One important lesson
from the crisis is the importance of making sure that huge global markets are
built on solid foundations which cannot be eroded as demand and optimism
increases. Whereas substantial emphasis has been placed on making the OTC
derivatives markets more transparent and lower risk, there has been less focus
on the fundamentals of the securitisation market which was at the heart of many
of the losses in the first phase.
In the crisis, some large risk exposures,
both on- and off-balance sheet, appear to have been unappreciated or
unreported. The pricing and design of complex structured credit products were
opaque to many investors, though much of the information was available if
investors were willing to look hard enough. Lack of transparency in some over the-counter
(OTC) derivatives markets has also caused difficulties and uncertainties about the
risk of some counterparties. More information disclosure, at a higher level of
granularity, about risks and exposures and how they are managed could help to
improve market discipline. Proprietary information should not be publicly
released, but would still need to be collected (and acted upon in some cases)
by those tasked with monitoring and mitigating systemic risks.
Those factors can be
summarized as: (1) High leverage which was sustainable only under conditions of
increasing asset prices and investor confidence. (2) Inadequate governance,
accountability and remuneration practices within financial institutions. (3)
Growth of the, largely unregulated, construction of complex financial
instruments and techniques which saw risk spread throughout the global
financial sector and significant interdependencies created. (4) A lack of
public information about the level and distribution of risk in the financial
First, financial institutions and other
investors were excessively optimistic about asset prices and risk, lulled by a
low interest rate environment and changes in the financial landscape that
masked the extent of leverage and made these risks more opaque and interconnected.
Second, neither market oversight nor prudential supervision were able to stem
excessive risk-taking or take into account the interconnectedness of the
activities of regulated and non-regulated institutions and markets. This was
due in part to fragmented regulatory 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
the limitations of existing mechanisms for central bank liquidity support and
the need for significant changes in practice on this front.
The Financial Stability
Forum outlines principles for preparing for financial crises (involving
information, techniques, cooperation, requirements on financial institutions)
and in managing crises via coordinated solutions. (http://www.fsa.go.jp/inter/etc/20090403_2/03.pdf)
Regulators need better
information on a much wider range of financial institutions, including
‘off balance sheet’ risks (involving better consolidated supervision), and the risks
of financial interlinkages. Investors also need more disclosure and a higher
level of granularity in information provided. Careful consideration will have
to be given to the costs and benefits of enhanced information collection and
disclosure, especially the additional information that regulators require.
Progress is needed in tackling political and
legal impediments to the regulation and resolution of cross-border institutions.
Developing harmonized insolvency regimes governing the resolution of large
cross-border financial firms and early remedial action frameworks would be a
desirable feature of a reformed crisis management framework of the future.
Absent action on these fronts, the risk is that national authorities will begin
to resist financial globalization.