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Policies against financial crises

Learning Object Description:
Instability on financial markets can have severe economic and political repercussions.
Governments try to protect their countries by regulating markets and by reforming the
international financial architecture. This lesson explains the two main strategies against
financial crisis, crisis prevention and crisis management, and shows that they can have
paradoxical effects. As an example of a multilateral attempt to stabilize the international
financial architecture, the lesson refers to the Financial Stability Forum.

Learning Object Objectives:

To be able to name the pillars of the international financial architecture and explain why they
can help prevent and manage financial crises; to discuss some of the paradoxical effects of
policies against financial crises; and to list the functions of the Financial Stability Forum.

International finance often seems to be spontaneous or even chaotic, but this is hardly the case.
Without a stable framework, international finance would not exist. This framework consists of:

• Rules regulating the behavior of financial actors (e.g. prohibition against inside trading)
• Regulatory agencies able to enforce the rules
• Central banks providing liquidity and information
• International organizations providing coordination of international actions of various
regulatory agencies and central banks

To describe this set of key elements, we also speak of the international financial architecture .

The international financial architecture and its

reform
The discussion about reforming the financial architecture is as old as international finance itself. But
after the financial crisis of Mexico and the Asian crises, the debate about reforming the international
financial architecture was picked up with new emphasis. This debate focuses on crisis prevention and
crisis management .

Crisis prevention
seeks to reduce the probability of financial crises occurring
Crisis management
tries to limit the economic consequences of financial crises once they have already begun

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Crisis prevention
The best way of reducing the probability of a crisis occurring is to enable the market to discipline
itself. For this, a certain level of transparency is the prerequisite. Financial markets are information
markets. Information is incomplete and unequally distributed. Market participants act because of their
particular assessment of the information they have. Their decision to invest in a certain country
depends on information assessment, as well as on their decision to buy or sell a currency at a certain
time. It's all about information. To ensure that market participants get the necessary information,
markets have to be transparent. The standardization of information (e.g. accounting rules) is one way
to improve transparency.

A basic set of regulating and supervising institutions is also needed. A level playing field is
important, because unequal treatment can also lead to imbalances on the markets. The capital
standards of the Basle Committee for Banking Supervision are an important example of an attempt to
create a level playing field for market participants across Organization for Economic Cooperation and
Development (OECD) countries. Commercial banks in OECD member countries are required to keep
a certain amount of money in reserve in case credits are not paid back. Thus, the banks are obliged to
build their own safety nets for times of crisis.

Regulation and supervision are generally organized at the national level. (The European Union is, in
this respect, an exception because it organizes regulation on a supranational level.) Because of the
trans-national nature of capital flows and international actors, national efforts have to be coordinated
internationally. The exchange of information is therefore also important for reducing the probability
of financial crises.

Many financial crises start as currency crises. The management of exchange rates is therefore
important. Setting exchange rates is a difficult and highly disputed task. The spectacular failure of the
fixed exchange rate of Argentina in 2001 shows the dramatic consequences of a poorly managed
exchange rate.

Question:

Attribute conditions of successful crisis prevention to their strategies:

1. To ensure that market participants receive all the important information (correct match is 4)
2. To ensure a level playing field (correct match is 1)
3. To ensure that national efforts are coordinated internationally (correct match is 3)
4. To prevent currency crises (correct match is 2)
List of all matchables:
1. Regulating and supervising institutions; 2. Management of exchange rates; 3. Exchange of
information; 4. Transparency;

Information and the paradox of early warning

As financial markets are information markets, and as information is normally incomplete, financial
crises are an unavoidable concomitant of financial markets. Information arrives at random, and when
it arrives, markets react. Sometimes new information shows that former assessments were wrong, and
sometimes the subsequent market reaction is so strong that it threatens the stability of the financial
system.

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The probability that market participants assess the situation so incorrectly that new information leads
to a financial crises is higher on markets with a low level of transparency. Because markets do not
always provide the necessary information, government bodies try to fill this gap. The central bank and
the supervisory agencies provide information about the financial situation of the financial markets and
their participants. Especially the financial situation of the government (government debts, tax
revenues or currency reserves) is often well documented by the country's central bank and by the IMF.
Supervisory agencies use early warning systems in order to assess the financial stability of markets.
These early warning systems are indices that portray economic imbalances that can lead to a financial
crisis. Major market participants use their private early warning systems for the same purpose but
would never publish the results. The use of early warning systems to prevent financial crises can have
the opposite effect. This paradoxical situation can occur when the official institutions (either the
national central bank or the IMF) published the results of their market assessment in order to warn the
governments and the market participants of the likelihood of a financial crises. This official warning
can be the crucial information for the market participants that finally triggers the financial crisis (and
without the official warning perhaps nothing would happen). The assessment of rating agencies,
which provide financial information and assessment of markets to their clients, can have a similar
effect. That is why their crucial role during the Asian crises was so controversial.

Crisis management
When a financial crisis happens, it depends on the financial authorities whether or not the crisis
becomes serious and whether or not it spills over to other sectors of the economy. The central bank,
for example, can support a market in times of crisis as a "lender of last resort". This means that when
financial difficulties occur, the central bank provides liquidity and prevents market participants from
becoming insolvent. At the international level, states are also market actors who can face financial
difficulties. Often the International Monetary Fund (IMF) acts as a lender of last resort by providing
credits to governments.

The paradoxical effects of crisis management

The existence of a lender of last resort, however, can create an incentive problem. The more certain
economic actors become that they will be helped in an emergency, the more risks they will take when
investing. The result is that it becomes more likely that the lender of last resort actually has to lend.
This problem has already been discussed as the moral hazard-principle in insurance: The more
insurance one has, the less motivated one is to be careful. For this reason, monetary authorities
usually leave some doubt as to whether they will rescue markets and banks in difficulty. The dilemma
for the International Monetary Fund is that it cannot renounce its de facto function as a lender of last
resort. The economic and social consequences of financial crises can be so tremendous that an
inactive IMF could not stand the public pressure.

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An additional problem of lending in times of crisis is that observers often cannot

assess how severe a crisis has already become. If the crisis has already gone too
far, additional lending is like throwing money away.

The Financial Stability Forum

One of the few concrete measures adopted in response to the `Asian crisis' was the establishment of
the Financial Stability Forum (FSF) in 1999 on the initiative of the G7. At a summit in Cologne in
June of that year, the G7 governments agreed that one of the main causes of the crisis had been the
poor financial systems in Asia. They formulated their response as follows:
Our overall strategy is to identify and put in place policies to help markets work properly and to
provide the public goods necessary to achieve this objective. This requires public authorities to
provide for enhanced transparency and disclosure, improved regulation and supervision of financial
institutions and markets, and policies to protect the most vulnerable. It also requires that private
creditors and investors bear responsibility for the risks that they take, and are involved appropriately
in crisis prevention and crisis management. In these respects, the establishment of internationally-
agreed codes and standards for policy-makers serves both as an incentive for better governance and as
a yardstick against which to measure country risk.
Final communiqué of the G7 Finance Ministers summit, Cologne, June 1999

The FSF was to coordinate this task in a number of ways, including through the compilation of a
compendium of Standards and Codes for financial systems. A wide range of institutions contributed
to the compendium, including the World Bank, the IMF, the OECD, and the International
Organization of Securities Commissions, as well as more obscure ones like the Committee on
Payment and Settlement Systems. These institutions formulated best practices for the governance of
financial markets. The IMF's task is to report whether countries comply with these rules. To this end,
the IMF publishes Reports on the Observance of Standards and Codes (ROSCs). Global financial
institutions and investors, the idea goes, can use the reports to assess the stability of a country's
financial system before investing there. Countries that fail to comply with standards are `punished' for
their non-compliance by investors who demand extra-high interest rates to insure themselves against
risks resulting from financial system weaknesses.

Some have criticized this procedure. Critics argue that it puts the blame on countries affected by
financial instability, rather than on investors and speculators that might be responsible for the
instability. Many academics, as well as some investors themselves (notably the famous George Soros)
rather see things the other way around. Furthermore, the FSF initiative has been accused of spreading
`Western' ideas about financial market governance around the world. Critics see the initiative as an
attempt to establish Western economic, and ultimately also cultural, hegemony.

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In addition to compiling the Compendium, the FSF has set up a number of working groups on a
variety of issues. The significance of some of these for global financial stability is poorly understood.
Among others, there are working groups on offshore financial centres such as the Caymans and the
Bahamas, and on `highly leveraged institutions'—a technical term for what are normally called hedge
funds.

Conclusion
Even though some progress has already been made in reforming the international financial
architecture, much more still has to be done. But despite all efforts, financial crises will always
happen. The dependence of economic actors on information (which is normally incomplete) makes
them vulnerable. Information arrives at random, and when it arrives, markets react. Sometimes new
information shows that former assessments were wrong, and sometimes the subsequent market
reaction is so strong that it threatens the stability of the financial system. Financial crises are
unavoidable, and therefore a panacea does not exist.

PfP ADL- WG, 2005 generated from a PfPLMS 0.2 learning object