The board of governors of the World Bank Group and International Monetary Fund met on 6 October 6. The IMF and the World Bank lack the political clout of the G-20 and are more business like. The IMF is an organisation of 186 countries and seeks to foster global monetary cooperation and financial stability. The World Bank is like a cooperative whose members are the shareholders.
The first meeting of the IMF and the World Bank boards of governors was held in Savannah, Georgia, the US, in April 1946. John Maynard Keynes and Harry Dexter White are the intellectual founding fathers of these institutions. White, though not as well known as Keynes, also did defining work in laying the foundations of these supranational structures. He was the chief international economist at the US treasury and was also instrumental in the creation of the Bretton Woods. Both did not live to see the structures they conceptualised achieved glory and power. Hypothetically, if the two old-time economists were alive today and were asked for a prescription for the current financial crisis, chances are they would have suggested a simpler remedy than the convoluted regulation the G-20 has prescribed. So let?s look at how they would have probably viewed the crisis and what prescription they may have suggested.
Simply put, the crisis was caused by three interlinked factors?high liquidity, high leverage and regulatory oversight. The high liquidity in the system was catalysed by imbalances in payments. The US had an unusually high current account deficit which was funded by ample flow of capital from Asian countries and the oil-exporting countries. Monetary policy in the US was a lot more expansionary than what was optimal. The monetary policy was one-dimensional in the sense that any price decline in the years preceding the crisis was countered by decreasing the rent on money ie, low interest rates. However, there was no monetary policy response to adjust for soaring asset prices.
The second factor was high leverage. The economy in general, and in particular households, was allowed to build up too high leverage. In the US, household leverage increased to 40% of its GDP. During the period 1999-2007, financial sector leverage as a proportion of GDP increased by 80% in the US and by 100% in the European Union. In the good years, the money market was flush with liquidity. As a result, US investment banks like Lehman got a good proportion of their funds from the money market. A quarter of US investment banks liabilities, on average, were funded from the wholesale money market. When banks started to report losses and confidence got low, the liquidity in the money market evaporated pushing these institutions over the brink. The European universal banks which had both commercial and investment banking operations not only became overleveraged but also had a mismatch in currencies on their assets and liabilities. Their liabilities were still predominantly in European currencies since their deposit base had not undergone much change. However, their assets had disproportionately large US dollars, that too in toxic financial securities.
The accumulation of US dollar toxic assets by European financial institutions can in part be attributed to regulatory oversight. Within the US, the ?originate to distribute? model facilitated creation of sophisticated financial assets. It also helped increase household leverage and made lending standards sloppy because each entity in the financial chain thought that it was passing the risk to somebody else. Here again the regulators largely looked the other way when there was considerable evidence that the risk management buck was being passed around .
As a response to the crisis, the G-20 has suggested among other regulations, a rule to restrict financial institutions from growing too big so that their failure does not result in larger systemic risk. The regulation also seeks to separate large cross-border banking groups. Such regulations, though they seem fine on paper, may not be too useful in preventing a future crisis. Regulation cannot be like driving while looking at the rear window.
Multinational banks did not cause the crisis. True, they were the most vulnerable along with the really large banks. The massive instability in the markets was primarily due to one-dimensional monetary policy and lax regulatory oversight. If there is one take away from the crisis, it is that we do not need more complex regulation. Regulators would do well to do the basic things properly. Keynes? and White?s prescription may have been just ?KISS?keep it simple and straightforward.?
?The author, formerly with JPMorganChase?s Global Capital Markets, trains finance professionals on derivatives & risk management