John Lipsky, Senior Fellow, Johns Hopkins School of Advanced International Studies; former Acting Managing Director, International Monetary Fund; former Vice Chairman, JPMorgan Investment Bank; former chief economist, JPMorgan Chase.
Has the experience of the crisis changed your view of the central bank policy toolkit?
Managing Director Lipsky: In many ways, the onset of the Global Financial Crisis (GFC) underscored earlier views about central banks’ policy roles and policy options. At the same time, recent experience highlighted both the expanded policy agenda currently facing central banks, as well as the inevitably individualized nature of the responses of any single monetary institution to a specific set of practical challenges. The justified but unsatisfactory conclusion at this time is that – like the process of financial sector reform – the post-Crisis reassessment of central bank policy is far from complete or conclusive. To the contrary, it remains a substantially unfinished business.
First, the traditional – and crucial – role of the central bank as a lender of last resort has been reaffirmed. This will come as no surprise, however, as the past two decades provided numerous important demonstrations of the traditional view that central banks have the unique responsibility – as well as the ability – to prevent dangerous and damaging bouts of market illiquidity. In fact, the conventional admonition that central banks should respond in such circumstances with clarity and decisiveness has been justified repeatedly.
The growth in non-bank financial intermediaries and in cross-border exposures during the two decades prior to the GFC – together with the enhanced supervisory responsibilities that have been assigned to many monetary authorities – inevitably has broadened these institutions’ responsibilities, either in a de facto or a de jure manner, thereby affecting their policy toolkit. In particular, these developments have been associated with a growing preoccupation of monetary authorities with financial stability concerns. This has taken central banks beyond simple inflation goals and their traditional deep interaction with the banking system, regardless of their formal mandates.
For example, interest has been widespread in developing macroprudential policies – and in several key cases, macroprudential policy formulation either has been assigned directly to, or with the participation of, monetary authorities. Of course, there is of yet no broad consensus about exactly how such policies should be formulated, or even about exactly what policy tools they should encompass.
The growth in cross-border financial exposures, and of cross-border economic linkages in general, has placed a much greater burden on international policy cooperation. This is an extremely sensitive subject for monetary authorities, as there is limited agreement among practitioners on the terms and even on the potentially beneficial scope of such cooperation. Moreover, there is no explicit mandate for such actions, and there is a deeply held and traditional view among many experts – justified or not – that if every monetary authority just “stuck to its own knitting”, that the result would be every bit as positive as the outcome that could be obtained through any potential effort at explicit cooperation.
Nonetheless, the widespread claim that some key central banks recently have been attempting to influence exchange rates under the guise of domestic monetary policy action has underscored that in practice, the issue of international cooperation is far from moot. In fact, the post-Crisis expansion of the G20 process to the Leaders level has increased the frequency and importance of the gatherings of the G20 Finance Ministers and Central Bank Governors. At the same time, creation of the Financial Stability Board has brought many more central banks to the “top table” of international discussions of financial sector regulation and supervision. Finally, the 2009 expansion of participation in the Basel Committee on Banking Supervision (the BCBS – usually known as “The Basel Committee”) resulted in the inclusion of all G20 members, while the associated widening of the membership of the BIS has broadened the attendance at the regular, Basel-based policy discussions among central bank governors. Whether these developments should be viewed as new policy tools remains to be seen. However, it seems self-evident that market stability is enhanced when financial market participants sense that key monetary policymakers are following a coherent and mutually consistent set of policies.
Interestingly, it is the actions of central banks when confronted post-Crisis with wide margins of economic slack, weak output growth, limp credit expansion and very low inflation that has attracted the most attention and generated the most controversy. With all the central banks that issue key international currencies effectively still at the zero lower bound for policy interest rates seven or eight years after the onset of the GFC (depending on when one sets the starting date), the unprecedented expansion of their balance sheets through a variety of novel means has been viewed alternatively as the wise and creative continuation of their traditional policy roles, or of dangerous and uncertain ventures into unknown territory. Critics typically assert that the combination of sustained super-low policy rates – together will large-scale asset purchases – are creating asset bubbles that will deflate in the future in a damaging fashion.
That there is so much disagreement on the counterfactual – “Where would we be if they hadn’t undertaken these actions?” – and reflecting the ongoing uncertainty about the disposition of the unprecedented central bank asset holdings, we are a long way from being able to draw definitive conclusions about the future content of “tested and approved” central bank toolkits. As a result, the debate about the recent applications of quantitative easing (or whatever term one might apply to the huge expansion of central bank balance sheets) likely will extend for some time to come. With luck, we will never again face the same set of challenges. With virtual certainty, we will face new ones.
From today’s perspective, central bankers in the future likely will once again be willing to do “Whatever it takes.” But perceptions about the content of “Whatever it takes” no doubt will depend on how successful current policies will be deemed to have been, and on the future shape of global markets, specifically, the relative role of banks versus capital markets.
Where should we be looking for financial stability risks?
Managing Director Lipsky: The theme here is straightforward: The systemic repairs that were deemed to be necessary in the wake of the crisis’ onset remain unfinished, seven years after the most dramatic point in the GFC – the September 2008 collapse of Lehman Brothers. By November of that year, the newly formed G20 Leaders, in their first Summit meeting, agreed on a four-part agenda of post-Crisis actions: 1) To halt the economic downturn and to restore economic growth; 2) To repair and reform the international financial system; 3) To prevent new trade protectionism and to promote new trade liberalization; 4) To reform the International Financial Institutions (with a special focus on IMF governance and resourcing). Nearly seven years after that Agenda was set, none of these policy goals has been achieved. Just as attaining these goals would reduce financial stability risks, failure to do so implies that such risks remain relevant.
With regard to financial sector reform, it was obvious to all in 2008 that the system was undercapitalized. According to IMF analysis at the time, the GFC reflected four additional basic weaknesses; 1) Weak regulation – in particular, that many systemically important institutions existed outside the perimeter of effective regulation, creating incentives that produced systemic fragility; 2) Weakness in supervision – as exemplified in the Senior Supervisors Group report in October 2009 (in other words, after the fact) noting that most of the systemically important financial institutions had risk management processes that were inadequate to deal with the risks that they had been incurring; 3) Lack of clear and adequate resolution mechanisms, especially with regard to institutions operating in multiple jurisdictions, making too-big-to-fail concerns relevant; 4) Incomplete assessment processes that would insure that agreed reforms in fact were implemented in a satisfactory fashion.
As judged by these standards, the reform effort – carried out in large part under the auspices of the newly formed Financial Stability Board – has made substantial progress in some areas, but still is far from complete. In particular, new bank capital standards are being implemented, but the regulation of non-bank intermediaries remains a work in progress. In addition, the reformed system – such as it is – remains relatively new and untested. The U.S. reforms under Dodd-Frank remain unfinished, and in any case retain the complex and fragmented network of state and federal authorities that existed previously. If anything, the post-GFC US system has become more complex, not less. In the Eurozone, the creation of the Single Supervisory Mechanism under the European Central Bank is less than a year old, and the reorganization of the UK’s system once again under that Bank of England also is new.
Progress on resolution remains a work in progress. The G20 Leaders’ admonition that the financial sector should be made responsible for the funding of its own resolution needs is not yet implemented generally. Cross-border resolution regimes are not yet agreed, let alone implemented. Only in assessment has there been notable progress: G20 members have agreed to host an IMF/World Bank Financial Sector Assessment Program (FSAP) examination at least every five years, thus providing for an independent systemic assessment, while FSB members have established a peer-review process, utilizing FSAP results as a key input.
Other aspects of note include the pending assignment of trading in standardized derivatives contracts to newly created central clearinghouses. Of course, while intended to enhance confidence in market liquidity, this development at the same time creates a new reliance on the analytical skills and the capital solidity of the clearinghouses. Previously, the responsibility of end-risk takers to conduct their own due diligence on the solvency of their counterparties was clear-cut. That this discipline failed spectacularly in the case of AIG Financial Products is obvious. However, some participants had conducted the needed analysis, thus avoiding unsafe exposures. Under the new construct, market participants will have to rely on the clearinghouse.
There is little doubt that international financial intermediation is less liquid and effective than it was prior to the crisis. The effort at “ring-fencing” banking systems reflects an effort to insure that individual country markets are more stable, but it isn’t clear to what degree this will enhance overall financial stability internationally, as it will continue to encourage the deleveraging of banks, and the migration of credit to non-bank institutions. At the same time, the drive to eliminate money laundering and the financing of terrorism has resulted in the severe shrinkage in many international banks’ correspondent networks, thus making traditional trade and other finance much more difficult in some less developed economies.
Finally, it appears – at least from superficial observation – that economies where securities markets take the lead role in fund raising have performed better than those that are more reliant on traditional bank lending. One possible (at least partial) explanation could be that market-based systems force relatively more rapid recognition of changes in asset valuations resulting from changing economic and other circumstances. While this may tend to sharpen short-term strains, one result is enhanced market liquidity and more agile deployment of productive assets.
What do we need to do to preserve the benefits of global finance?
Managing Director Lipsky: The G20 Leaders’ Agenda – if and when attained – would notably improve the performance of the global economy in terms of growth, balance and stability. Undoubtedly, this would add to the scope for global finance to enhance economic performance. It should be noted that the G20 Leaders made clear assignments regarding the responsibility for completing each of the four key agenda entries.
To restore global growth, the G20 Leaders created the Framework for Strong, Sustainable and Balanced Growth, to be implemented via a Mutual Assessment Process (or MAP) to be conducted by a Framework Working Group constituted at the Deputy Minister/Deputy Governor level. The Working Group was tasked with developing country-specific and mutually consistent Action Plans of economic initiatives and reforms. At their Brisbane Summit last November, the Leaders pledged to implement measures that would increase global GDP by 2% by 2018 relative to the then-existing baseline forecast. It is far from clear at this point whether this worthy goal will be attained, or whether the political commitment even exists to implement the specific measures included in the Brisbane Action Plan that was endorsed by the Leaders.
To reform and repair the financial system, the Leaders mandated the creation of the Financial Stability Board. Trade issues were assigned to the WTO. And the G20 Leaders approved a specific set of IMF reforms at their November 2010 Seoul Summit. As I mentioned previously, none of these agenda items can be viewed as completed, or even close to complete, at this point. But their attainment would substantially enhance both global economic performance as well as the benefits of global finance.
Four other challenges remain relevant for enhancing global economic performance. First is the need to overcome the current strains in the Eurozone, and to enhance the stability and growth performance of the entire European Union. Second is the successful implementation of China’s planned economic reforms, including the internationalization of China’s currency, the RMB. Third is the peaceful stabilization of the Middle East, and the reduction of potential threats to stability in international energy markets, among other aspects. Finally, there is the challenge created by Russia’s actions with regard to Ukraine and the resulting sanctions and troubled relations between Russia and the G7 and other countries. The G20 Leaders Process was created in a spirit of global cooperation. Ongoing and significant tension and conflict among key G20 members can’t be helpful in promoting global progress and the benefits of globalization in general, and of global finance in particular.
A fifth, and long-term, challenge – climate change – will receive high profile this year, as the UN’s Climate Change Conference (COP21) convenes in Paris in December. The financial implications of effective action regarding climate change mitigation potentially are enormous, and they are global in nature. There is no way that this challenge can be addressed in a serious way in the absence of an effective and appropriate global financial system.