Reforms need to start from three tenets: adopting a system-wide perspective explicitly aimed at addressing market failures; understanding and incorporating into regulations agents’ incentives so as to align them better with societies’ goals; and acknowledging that risks of crises will always remain, in part due to (unknown) unknowns – be they tipping points, fault lines, or spillovers. Corresponding to these three tenets, specific areas for further reforms are identified. Policy makers need to resist, however, fine-tuning regulations: a “do not harm” approach is often preferable. And as risks will remain, crisis management needs to be made an integral part of system design, not relegated to improvisation after the fact.
The paper begins by reviewing the most common explanations for the recent financial crisis, which tend to stress both causes common to many other, past financial crises and a set of new causes. The exact weight to put on each of these causes is not clear, however. It also briefly reviews the main financial reforms, highlighting the areas where progress has been greatest.
Section three frames the overall challenges in developing policies that will prevent future crises, considering three perspectives: taking a system-wide view and addressing market failures and externalities; improving incentives at all levels (i.e. including market participants, other monitors, and supervisory agencies); and improving data and analyses to reduce the unknowns. It recognises that these general principles do not suffice to determine specific reforms. It thus ends by suggesting specific further steps that can be undertaken, within all the constraints, to improve financial policy making. That said, the report does not flesh out specific reforms, but simply intends to provide ways in which the principles could be met.
The next section assesses progress in three areas corresponding to the perspectives identified in the previous section: first, pursuing a system-wide view – adopting macro-prudential policies, reducing procyclicality, and addressing the shadow banking and OTC derivatives markets; second, encouraging more prudent banking, reducing the too big to fail problem, improving regulatory governance, and achieving better international financial integration; and third, getting more data and conducing better analyses. Unfortunately, rigorous theoretical analysis of recent and historical experiences remains in short supply, as does relevant evidence about the impact that various new regulations and requirements have on the risks of new financial crises. As a result, the authors caution that in designing reforms, policy-makers have to be more explicit about the analytical, practical and data constraints, and the many remaining known unknowns and unknown unknowns. The section ends therefore with a (sober) message: given the likely inability to prevent all future financial crises, there is a need to enhance crisis management and resolution as part of the ongoing reform agenda.
The last section concludes with some general lessons.
See also: Financial Crises: Taking Stock
© International Monetary Fund
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