by Don Alexander, MBA
Associate, RSD Solutions Inc.
A key question for risk management: do you have the correct framework to analyze risks. This is a question that Claudio Borio & Piti Disyatat (Bank for International Settlements) ask in a recent VOXEU communiqué “Did Global Imbalances Cause the Financial Crisis?” about international policymakers? The authors note the emphasis on current-account imbalances diverts attention away from monetary and fiscal factors that sowed the seeds of destruction leading to the underestimation and mispricing of risk.
A key part in G20 and IMF discussions was the role of financial imbalances in causing the recent financial crisis. The focus on savings-investment balances, current accounts and net capital flows may be flawed. The authors suggest that other factors should be considered as causal factors and could provide a better understanding of the process and linkages.
The authors object to two key policymaker assumptions: (1) net capital flows from current-account surplus to deficit countries helped finance credit booms; and (2) a rise in savings relative to investment in surplus countries depressed global rates. The authors argue that global imbalances, which measure net flows, provide little evidence about global financing patterns based on the surge in gross capital flows that was largely between advanced countries. These flows increased from 10% of world GDP in 1998 to 30% in 2007 and were driven by flows between advanced countries. The surge in US gross capital flows involved developed areas not running a current account surplus and was private in nature. Net capital flows do not capture the disruptions created by 2008’s collapse in cross-border lending. Excess savings or the unwinding of global imbalances did not trigger the crisis; disruptions in the chain of global intermediation did.
Their second critique is that the excess-savings view provides an incomplete explanation of low global rates. Market interest rates reflect both monetary and financial factors: central bank policy rates, risk premia, market expectations, and supply and demand for assets. These factors interacting with artificially low policy rates contributed to the turmoil.
The authors conclude that global imbalances offered little explanation about the global intermediation process behind the credit boom or how contagion is transmitted. The international monetary and financial system lacks a strong policy framework to prevent future credit bubbles and asset booms. The authors suggest that without a better understanding of the analytical framework, policymakers could be prone to policy errors, faulty assumptions and flawed risk estimation.
Do you have the correct framework in place to understand potential risks?
The first author, Claudio Borio, was one of the first to note a rise in systemic risk at a presentation at Jackson Hole in 2003.
http://www.voxeu.org/index.php?q=node/6795
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