IMF’s approach to financial regulation “behind the curve”

5 April 2012

While the IMF’s strategic plan for boosting its financial sector surveillance has not been published, the Fund continues to argue that developing countries need more liberal financial systems.

Since the financial crisis, the IMF has been trying to boost its work on overseeing risks from the world’s financial system (see Update 78, 74). The IMF’s strategic plan for financial sector surveillance was due to be discussed at the executive board in February, but neither a date for the actual discussion nor any policy papers were released publicly.

An October 2011 IMF staff discussion note, Financial deepening and international monetary stability, is the only indication of how the IMF plans to give advice on financial reform. The paper seeks to “shed light on the role of financial deepening in promoting the stability of the system as a whole”, by analysing the financial ‘depth’ of advanced and emerging economies over the past 20 years. Depth is defined simply as the size of economies’ balance sheets – “the total financial claims and counterclaims of an economy, both at home and abroad.” This makes financial depth analogous to a measure of debt in an economy.

The paper argues that “in stark contrast to average real incomes, which have been converging, financial depth has been diverging,” with advanced economies becoming more indebted, with a rapidly growing financial sector compared to the real economy. In contrast, the financial sector in emerging markets, which have been far more successful in terms of economic growth over this period, expanded “at a more measured pace.” The paper also noted that emerging markets have not focused on growing the size of their capital markets and “remain largely bank based” – something IFIs have advised against for some time – advice that was repeated in this paper.

Despite those observations, the paper argues that “financial deepening in emerging markets can bring important benefits”, and justifies this with data that “the frequency of crises” declines with deepening. However, the data analysis fails to consider that fewer emerging markets are considered financially deep, biasing the analysis of the frequency of crisis, and skates over the fact that the worst financial crises in the last century started in countries with the deepest financial markets. Conversely, in early March IMF deputy managing director Min Zhu argued that “debt levels are excessive in many financial systems.” The paper does recognise that “policies to build reserve buffers, manage capital flows, and limit exchange rate flexibility may bolster stability at the country level”.

The IMF’s first Consolidated spillover report (see Update 78), published in October 2011, calls for Europe and the US to sort out their financial regulation, saying that “given the importance of financial channels in the propagation of global shocks, and the centrality of US-UK-European financial core, stronger and more coordinated regulation in the core is essential.” However the IMF fails to assert itself, mainly confining its criticism of the US to having “unclear” plans for the implementation of financial sector reform. This analysis about the failure of regulation in advanced economies is not tied in with the analysis on financial deepening. The IMF does not consider that the deepening itself may instigate both regulatory capture and subsequent regulatory failure, leading to financial crises.

It is unclear in which direction the IMF will try to push the debate over the depth of financial markets since the surveillance plan has not been made public. Ilene Grabel of the University of Denver, said “the IMF is about 10 years behind the curve in realising that excessive financial sector deepening presents many more risks than potential benefits. The IMF should be using its surveillance to advise against greater financialisation of economies and to make a clear case for serious re-regulation of the financial sector, including the shadow banking sector.”