Managing Financial Innovation in Emerging Markets-Remarks by John Lipsky, First DMD, IMF

Lessons from the crisis

Perhaps the key lesson of the current crisis is that traditional virtues -- of maintaining adequate capital, of avoiding excessive reliance on short-term funding, of maintaining proper loan underwriting, of following sound risk management and effective corporate governance -- remain as critical as always. We have been reminded again by recent events that securitization – an innovation that has the capacity to enhance systemic efficiency and effectiveness – must be developed within a sound regulatory and supervisory framework, especially when facilitated by intermediation paths outside of the formal banking sector.

In the United States and some other markets, it is clear that the fundamentals underlying some forms of securitized mortgages and other complex instruments simply were inadequate: Underwriting standards in many markets had become lax and were not properly regulated, ultimately harming both consumers and investors. The role in this process of the United States’ so-called shadow banking sector also highlighted weaknesses in regulatory cooperation and in the construction of the regulatory perimeter.

Complexity was an element that contributed to the crisis, but excessive instrument complexity in some cases -- and the lack of a clear economic function of some of the most exotic products – was more a reflection of systemic weaknesses than an underlying cause. It is painfully evident that many institutional investors failed in their most basic fiduciary duties by purchasing instruments whose risks they simply did not understand on the basis of third-party recommendations and ratings. The lack of attention to risk management practices and the lack of understanding of liquidity risks being accumulated played an important role in creating, overpricing, and overleveraging complex assets. Unfortunately, the consequences were nearly catastrophic.

Some aspects of the crisis reflected a lack of transparency in products and markets. A principal example of this is the credit default swap market -- an enormous market that developed almost entirely over-the-counter. In the event, some of the key participants in this market simply failed to assess counterparty risks adequately, with disastrous results. The move to standardize and centrally clear a substantial portion of derivative trading will help to address these risks, as will a redrawing of the regulatory perimeter and an improvement in supervisory effectiveness.

Even in the extraordinarily deep and broad crisis of the last two years, not all major firms and not all advanced financial systems were affected equally. Canada and Australia, for instance, escaped most of the problems affecting the United States and Europe. While their financial institutions were exposed to the same disruption in global capital markets, they weathered the crisis well, underlining the importance of ensuring that as financial systems become more complex, prudential supervision and regulation remains appropriate.

The Role of International Cooperation

This crisis has had at least one beneficial effect: it has galvanized international cooperation in economic policy-making in general and, specifically, in seeking to build a global financial system that can contribute to strong and sustainable growth. The G20 leaders—including India’s Prime Minister Singh—agreed at last year’s Pittsburgh Leaders Summit to establish a Financial Inclusion Expert Group to identify innovative approaches to enhancing financial access, financial literacy, and consumer protection.

At the same time, efforts are underway at an international level to reduce the likelihood that the current financial sector crisis will be repeated. Regulatory reform, spearheaded by the G20 leaders, is being implemented both at the national level and internationally. The London Declaration on Strengthening the Financial System included a series of recommendations on overhauling the financial sector’s regulatory framework. It also established the Financial Stability Board—with both India and the IMF as members— that is charged with implementing the agreed recommendations.

Many of the proposals being considered—notably those on the quality of bank capital, liquidity metrics, and leverage ratios— have been under discussion for several years. The crisis has created a powerful incentive to forge a consensus on these as well as newer initiatives, such as focusing on macro-prudential supervision and on aligning compensation with firms’ risk management objectives.

Creativity is called for in these reform efforts. An example of this is the request by the G-20 Leaders to the IMF to prepare a report on policy options for the financial sector itself to cover the costs associated with crisis-related government intervention in the sector. We are exploring options for a financial sector levy that would create the appropriate incentives for reducing risks while at the same time providing the required anti-crisis funding.

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(Extract from Speech of John Lipsky, First Deputy Managing Director, International Monetary Fund At the RBI International Research Conference... Read more )


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