What went wrong with the international financial architecture leading up to the global crisis of 2008? And what is being done today to prevent a similar crisis in the future?
Economist Anthony Elson spoke about the institutions and systems charged with preventing and managing financial crises during his Rethinking Development Policy talk on Thursday, March 30. While these institutions failed to avert the crisis, he said, they had much more success managing its most negative effects.
The crisis of 2008 had much in common with others that preceded it, Elson said, but was a different animal in many ways. Like previous crises, it was associated with housing bubbles, easy access to credit, and a weak regulatory environment.
However, this crisis set itself apart with new and toxic financial instruments such as mortgage-backed securities and credit default swaps, as well as the perverse role played by credit-rating agencies. It was also rooted in a “shadow banking system” with a fragile liability structure.
“It took place outside the traditional banking system, which is characterized by having a certain safety net,” Elson said. “They operated essentially on their own controls.”
In addition, many capital flow transactions were taking place that were not well understood or monitored by global institutions, enabling a crisis that originated in the United States to spread globally almost overnight.
The role of the international financial architecture
The international financial architecture, a collection of guidelines, rules and institutions designed to safeguard the global financial system, was put in place to head off crises like the one that happened in 2008. The main players include the International Monetary Fund (IMF), where Elson worked for a number of years, as well as the Financial Stability Board and the Bank for International Settlements.
Unfortunately, Elson said, the architecture was weak and fragmented leading up to the 2008 crisis. For one thing, it lacked the oversight framework to monitor cross-border capital flows. Detailed data on flows of capital and the riskiness of the assets into which capital flowed was lacking, and tracking current account balances, especially for the EU as whole, failed to illuminate the imbalances within some of the weaker member countries. The international finance architecture also lacked a mechanism to promote international policy cooperation.
“It’s up to individual countries to take the advice the IMF provides,” Elson said. “Countries resisted any recommendations to make adjustments in macroeconomic policy, and there was no system of sanctions in place if they didn’t comply.”
Finally, there was a lack of global financial regulation. Although the Basel Accords of 1988 and 2004 put in place rules for supervisory review and minimum capital requirements for financial institutions, they were insufficient to avert the worst economic disaster since the Great Depression.
Cleaning up the damage
Although the international financial architecture failed to stop the 2008 crisis, it took several decisive steps to mitigate its worst effects.
It doubled the financial resources of the IMF and coordinated the relaxation of monetary policy and a 2 percent fiscal stimulus for advanced countries. It compiled a list of banks and insurance companies for special oversight, and conducted “stress tests” to more carefully supervise them. Finally, it stepped up its efforts to fill data gaps between agencies.
It also changed its own governance structure to make itself more relevant and effective. It promoted better coordination among its various members under the leadership of the G20. The Financial Stability Board and IMF partnered to conduct “early warning exercises” to assess vulnerabilities in the global financial system.
The Basel Accords were also updated with new requirements and safeguards, including special rules for institutions deemed “too big to fail.” The accords went from 12 pages to nearly 1,000 pages in a little over 20 years, Elson said.
While these are positive steps, he argued, more needs to be done to reform the IMF.
“It needs to improve its surveillance and the regulation of capital flows by member countries, strengthen its financial base, and better coordinate the global financial safety net,” he said.
Richard Hemming, visiting professor at the Sanford School and former deputy director of fiscal affairs for the IMF, argued that another global financial crisis was inevitable. The safeguards put in place, he said, were designed to prevent only crises identical to the one in 2008.
“It’s not a matter of whether we will have another financial crisis, it’s a matter of when,” he said. “We’re not forward thinking enough. We’re always looking backwards.”