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Ceyla Pazarbasioglu Headshot

Root Causes of Financial Crisis Remain Unaddressed

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Crises are like stories; they have a beginning, middle and an end, and on occasion, we learn something along the way.

In times of crisis, choices must be made. In the most recent global economic crisis policymakers moved quickly to stabilize the system, providing massive financial support, which is the right response in the beginning of any crisis. But that only treated the symptoms of the global financial meltdown, and now a rare opportunity is being thrown away to tackle the underlying causes.

Without restructuring financial institutions' balance sheets and their operations, as well as their assets -‒ loans to over-indebted households and enterprises -‒ the economic recovery will suffer, and the seeds will be sown for the next crisis.

In our new paper we analyze the policy choices made during the crisis and compare them to a number of past ones. It turns out the phases of this crisis followed the same pattern as previous ones, but policymakers made different choices this time around. This has a lot to do with the distinct nature of this crisis; unlike those in the last 20 years, it was truly global and more complex to handle because financial institutions and markets are larger and more interconnected than ever before.

Lesson # 1 - All choices have a cost, some with long term effects

The complexity and severity of the recent crisis justified a rapid response to contain risks and restore confidence. While less deep restructuring early on lowered the costs in the short term, there may be higher costs in the years ahead. In particular, the policy mix chosen precluded thorough due diligence, and may reduce incentives to restructure assets. The risk is that, instead of a policy of triage, diagnosis-based resolution, and early asset restructuring, a muddling-through approach prevails. This approach, including accounting and regulatory forbearance, guarantees, and implicit public support stalls addressing nonviable banks and nonperforming assets.

Many of the structural characteristics that contributed to the build-up of systemic risks are still in place today, and moral hazard has increased. In most countries, the structure of the financial system has changed little. In fact, concentration often has increased--on average for the 12 crisis countries we examined, the assets of the five largest banks have gone from 307 to 335 percent of GDP--as large banks acquired failing institutions. This complicates resolution efforts. The large-scale public support provided to institutions and markets--a contingent liability equivalent to one-fourth of GDP at the peak of the crisis--has exacerbated perceptions of too-important-to-fail.

Lesson #2 - Find out what you don't know and fix what you can

Diagnose the problem to learn about the viability of financial institutions and support only those that are viable, and close or restructure the nonviable ones. Stress tests were conducted and the results published in the U.S. and in Europe in May 2009, and July 2010 respectively, but only after initial government recapitalization.

While these stress tests restored short term investor confidence, their long term impact has been uneven, especially in Europe, in part due to different financial market perceptions about the credibility of assumptions used and remedial actions announced in conjunction, and subsequent events. As a result, European authorities have been compelled to engage in a new round of stress tests.

Lesson #3 - Create a global playbook

Restructuring the global financial system requires tools and policies that, just like banks, reach across country borders. It will also require policymakers to cooperate globally, just as they did at the peak of the crisis.

Since the crisis, several countries have adopted more effective resolution schemes for large financial institutions, which should allow future losses to be borne by uninsured creditors. But many countries still lag in this respect, including in how to allocate losses. The new resolution schemes remain untested to deal with failures of large cross-border institutions, and much more needs to be done to enhance the supervision of cross-border exposures and related risks.

The end of this story hasn't been written yet, and we shouldn't throw away the opportunity to change the way the global financial system operates for years to come.

Via iMFdirect.