by Don Alexander, MBA
Associate, RSD Solutions Inc.
Five years have passed since the onset of the financial crisis and there is little agreement on the root causes or potential indicators of rising financial system stress. Erlend Nier and Ouarda Merrouche address a number of these issues in a recent (25th March) VOXEU communique called The global financial crisis – What caused the build-up?
Nier and Merrouche, IMF economists, summarize some of their recent research. They start off asking a couple of questions: did central banks keep policy rates too low too long? Or were rising global imbalances the underlying cause of the crisis? The answers to these questions are important to help contain and prevent the build-up of systemic risk.
The authors noted the following results: net capital inflows can account for the differences between countries in the build-up of financial imbalances, the compression of the spread between long and short rates contributed to the rise in leverage and balance-sheet expansion, a weak supervisory and regulatory environment along with macroeconomic factors added to financial system stress and the relative importance of external imbalances relative to monetary policy.
Their research suggests that net capital inflows, rather than monetary policy stance, emerges as the key determinant of differences in the growth of financial imbalances across OECD countries over the pre-crisis period.
Capital flows along with weak regulation and supervision were the key drivers of the financial crisis. The authors note that inadequate prudential policies failed to address systemic problems by over-reliance on wholesale funding. The financial crisis corresponded with a sustained period of low interest rates globally, but the path of monetary policy (different across countries) was not a main contributor to the build-up of financial imbalances. This suggests caution against a re-orientation of monetary policy frameworks in response to the crisis.
The lesson for policymakers and regulators is the need for effective macroprudential policy tools and effective/efficient regulation. Otherwise, the use of the wrong policy options combined with over-regulation may result in rising systemic risk and increased contagion.
For more on this follow the link: http://www.voxeu.org/index.php?q=node/7774
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