Financial Market Regulation and Reforms in Emerging Markets

7. Who Should Regulate Systemic Stability Risk? The Relevance for Asia

171 7 Who Should Regulate Systemic Stability Risk? The Relevance for Asia masahiro kawai and michael pomerleano Areview of past crises suggests that there were almost always policy mistakes leading to financial vulnerabilities, systemic risks, and eventually financial crises. Often these past crises were slow to unfold. In the case of the United States’ subprime loan crisis, incipient signs of a crisis appeared in the summer of 2007. Bear Stearns collapsed in the spring of 2008. The crisis could have been spotted in its early stages. So the questions are: What is needed to prevent a systemic crisis? Who should have the responsibility to do this? How should a country establish such an arrangement to forestall a crisis? These subject matters are quite relevant to many emerging economies, particularly those in Asia. There were several policy mistakes behind the global financial crisis. The International Monetary Fund (IMF 2009) identified three policy mistakes: mismanagement of macroeconomic policy, particularly monetary policy in the United States; flaws in financial regulations and supervision; and a weak global financial architecture . These factors all contributed to the failure to contain the buildup of financial vulnerabilities and systemic risks in the United States and some European countries. First, the U.S. Federal Reserve took the view that no one would be able to reliably identify bubbles in asset prices and that monetary policy should not prick The authors are thankful to Charles Calomiris, David Mayes, and Larry Wall for comments and Barnard Helman for editorial assistance. The findings, interpretations, and conclusions expressed in the paper are those of the authors and do not necessarily represent the views of the Asian Development Bank, its Institute, the World Bank, their respective executive directors, or the countries they represent. 172 masahiro kawai and michael pomerleano asset price bubbles but should wait and respond to the bursting of the bubble and just mitigate its negative impact. The overall philosophy behind the Federal Reserve was that an effective post-bubble response was more important than the prevention of the bubbles, which would be difficult to accomplish using monetary policy. This philosophy may well have fed the so-called “Greenspan put” and encouraged the buildup of financial vulnerabilities. Second, financial supervisory and regulatory frameworks around the world were weak. Neither the unified regulator of the United Kingdom nor the highly fragmented regulators of the United States were able to prevent or deal promptly with the crisis. There were regulatory gaps everywhere and a fallacy of composition —that is, while individual financial firms were deemed sound, systemic risk still built up in the system. The authorities were looking at the “trees” and not the “forest.”1 A key lesson of the crisis, therefore, is that financial policymakers need to strengthen top-down macroprudential supervision, complemented by bottom-up microprudential supervision. Third, the global financial architecture was weak. Global organizations including the IMF, the Bank for International Settlements (BIS), and the Financial Stability Forum (FSF) did not conduct effective macroeconomic-financial surveillance of systemically important economies (United States, United Kingdom, the euro area) nor provide compelling warnings. International arrangements for the regulation, supervision, and resolution of internationally active financial firms were highly fragmented. In addition, the global discussion of the “global payments imbalance” may have diverted attention away from the buildup of U.S. domestic financial vulnerabilities toward China’s exchange rate policy. Learning from the lessons of the crisis, the United States and the United Kingdom have been shifting their regulatory structures toward empowering their respective central banks with new and greater authorities of systemic stability regulation . Now the question is how policymakers in other countries, particularly those in Asia, should formulate a strategy of systemic stability regulation to prevent a financial crisis, and how they should organize themselves to effectively implement it at the national level. Another issue is whether there is any role for regional mechanisms for financial stability to complement the national and global efforts. Crisis Prevention, Management, and Resolution The most fundamental approach to a financial crisis would be to prevent one from taking place. The key principle should be: “Preventing a crisis is better 1. According to the IMF (2009), “A key failure during the boom, was the inability to spot the big picture threat of a growing asset price bubble. Policymakers only focused on their own pieces of the puzzle, overlooking the larger problem.” who should regulate systemic stability risk? 173 than curing...