The 2008/09 Annual Report from the Bank for International Settlements reflects on the dramatic events affecting the world’s financial system and economy over the preceding two years. The essential and complex system of finance has been critically damaged; trust has been lost. There were both macroeconomic and microeconomic causes of the collapse. The former included imbalances in international claims and a long period of low real interest rates, while the latter consisted of problems with incentives, risk measurement and regulation. Some are inherent in human behaviour, while others represented policy failures. There were danger signs that led to warnings; some were accurate, others were not, and most were in vain. It is easy to see why. Understanding the nature of many of the problems would have required a history of events which are by their nature infrequent. And, when the existing policy apparatus appeared to be working so well, making what would have been wholesale changes to the monetary and regulatory policy frameworks in many countries would have presented nearly insurmountable political and intellectual difficulties.
Also: Risk and opportunities: towards a fail-safe financial system
Financial regulators, fiscal authorities and central bankers face enormous risks. To avoid deepening and prolonging the crisis, they must act quickly while guarding against policies that hinder adjustment or create additional distortions in financial flows. For financial rescue and repair, there is a need to persevere until the job is done. For fiscal policymakers, there is a need to ensure that policy is on a sustainable long-run path. And for monetary policymakers, there is a need to plan their exit from unconventional policy actions, and then to execute it in a timely fashion.
Looking further ahead, ensuring sustained 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, this 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 procyclicality that is inherent in financial institution management and can be compounded by microprudential regulation.
Related:
BIS Annual Report 2008/09