Conclusions
• A playbook to contain a systemic financial crisis
does exist
• The best way is to prevent a crisis by identifying
and acting on sources of instability
• A systemic stability regulator should be created at
the national and regional levels, and support the
global efforts
• For effective crisis management and resolution,
there is a need to create a binding cross-border
resolution regime for internationally active
financial institutions
• The US and the UK need to commit themselves
to effective financial stability regulation
For More Information:
Dr. Masahiro Kawai
Dean & CEO
Asian Development Bank Institute
mkawai@adbi.org
+81 3 3593 5527
www.adbi.org