The Independent Evaluation Office (IEO) found major IMF lapses in judgement before the financial crisis, including the promotion of “light-touch regulation”, casting doubt on the Fund’s ability to contribute to taming global finance. As the banking crisis has been transformed into crises of public finance, and while the financial sector returns to business as usual, the IMF has grown increasingly vocal about the insufficient attention being paid to regulation and reform. Analysts ask if we should be looking elsewhere.
The IEO report IMF performance in the run up to the financial and economic crisis, released in early February, covered the work of the Fund from 2004 through 2007. It found that “the IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not ‘connect the dots’ or ensure follow-up also played an important role, while political constraints may have also had some impact.”
The report analysed IMF multilateral surveillance and bilateral oversight of 40 countries, including those with financial centres and the G20. As examples of how “the IMF missed key elements that underlay the developing crisis” it highlighted poor analysis of the US financial system, of which IMF staff were “in awe”. According to the IEO, “the IMF praised the US for its light-touch regulation and supervision that permitted the rapid financial innovation that ultimately contributed to the problems in the financial system. Moreover, the IMF recommended to other advanced countries to follow the US/UK approaches to the financial sector.”
In setting out recommendations, the report roundly criticised previous reform of internal governance of the Fund (see Update 65, 61, 51), “The IMF expressed the need for similar steps after previous crises, but some of them were not implemented at that time and the results of others have not been as positive as had been hoped.” And in a swipe at the unwillingness of the IMF to accept independent evaluations, the IEO professed “the need to address weaknesses in IMF governance, a recurrent theme in IEO evaluations”. It also made numerous suggestions related to remedying the “insular culture”, “silo behavior and mentality”, and “actively seek[ing] alternative or dissenting views”.
Rhetoric on regulation
The IEO report comes in the middle of the IMF’s push on financial regulation, so it is unclear how influential it will be. In 2010, managing director Dominique Strauss-Kahn started to argue for deeper and more systemic financial reform. In his speech at the October IMF annual meetings, he said: “We will fix the financial sector. We will create new rules, have a safer financial sector. We promised a lot; we didn’t deliver enough.” Again in December, he warned: “The next step is to deal with the regulation of non-bank financial institutions,” admitting “we are not moving fast enough in this area.”
In very modest tones, the IMF staff have admitted that they failed in the run up to the crisis. An October 2010 IMF staff position note on Shaping the new financial system – which reflects staff opinion but has not been endorsed by the executive board – argues that “it is now widely recognized that in the run-up to the crisis, there was a significant under-appreciation of systemic risk.” That assessment implicitly includes the IMF. The position note also contains a fundamental critique of the size and shape of the finance sector. The note finds it “distorted”, “opaque”, “over-leveraged” and says that “an increasingly large portion of financial activity did not seem to serve the needs of the real economy.”
The staff position note, lead authored by the head of the IMF’s monetary and capital markets department José Viñals, goes on to complain that so far G20 activity has been “centred on fixing identifiable problems in each market, without a holistic approach.” It recommends “enlarging the regulatory perimeter”, imposing “systemic capital surcharges and levies”, “heightened oversight” of credit ratings agencies and more “accurate and timely reporting and public disclosure.”
“One important limitation of the IMF’s approach is that it does not see financial globalisation per se as a problem,” says Fernando Carvalho of the Federal University of Rio de Janeiro. “Rather, in the view of the Fund, reforms in financial regulation should be limited to avoid losing the ‘gains of financial de-regulation and globalisation’, which means that in no way will the proposed reforms address the deeper causes of the 2007 crisis.”
Global rules or national space?
The IMF staff position note also argues for greater global cooperation on regulation, saying that “if they are allowed to develop piecemeal, a de facto fragmentation of global financial markets could lead to regulatory arbitrage and a build-up of systemic risks in countries or regions where such measures are absent or oversight is lax.”
In July 2010, the IMF discussed a framework for enhanced coordination of cross-border bank resolution. The policy paper for that discussion set out a range of options for dealing with failing banks, including an international treaty for cross-border bank resolution, a non-binding framework for “enhanced coordination”, and the de-globalisation of financial institutions. The IMF board “recognised that the ‘de-globalisation’ of financial firms could, to some extent, alleviate the problem of the absence of an international resolution regime,” but argued against this approach because it would “likely entail efficiency losses”, a position supported by the staff report. This is despite repeated research findings that financial globalisation produced no discernable positive impact on economic growth (see Update 68, 61, 35). The board agreed that the staff should pursue, in conjunction with financial regulators, a non-binding system of enhanced coordination.
“The international approach to regulation needs to differentiate between systemically significant financial systems that exist in most large rich economies and systemically insignificant ones in most of the poorer developing countries,” said Sony Kapoor, managing director of Brussels-based think tank Re-Define. “Problems in the US financial system triggered the global financial crisis whereas a collapse of the Zambian financial system, had it occurred, would have had few effects outside of the country. There is a need for a special differential treatment of developing countries where they should have the ability to develop regulatory regimes best suited for local circumstances.”
Middlesex University’s Ricardo Gottschalk, a critic of the impact of past global financial standards on developing countries, agreed “that we may end up with the old problem of ‘one size fits all’ approach, which may not be suitable in a world where countries are still so diverse and at different stages of development. Each country needs its own space to design its financial regulation and capital account management policies to ensure their domestic financial systems support the productive sectors and the SMEs, and to avoid the macroeconomic destabilising effects of short-term capital flows.”
IMF searching for a new role?
Many have questioned whether the IMF is trying to take on a financial regulatory role. While Strauss-Kahn has led from the top, it is not clear how effective the IMF is in pushing its point of view in the global circles where regulatory rules are now being set. Most financial regulatory policy is now negotiated at the Basel-based Financial Stability Board (FSB), a body with little staff capacity and where most of the work is done by committees of officials from member countries (see Update 65, 63).
Since the publication of the staff position note the IMF board has been discussing a number of papers that set out ideas and policy lines on financial reform. Most of these discussions are based on staff papers that are being considered in “informal discussions”. This means the IMF will not take an institutional view on the topics, but will spend a lot of time debating them at the board. Topics included “the organisational structure of cross-border groups and the implications for financial stability”, “the challenges with ‘too-important-to-fail’ institutions”, and “tools for the management and resolution of financial institutions”. Because they are being held as informal discussions, there is no summary of the board’s opinions, so it is impossible to know the thrust of the debate or how influential the IMF discussions are when it comes to decisions at the FSB.
One of the few policy papers with a formal board discussion was on so-called financial interconnectedness. The paper set out to “ma[p] some aspects of the architecture of global finance and investigat[e] a set of critical ‘fault lines’ related to interconnectedness along which systemic risks were built up and shocks transmitted in the crisis.” The IMF board formally agreed in November 2010 that it should conduct more analysis of “financial interconnectedness”, but that “the objective of such analysis should be to enhance macrofinancial assessments of risks.” Inevitably that will involve assessing the financial threats alone to determine which are related to macroeconomic risks. This is very similar to what any global financial supervisory body would need to do to manage systemic financial risk.
Would the IMF like to be actually implementing the comprehensive framework of regulation and supervision that it continually calls for? In November, Viñals said that because financial institutions could move their operations to low-regulation jurisdictions, “there will certainly be a need for international consistency. … Given its all but universal membership, surveillance mandate, and financial sector expertise, the IMF can be helpful in facilitating this task.”
Carvalho countered that “in the informal division of labour before the crisis, the IMF was supposed to act more or less like a financial supervisor, … now the Fund wants to upgrade its role to financial regulator. At first sight, it would be a change for the better, given the near-universal membership of the Fund, in contrast to the exclusive world of the FSB. However, the different voting weights of each IMF member strongly biases the institution in favour of whatever richer countries wish. Moreover, by both training and experience the Fund staff has always shared the view that the Anglo-Saxon model of capitalism is superior to all its alternatives. So no significant change is to be expected.”