Crisis Talk - The World Bank Group

Today in Bubbles

The editors of the Financial Times appear to be concerned about bubbles. Three out of today's four op-eds are dedicated to the theme.

First, George Soros argues that the implosion of 2008 was an aggregation of a series of bubbles over the past decades, creating, in his words, a "super-bubble":

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

Weekend Reading

"Good news for investors who like to lose all their money". LTCM 3.0 is here.

The dangers of ultra cheap money.

Is US Government debt actually "risk-free"?

Historically, a weak dollar has been deflationary.

Great charts from Calculated Risk and Barry Ritholtz.

The average unemployment period in the US is at an all-time high.

Another take on why bankers make so much money.

Is Paul Krugman Panda-bashing?

"If you are going to be doing business in a foreign country, particularly China, it pays to do so legally and it pays to have the right visa."

The Fed's Next Move: Hibernation

Yesterday I commented on the role of inflation in the crisis, which was explored at length during a symposium on Dealing with America's Debt Overhang. Any good conversation about inflation has to be followed with a discussion about the Federal Reserve.

Liaquat Ahamed, author of Lords of Finance: the Bankers Who Broke the World, gave a summary of the Fed's exceptional role during the crisis, which can be broken down into three key areas:

1. Acting as a lender of last resort
2. Aggressively cutting interest rates
3. Lending against assets that would normally be considered unacceptable collateral

The Bernanke Fed has been lauded for having prevented another Great Depression, and many, including Barack Obama, consider Bernanke to have been the right man for the right job at the right time.

But times are changing, and now that we are no longer looking into the abyss, what's next for the Fed? What role should it play in the recovery?

One Year On

On the one-year anniversary of the Lehman Crisis, the biggest names in financial punditry have been voicing their thoughts and concerns on the most important issues facing the world economy.  Let's take a look:

Martin Wolf, who spent most of the crisis bringing attention to global imbalances, has become a China bull:

China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Crisis Roundup: Financial Bureaucrats Edition

Tim Geithner wants tougher capital requirements...

...and seven of his European counterparts want to end banks' bonus culture.

Claude Trichet has a plan. So does Geithner.

Bernanke is the dollar's new father.

Volcker and Soros discuss innovation.

Finally, did miscommunication between the US and UK Treasuries push Lehman over the edge?

Central Bank Intervention, Volatility and the Interbank Market

The IMF held an unofficial conference yesterday on "The Effects of Central Bank Intervention on the Interbank Market During the Sub-Prime Crisis." The presentation was led by Economist Ceslo Brunetti from Johns Hopkins University. 

Brunetti and his team analyzed data from Milan-based e-MID, the only electronic, regulated interbank market in the world, in order to measure volatility in bid-ask spreads, transaction prices, and trading volume. They compared data from the pre-crisis period (Jan 2006-April 2008), and the first stages of the crisis (Aug 2007-April 2008).  

A contrast of these two periods found that whenever the European Central Bank took action, regardless of what it was, volatility increased. When new liquidity provisions were announced, vulnerable banks increased their borrowing from the ECB directly, leaving only large, sound financial institutions in the e-MID market, which reduced overall liquidity and increased volatility:

Weekend Reading (and Listening)

What exactly is quantitative easing, and how do we measure its effectiveness? Buttonwood explains.

Is the Credit Crisis the largest outlay in American History? Some are arguing it is more costly than WWII. (via Ritholtz)

Zero Hedge shows us the Fed's balance sheet:

Foreign holdings of USTs and Agencies increased by $23.5 billion monthly to $2,810 billion from $2,787 billion in the prior month. This is now less than 20% of the comparable increase in Securities Held Outright by the Federal Reserve, implying foreign purchasers are starting to fall far behind in their purchases of US securities relative to the Fed's monetization rate.

Our East Asia blog writes on China's import surge.

Simon Johnson discusses bubbles and Goldman Sachs.

The IMF's new blog asks, "After averting a second Great Depression, what should policy makers do to foster recovery?"

The New Yorker's James Surowiecki and Ryan Lizza discuss the state of the stimulus (audio).

China: Bubble on the Horizon?

A new paper has been released by former Morgan Stanley Analyst Andy Xie that is garnering much chatter in the blogosphere. It addresses two of my favorite issues, China and the dollar. Surprisingly, the author is bearish on the former and bullish on the latter. 

The paper, via Big Picture, is well worth reading in its entirely. Xie's assertions are quite harsh:

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast

Dynamic Provisioning: The Experience of Spain

Editor's Note: The World Bank has released the seventh brief in its Crisis Response series. The latest contribution, written by Jesus Saurina, director of the Financial Stability Department at Banco de España, discusses anticyclical loan loss provisions.

Dynamic loan loss provisions can help deal with procyclicality in banking. By allowing earlier detection and coverage of credit losses in loan portfolios, they enable banks to build up a buffer in good times that can be used in bad times. Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole.

While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis. They could be an important prudential tool for emerging economies, where banks dominate financial intermediation.

Click here to download a PDF of the brief.

This Week in Crisis

Tyler Cowen claims that a new book on the crisis, In Fed We Trust: Ben Bernanke's War on the Great Panic, is "so far the most entertaining and most readable book on the financial crisis". In typical dramatic fashion that makes Cowen's praise seem subdued, Joseph Stiglitz argues, "no one can understand what happened and what did not happen without reading this book". 

East Asia & Pacific on the rise has two excellent articles on China's economic robustness. The first discusses the growing presence of Chinese firms on the Fortune 500. The second post highlights growing internet use in China, with current figures topping 338 million users.

Supervision, Regulation and the Crisis

In addition to our policy brief on Blanket Guarantees, the World Bank Group has released two more papers as part of the Crisis Response series:

• In Trust Less, Verify More, Clive Briault, director of Risk and Regulation Consulting Limited, argues that financial supervision will need to change in response to the causes of the financial crisis and the regulatory proposals arising from it. Supervisors will need to take a tougher and more challenging approach to the firms they regulate, exercise more supervisory judgment, involve themselves in macro-prudential oversight, and participate more actively in the supervision of firms with crossborder activities. Supervisors in all countries need to take up these challenges—notwithstanding differences in the style of supervision, in culture and legal tradition, in institutional and organizational structure, and in the powers and resources available to the supervisory agency.
  
• In Macro-Prudential Regulation: Fixing Fundamental Market (and Regulatory) Failures, Avinash Persaud, chairman of Intelligence Capital Limited, describes how this is not the first international banking crisis the world has seen. The previous ones occurred without credit default swaps, special investment vehicles, or even credit ratings. If crises keep repeating themselves, it seems reasonable to argue that policy makers need to carefully consider what they are doing and not just “double up” by superficially reacting to the specific features of today’s crisis. While we cannot hope to prevent crises, we can perhaps make them fewer and milder by adopting and implementing better regulation—in particular, more macro-prudential regulation.

Bank Dividends and Failures in Governance in the Crisis

An excellent new paper, Dividends and Bank Capital in the Financial Crisis of 2007-2009, provides an important contribution to the debate on the role of bank governance in the crisis. It shows how large banks have been steadily eroding the quality of their capital over time and continued to pay dividends even during the rapidly-worsening situation of 2007-08 in an attempt to keep shareholders happy:

Friday Crisis Roundup

Here are some of this week's highlights, from inside and outside the World Bank:

Does easy money and capricious legislation fuel commodity speculation? (Baseline Scenario)

Or is it a curse in general? (The Big Picture)

The World Bank's East Asia blog gives a roundup of the region, arguing that Asia will lead the world out of the crisis.

Meanwhile, our Africa blog ponders success in South Africa.

The European Central Bank has released a report on the international role of the euro...

...with Alea giving us the highlights. Bottom line:

The international role of currencies tends to be relatively stable over time.

Europe: The Biggest Loser?

The IMF just released a revised survey of its global economic outlook, which is generally less pessimistic than the one it originally released in April, particularly for GDP growth in 2010. There is one obvious exception amidst this "optimism": Europe.

Of all advanced economies, only Japan is expected to perform worse in 2009 (though the German economy, Europe's largest, should contract more). The Eurozone is the only entity forecasted to experience negative growth in 2010. The recovery in Central and Eastern Europe, when it arrives in 2010, is forecasted to be slower than in any other emerging market.

A Return to Risk

There is a false sense among some regulators that more capital is the 'solution' to banking problems. Takafumi Sato, commissioner of Japan’s Financial Services Agency, takes issue with this supposed axiom. Writing last week in the Financial Times, Sato argues that bank management needs to change its (excessive) risk-taking behavior, with capital acting as the ultimate backstop:

Just asking for more capital will not cure the disease of capitalism. To avoid a recurrence of crises, we need a paradigm change. A global community adopting a uniform platform is vulnerable to a virus, as we have witnessed during the current financial pandemic. Capital adequacy regulations should be designed to foster diversity in business models, demanding the right level of capital for the business type of the bank in question.

More capital and no change in behavior leads to nothing - hence the importance of governance, where the reforms announced to-date, focusing primarily on executive compensation, are (at least in my mind) very timid in nature.

Charting a Path out of the Crisis

The World Bank Group (WBG) has just released the first batch of a series of policy briefs on the financial crisis, whose aim is to assess government responses to the crisis, shed light on the financial reforms currently under debate, and provide insights for emerging-market policy makers. The first three papers cover a lot of ground in a short amount of space—sizing up the global policy response, forecasting what future financial systems will look like as a result of these policy responses, and determining how financial regulation will evolve. They will be followed by papers, written by different authors inside and outside the WBG, that will take ‘deep dives’ in specific crisis-related financial sector topics.

• Dealing with the Crisis: Taking Stock of the Global Policy Response provides an overview of the immediate financial sector policy responses to the financial crisis—including emergency liquidity support, expansion of financial safety nets, and interventions in financial institutions—that have succeeded in stemming widespread panic. But the effort has generally been ad hoc and insufficient. Issues that remain include the resolution of problem assets, the restructuring of troubled, systemically important financial institutions, and the development of credible exit strategies. Only a handful of countries have attempted to tackle these issues head-on. As past experience has shown, that may well have negative repercussions for the duration and strength of a subsequent recovery.

• The Reform Agenda: Charting the Future of Financial Regulation reviews the crisis-induced shift toward a tighter and more macro-prudential approach to financial regulation. But the reform agenda still needs to address the role of supervisory (rather than regulatory) failures, while the institutional arrangements needed to implement the new framework remain to be worked out. For most emerging economies, the existing reform agenda—developing institutional and legal underpinnings for the financial system and promoting financial access—remains valid. But for those characterized by weak financial oversight structures and more volatile economic cycles, adopting capital “buffers” as part of a macro-prudential regime may be a useful complement.

• Safe but Smaller? The Shape of Financial Systems to Come describes how global trends taken for granted in recent decades—the big expansion in global financial assets compared with underlying economic activity, growing global financial integration, shrinking role of the state in financial systems, and rising share of cross-border ownership of financial institutions—may reverse over the foreseeable future. In addition, the structure of financial systems, particularly in developed countries, will likely become oriented less toward capital markets and more toward traditional (and simpler) banking activities. The impact on economic growth and overall welfare is likely to be negative—perhaps the price we have to pay for living in a brave new (and presumably safer) financial world.

Managing Systemic Crises

On Tuesday the World Bank and IMF held a joint conference on Managing Systemic Crises and Redesigning Financial Systems. Check out presentations from heavyweights in the world of economics, including Luigi Zingales, Andrei Shleifer, and Daron Acemoglu.

It's also worth checking out a presentation by Charles Calomiris in which he discusses why we need macro-prudential regulation as a complement to micro-prudential discipline:

• Because of agency problems, pricing of risk on buy side is not always accurate.
• The combination of monetary policy looseness and agency problems can create incentives to ride a bubble.
• Market discipline is not enough under these circumstances; there needs to also be a belt on top of the suspenders, because of agency problems.

Some Recommendations for Dutch Banks

The Dutch banking association recently commissioned a report by an independent committee (including my Tilburg and European Banking Center colleague Sylvester Eijffinger) to draw lessons from the recent financial crisis, which hit the Dutch banking sector quite hard, and formulate recommendations. This committee just released its report. Before you reach for your Dutch-English dictionary, please be assured that the report is actually in English, reflecting the international character of the Dutch academic and financial sectors. 

Some of the recommendations do not surprise, such as better governance structures, remuneration policies that do not award large bonuses if the bank makes losses, and anticyclical capital buffers. Others I find rather difficult to achieve, such as aiming for non-financial targets including customer satisfaction (where Dutch banks have lots of room for improvement, as I can assure you from personal experience). 

Where I am getting really nervous is when too much focus is put on non-owner stakeholders' interests, including employees of banks, or rewarding shareholders who hold on to their shares for at least four years, such as individual shareholders whose shares will probably be voted by someone else through proxy votes. Delinking the ownership structure from the voting structure has rarely fostered efficient banking, as examples from many emerging markets have shown.

Bank Fragility in Spain

A recent article in the Economist points to the Spanish savings banks (cajas de ahorro) as cause for worry. The ownership and governance structure of these financial institutions is somewhat odd, as they are not really owned by anyone, but rather have the form of a private foundation, with a board of trustees that includes representatives of local governments, depositors and clients. 

While originally geographically restricted, many of these cajas are now active throughout Spain. These institutions have been very successful over the past years, growing their market share at the expense of the commercial banks (the largest of which looked for profits beyond Spanish borders, especially in Latin America). A recent paper found these savings banks to be less risk-loving and more stable than commercial banks in Spain. More recently, however, Spain’s savings banks started to tap wholesale funding markets to continue their expansion while commercial banks put on the brakes, which exposed the savings banks to new funding risks.

Banking and the Leverage Ratio

The World Bank has just put out a helpful background note on Banking and the Leverage Ratio. The leverage ratio is a prudential tool that helps limit excessive leverage in a banking system. The note is quite a propos, as the Financial Stability Forum is expected to propose that a leverage ratio be added to bank-capital requirements at the G20 summit in April. So how exactly could a leverage ratio help?

• Limits balance sheet size: The current risk based capital measures (both Basel I and Basel II), encourage banks to assume exposures that attract a low risk weight, as the capital required to be set aside for these exposures is relatively small. As a result, in absolute terms bank balance sheets can become highly leveraged and can include assets that would be difficult to liquidate in times of need without incurring large haircuts. Hence, the prudential leverage ratio can serve as an additional measure to ensure that banks do not become excessively leveraged, as seems to have happened in recent years (see Figure 1).

• Reduces regulatory arbitrage: As described above, the more risk sensitive nature of Basel II can result in the perverse incentive to structure products to obtain a high credit rating, so that they qualify for lower prudential capital requirement. When this incentive is collectively exploited, the system is likely to end up with high concentrations of structured exposures attracting low prudential capital requirements. The prescription of a minimum leverage ratio, among other measures, can dampen this perverse incentive.
• Simplicity: The simplicity of the application and monitoring of the leverage ratio enables quick adoption without imposing high costs or expertise requirements on banks or their supervisors. Moreover, this can be applied irrespective of the capital adequacy regime implemented in a particular jurisdiction.
• Backstop against regulatory concessions: Reliance on banks’ own internal models for capital adequacy purposes, as mandated in Basel II, entails a significant element of judgment and may expose regulators to industry pressures for lenient treatment. A leverage ratio would thus act as a backstop against any creeping regulatory concessions.

In other words, a leverage ratio could be a very useful complement to the Basel capital adequacy ratio. However, the note points out that a leverage ratio is not without limitations - read the whole thing here.

Kaufmann Takes Aim At Corruption

Dani Kaufmann, one of the pioneers of the governance agenda at the World Bank, discusses the role that corruption played in the financial crisis:

There are multiple causes of the financial crisis. But we can not ignore the element of "capture" in the systemic failures of oversight, regulation and disclosure in the financial sector. Concrete examples abound.

First, the way Freddie Mac and Fannie Mae spent millions of dollars lobbying some influential members of Congress in exchange for, among other things, lax capital reserve requirements for these mortgage giants.

Second, how AIG's "small" derivatives unit located in London managed to obscure its accounts, be governed by lax regulatory oversight, and take inordinate risks that effectively brought down AIG's empire of 100,000 employees in 130 countries, accelerating the global financial crisis...

Third, how giant mortgage lenders such as Countrywide Financial switched regulators so to fall under the lax oversight of the Office of Thrift Supervision, which was funded by fees paid by the regulated banks (and which also supervised AIG's derivative unit).

Fourth, how in April 2004, during a 55-minute-long meeting at the Securities and Exchange Commission, the largest investment banks persuaded the SEC to relax its regulatory stance and allow them to take on much larger amounts of debt.

Finally, Madoff's giant Ponzi scheme, some of which appears to be plain fraud, though system-wide irregularities also point to subtler forms of corruption and capture. Years ago the SEC knew that Madoff, who had served on the commission's own advisory committee, had multiple violations and was misleading it in how he managed the funds of his customers. Yet the SEC failed in unmasking the Ponzi scheme.

Worse yet, more governance challenges are yet to come, as fiscal stimulus packages present all kinds of opportunities for the ethically challenged. Kaufmann recommends far-reaching measures to improve transparency as an antidote. I agree with that but doubt that's enough.

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

Germany's Crisis Response

In terms of originality, Germany's crisis response package beats everyone else to date. One item is giving 2,500 euros to anyone who is willing to scrap any car that is 9-years old (or more) and buy a new one. This is both good for the economy and for the environment. Another item - my favorite - is reducing the payroll tax. The whole program, worth 50 billion euro, is described in this article from the BBC.
 
I spent some time trying to figure out whether the Germans have gone protectionist, and whether the subsidy only applies to German-made cars. The answer is 'No'. Any make will do. Perhaps implicitly the government knows no German would be caught buying a Renault. Germans like their cars to be of good quality.
 
A similar plan probably wouldn't work in the US to save the Big 3. It may increase sales for their rivals instead.

The Sacred Cows of Capitalism, Alive and Kicking

Wounded perhaps, but the sacred cows of capitalism are alive and kicking, according to a new World Bank working paper by Asli Demirguc-Kunt and Luis Serven. The authors of Are All the Sacred Cows Dead? argue that "the 'sacred cows' of financial and macro policies are very much alive...the on-going crisis does not simply reflect a failure of free markets, but a reaction of market participants to distorted incentives."

Demirguc-Kunt and Serven, however, aren't just adding another paper to the now large pile that do a post-mortem on the origins of the financial crisis. The approach is much more prospective than that. How are regulators and central bankers in emerging markets to deal with banking systems and financial markets facing severe stress? It's more of this type of analysis that's needed right at the moment.

On blanket guarantees (compare this to a recent post from Thorsten Beck):

It must be recognized that the short-term benefits of guarantees will vary with the fiscal strength of the guaranteeing government. To hasten the end of an insolvency driven banking crisis and to constrain the spread of insolvencies in the short term, the government must manifest a substantial capacity for absorbing losses. This is not a luxury most countries can afford since most governments do not have the required fiscal capacity. Depending on the depth of the systemic insolvency such support may not even halt the spread of crisis and delay healthy adjustments.

On government ownership of banks:

Given the extent to which lending policies are politicized, it is not surprising that state ownership appears to heighten the risk of crises instead of reducing it. If anything, research suggests that greater state ownership is associated with various measures of financial instability, including a greater probability of banking crises.

On market discipline and Basel II:

Many interpreted the crisis as a vivid example of market failure, evidence that there is no such thing as market discipline, reinforcing calls for stronger regulations through improvements in Basel II accord. But the crisis also spawned a growing argument about the role Basel I accord may have played in causing the crisis. Indeed, it is no secret that Basel I contributed to the growth in securitization by assigning lower capital charges and thus giving incentives to institutions to move their assets into off balance-sheet securitization vehicles. While advocates claimed that Basel II, had it been implemented earlier, could have lessened or prevented the turmoil, critics of the Basel approach to capital regulation pointed out that the crisis has simply reconfirmed fundamental flaws that have been evident in this approach.

>> Download a PDF of Are All the Sacred Cows Dead?

Slow and Steady Wins the Race

That, at least, is the opinion of Yan Qifa and Tang Ping, two economists at the Export-Import Bank of China. They urge caution regarding financial opening in today's China Daily:

In recent years, Chinese banks' balance sheets have seen much improvement thanks to continual banking reforms. However, with the global financial crisis deepening and domestic economic growth slowing, policymakers must pay more attention to the potential risks the banks are facing.

In the mean time, policymakers must become more cautious in dealing with the country's financial opening up.

China's financial opening up drive has been quite bold in recent years. By the end of last year, 21 foreign banks have become locally incorporated banks in China while 193 banks from 47 countries and regions have established their representative offices in the country. A total of 82 foreign banks have been allowed to conduct renminbi business.

China's financial opening up is faster than many developed countries. However, the global financial crisis reminds us that a major element in deciding the pace of financial opening up is whether it is conducive to the stability of the national economy and the soundness of the financial system and whether it contributes to effective financial regulation.

Their take on financial opening is not too dissimilar from a recent paper from the Growth Commission on International Finance and Growth in Developing Countries. Given the current financial turmoil, I take it as a positive sign that there are calls for continued financial opening in China, albeit at a slow-and-steady pace.

A European Contribution to Crisis (Management)

A lot has been written about the failures of bank regulation and supervision in the U.S., where the sub-prime crisis started, but what about Europe?  Problems abound here as well – bank runs in England, governance issues in state-owned banks, such as in Germany, where some of the first banks fell, and lots of interventions into failing banks. 

Unlike in the U.S., however, matters are complicated by the lack of a Europe-wide regulatory and supervisory framework despite the emergence of a pan-European banking system.  The consequence: national approaches, often resulting in nationalization, such as in Belgium and the Netherlands.  Private market solutions for large banks are not feasible as no bank strong and sound enough in the respective country exists to take on a large failing bank.  And private market solutions in Europe are impeded by the lack of a Europe-wide authority who could take the lead in organizing such a solution as the Federal Reserve or the FDIC do in the U.S. 

What's Next for Emerging Markets?

Download Michael Klein's recent speech on the international financial crisis. He discusses the various dimensions of the financial crisis, its effect on developing countries, and how the world's financial architecture may change. Michael is the World Bank Group's vice president for financial and private sector development.

G20 Summit: Unprecedented Focus on Financial Reporting

Financial accounting and reporting were a central issue at the November 15 meeting of G-20 leaders plus the leaders of Netherlands and Spain. The Summit’s Declaration sets the stage for several important reforms, some of which are already in progress.

First, the summit leaders agreed on “enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions….” This widely-heard complaint in the immediate aftermath of the crisis is something that securities regulators and accounting standard-setters have already begun addressing. For instance, in September 2008, the SEC sent a letter to certain public companies regarding disclosure and the application of FAS 157. Also, last month, the IASB has issued a proposal for improvements to financial instruments disclosures. Much work remains to be done on this front but a strong consensus exists.

Second, they agreed to “strengthen regulatory regimes, prudential oversight, and risk management….” This is a potentially more difficult issue insofar as financial regulators and accounting standard-setters do not necessarily see eye to eye on all accounting issues. Many in the accounting world are wary of possible interference from prudential rules with transparent financial reporting. One traditional sticking point has been fair value accounting, a major attribute of modern financial reporting, which has been blamed by some for its pro-cyclical effects.

The fact that the leaders of the world’s 22 largest economies devoted so much attention to accounting issues in their discussions is unprecedented and should be applauded. Indeed, strengthening prudential supervision and market discipline, two building blocks of the international financial architecture, will require bold action backed by strong political commitment at the highest level, and much closer cooperation between all key decision makers on the world stage. The Declaration sets forth an ambitious, fairly detailed and prescriptive Action Plan to Implement Principles for Reform, which is likely to keep policymakers, financial sector regulators and accounting standard-setters around the world very busy over the coming months.

"Solvency II" -- An EU Proposal for the Insurance Industry

Europe's ambitious plans to modernize its regulatory and capital adequacy regime for the insurance industry were discussed at a World Bank-sponsored event last week. More than 50 policy makers and financial and accounting practitioners from Latin America and Caribbean attended. The attached note  summarizes the proposal -- dubbed "Solvency II" -- and discusses the potential impact of the financial crisis on its future.

It's worth noting that the project emphasizes market discipline -- which many seem to have doubts about due to the current crisis -- as an important pillar of regulation. Similarly, it endorses a "market consistent" approach to valuing assets and liabilities, which is advocated by international accounting standards (IFRS). This is an encouraging sign for those who believe that prudential regulation and transparent financial reporting not only can coexist peacefully, but hopefully support one another.

Views of the World Bank Chief Economist

World Bank Chief Economist Justin Yifu Lin today discussed the origins of the financial crisis and its impact on developing countries, and proposed several ways to respond.

Speaking to the Korea Development Institute in Seoul, Lin called for a discussion on several ideas for economic policy management. Among them:

• Governments should consider carefully whether controlling asset price inflation should be added to the mandate of monetary policy authorities. ("If the Fed is not able to keep these bubbles from inflating, it will not be able to achieve its other objectives.")
• Financial supervision needs to try its best to keep up with financial innovation. ("The techniques and art of supervision must be able to follow financial-sector innovators into new territory where, by definition, innovation will always have a head start.")
• Responses to global crises must be systematic, comprehensive, decisive, and coordinated. ("Given how globalized financial sectors now are, piecemeal and unilateral responses to financial crisis will run the risk of worsening the ripples of negative reactions across borders without addressing fundamental problems.")
• Global problems may require global multilateral solutions. (" If indeed the world does find itself in a global recession next year, as we fear is possible, further and more creative multilateral action may be necessary.... [W]e cannot be constrained by the limits of institutional structures and approaches designed for a world before financial globalization."

How the Financial Landscape Will Change

Roberto Rocha and Costas Stephanou are the main authors of a new paper on The Unfolding Crisis: Implications for Financial Systems and Their Oversight. The paper is now available for consultation and public comment. The paper's main finding: it is going to be a very different financial landscape in the next few years, and beyond. Many governments will have substantial bank ownership stakes; deposit insurance, once it goes up, will stay up beyond the crisis; unbundling distress assets will be significantly more difficult than in previous crises; the role of credit rating agencies will be re-assessed; there will be some appetite to roll back pension reform (especially second pillar).

Softening the Impact of the Global Crisis

When a crisis is seen coming, the knee-jerk reaction of governments is to busy themselves with a variety of ill-thought interventions. Doing something, however inadequate, is considered a show of care. Most often, it is best if the government calmly assesses the developments and intervenes as little as possible. Two cases in point. First, the Great Depression was vastly exacerbated by the actions of the then-young Fed, which reduced money supply and thus prolonged the crisis unnecessarily. (Current Fed chairman Ben Bernanke has built his academic reputation writing on this issue.) Second, the IMF followed a similar increase-the-interest-rate-and-shrink-money-supply stance ten years ago in East Asia. The result was a deepened crisis and a stigma associated with any future IMF actions. Malaysia, the only country that openly avoided the IMF's advice, had a better time than its neighbors.

So what can be done to soften the impact of the unfolding global crisis? I suggest four things:

Time to rethink market discipline

What, really, is market discipline, and how much can we rely upon it for prudential purposes? Market discipline is usually defined as the mechanism or process by which market participants monitor and punish excessive risk-taking behavior by financial institutions. It has gained appeal in recent years--given global financial market trends that have limited the ability of supervisors to adequately monitor such institutions--and it has now become part of the supervisory architecture (pillar 3 of Basel II and Solvency II).

Market purists hold market discipline as an article of faith and as a means to criticize "excessive" government regulation. Some commentators have even argued that market discipline should progressively replace, rather than complement, official supervision. In reality, of course, market discipline has less to do with the market per se than with the institutional and legal framework used to address moral hazard and asymmetric information problems that are endemic in the financial system.

Ways to Tackle Procyclicality in Banking

Ask most bank supervisors and bankers about the causes of the subprime-cum-financial crisis, and their responses are typically the same. Banking problems manifest themselves in a different way every time, and one can debate whether excessive risk-taking behavior by banks is primarily due to misaligned incentives or to irrational exuberance. However, they all confirm that such behavior is conditioned by, and contributes to, the business cycle. It is difficult for banks to follow more prudent policies during an economic upturn, especially in a highly competitive environment. Credit mistakes made during that period only become apparent in the downturn, resulting in the well-known privatization of gains during good times (excess earnings shared among bank shareholders and staff) followed by the partial socialization of losses during bad times (public bailouts).

The unfolding financial crisis, or why lawyers will be hip

This entry starts a series of blogs on the unfolding financial crisis. Seen as primarily a US phenomenon only a month ago, the crisis has now reached countries as diverse as Hungary, Ukraine, Indonesia and Brazil. The stock exchanges in several countries, including Russia, Romania and Indonesia, were closed for days to avoid further loss of value. Banks in quite a number of emerging markets have experienced runs. Where is all this coming from, what are the remedies, and what are the implications for reforms in financial systems?

This blog has a modest aim: to talk about the likely impact on regulatory reform work. This has been increasing fast in the last few years, fueled by expanding economies and a desire to improve international competitiveness. On the latter, macroeconomic issues had subsided and so governments had turned their attention to regulatory reform. This was in part due to some new research work, notably around Hernando de Soto and our own Doing Business project. Mostly, however, it was due to an economic boom that made competition for capital and even qualified labor global. So you had to be more competitive than your neighbor to attract resources. This time may now be over.