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Lessons from Recent Crises and Current Priorities for Finance Practitioners and Policy-Makers

Maria Soledad Martinez Peria's picture

On May 14-18 the World Bank held its annual Overview Course on Financial Sector Issues in Washington, DC. Geared towards mid-career financial sector policy-makers and practitioners, the objective of this one-week event was to discuss issues of current and long-run importance to the development of the financial sector. This year’s course focused on Lessons from Recent Crises and Current Priorities for Finance Practitioners and Policy-Makers. The timing was quite fitting—the course took place the same week that JP Morgan’s billion-dollar trading became public and the European crisis intensified as Greek banks suffered large deposit runs.

Perhaps not surprisingly in light of recent events affecting the financial sector in the US and Europe, three main broad themes resonated in many of the sessions of the course: (1) the need for more and better bank capital, (2) the importance of putting in place the right incentives for banks to limit the risks they take, and (3) the role of macroprodudential regulation in monitoring and limiting systemic risk.

In a session discussing the causes and consequences of the recent crises, Simon Johnson, professor at MIT and former IMF chief Economist, blamed the US crisis on the lack of adequate capital and on “too big to fail” policies. In his view, unless banks have sufficient “skin in the game” and bankers and shareholders face the consequences of their actions (by being forced to suffer losses and, in the case of bankers, lose their jobs), large banking sector losses would happen again.

In a panel discussing lessons from the recent crises, Ceyla Pazarbasioglu, Deputy Director in the Monetary and Capital Markets Department of the IMF, argued for the “need to wean banks off their implicit government support, scale down deposit insurance schemes, and restore creditor discipline.” She supported a variety of measures to achieve these goals including: setting restrictions on the size and scope of bank activities, putting in place capital surcharges for systemic institutions and requiring banks to issue contingent capital (CoCos) bonds. The use of CoCos was also heavily endorsed by Charles Calomiris, professor at Columbia University Graduate School of Business. Professor Calomiris discussed CoCos as an important ingredient in building an incentive-robust regulatory framework. He also suggested (a) requiring rating agencies to report numerical forecasts of probabilities of defaults and to “sit out” in cases of egregious errors, (b) using loan interest rates as a measure of risk-taking and relating capital ratios to loan interest rates, (c) establishing a 20 percent remunerated liquidity requirement, and (d) putting in place counter-cyclical capital and provisioning requirements.

The role of incentives was also highlighted in a session led by Martin Cihak and Asli Demirguc-Kunt devoted to the presentation of the forthcoming 2013 Global Financial Development Report on the Role of the State in the Financial Sector. The authors argued that “the challenge for the state's involvement is to better align private incentives with public interest without taxing or subsidizing private risk-taking. Credible threats of market entry and exit, healthy competition, and disclosure of quality information in combination with strong and timely supervisory action are essential in getting the balance right.”

In a panel discussing the future of bank regulation and supervision, Jerry Caprio, a professor at Williams College who has written extensively on the topic, also brought up the issue of incentives. Based on his book Guardians of Finance with Jim Barth and Ross Levine, he argued that in large part the US crisis occurred because regulators did not do their job properly due to a lack of incentives to do so. He argued that the practice of a “revolving door”, where regulators become highly paid financial sector practitioners following their time in office, means that the potential for regulatory capture by the financial industry is very high. As a solution to the supervisory deficiencies witnessed during the global crisis, Caprio and his coauthors propose establishing a Sentinel – an independent organization with financial sector expertise in charge of providing independent, informed expert assessments of financial regulations.

A number of sessions touched on the subject of macro-prudential regulation. Most notably, Barry Johnston (former Assistant Director of Monetary and Capital Markets Department of the IMF) led a session specifically on how macroprudential regulation and supervision can be used to identify and mitigate the sources of systemic risk. This requires (a) identifying systemically important financial  institutions - SIFIs - those that are interconnected, large, or difficult to substitute, (b) monitoring the operations of these institutions frequently and in depth (possibly have in place SIFI capital charges), (c) extending the perimeter of regulation to deal with linkages with non-regulated entities, (d) having in place measures to deal with time-varying systemic risks such as: pro cyclical capital buffers and liquidity requirements; dynamic provisioning and maximum leverage ratios and (e) making sure the right incentives are set for the behavior of SIFIs and for the actions of supervisors that monitor them.

Aside from the sessions described above that focused on the more timely and crisis-related issues, a number of presentations dealt with other longer-term subjects such as how to develop capital markets, housing finance and payments and pension systems. Also, the course included sessions on financial inclusion, microfinance, Islamic finance, and SME finance. More information about the course can be found at http://blogs.worldbank.org/allaboutfinance/overview. And for those who couldn't make it to the conference this year, check back on the AAF blog in early 2013 when we'll announce the date of the next Overview Course.
 

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