Why are we trapped in financial crises?

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The financial crises has entered a new, difficult phase (Credit:©iStockphoto.com/Photomorphic)

The Thirteenth Annual Financial Sector World Bank/Federal Reserve/International Monetary Fund Seminar on Policy Challenges for the Financial Sector was held on June 5 to 7th, attracting more than 90 participants from over 60 countries. There were many distinguished speakers, including World Bank President Jim Yong Kim, IMF Managing Director Christine Lagarde and Federal Reserve Chairman Ben Bernanke.  One of the highlights was a provocative lunchtime address on The Contradictions of System Stability: One Asian View by Andrew Sheng, the President of the Fung Global Institute.

Mr. Sheng drew on the history of financial crises, which he termed “events”, to the process of bank restructuring and reform, involving four phases: diagnosis, damage control, loss allocation and changing the incentives.  The current global financial crisis is now in the difficult phase of loss allocation and it is still questionable whether the incentives that created the crisis in the first place have been sufficiently changed.

In looking at the causes of the crisis, Mr. Sheng focused on the domestic nature of monitoring and the enforcement of what is now a global financial network. There is no global central bank or clear global financial supervisor for this network. We still measure the money supply at the national level but we need to measure global money supply numbers to really understand the threats to financial stability. Global broad money supply numbers must include off-balance sheet and off-shore credit creation statistics. Financial systems are networks – they are inter-connected, they have interdependencies and major feedback loops.

The inability to deal with these problems at a global level is what Mr. Sheng termed the collective action trap: the inability of society at the national and global levels to agree on common goals, common processes or structures or common tools. Since there is no agreement on a global central bank, a global financial regulator or a global fiscal authority, there is no alternative but to suffer through occasional crises and disasters. More importantly, national policies cannot be effective without taking into consideration the spillovers from global capital flows. But, because there are no good tools to measure the spillover effects and every national authority thinks that someone else is taking care of the problem, the stability of the financial system globally is at risk. So we must have humility in the face of complexity and recognize that there are no unique one-size-fits-all solutions. Reforms must be prioritized, particularly for emerging markets where the regulators and banks have limited capacity and resources and core capital is not unlimited or costless. At the global level there can be agreement on principles but application of principles or rules has to be more calibrated, measured and paced. This is consistent with the work of the World Bank on issues facing Emerging Markets and Developing Economies (“EMDEs”) as a result of the many global initiatives on bank supervision that may have unintended, potentially harmful consequences to EMDEs.

Perhaps Mr. Sheng’s most important message was the need to encourage diversity in the financial sector. He objects to the recent regulatory reforms based on the “herding” effect – if all banks operate under the same rules and the thinking behind the rules is wrong then we have created a bigger problem rather than found a solution. Regulators need to nurture diversity in financial systems with a focus on serving the needs of the real or “non-financial”   sector. The real sector’s  need to create jobs and innovation will be served best by developing institutional investors that can provide the necessary long-term financing to support economic growth and development.  


Claire McGuire

Senior Financial Sector Specialist

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