Role of the IMF in the global financial crisis.

• Author: Xafa, Miranda

More than two years on, the impact of the financial crisis that erupted in August 2007 is still being felt as the global economy emerges from the Great Recession. The crisis intensified dramatically after the bankruptcy of Lehman and the rescue of insurance giant AIG in September 2008, which narrowly avoided a near-simultaneous failure of multiple counterparties. The International Monetary Fund's early forecast of the severity of the resulting economic downturn (IMF 2008a) helped mobilize concerted official action to address quickly and forcefully these extraordinary economic and financial events by providing fiscal stimulus to sustain growth, as well as capital injections and guarantees to ease the credit crunch. Following the emergency summit of G20 leaders in Washington in November 2008, support packages for banks were put together in a hurry in the United States, Europe, and elsewhere to prevent the disorderly failure of systemically important institutions and to restore confidence in the financial system.

These unprecedented interventions prevented a meltdown and contributed significantly to signs of economic and financial stabilization since the spring of 2009.

In this article, I review the role of the IMF in the global crisis and argue that the Fund has emerged as a powerful institutional force, providing analysis and recommendations that have served as the basis of official action on several fronts. By contrast, the Fund was barking up the wrong tree when it focused its attention on the global imbalances and adopted the Surveillance Decision in the run-up to the crisis in 2006-07.

IMF Policies and Reforms in Response to the Crisis

The Fund helped shape the global policy response through its policy advice and spot-on analysis of global economic and financial conditions, contributing to the process of modernizing the global financial architecture. It was also quick to adapt its own surveillance activities and lending policies in response to the crisis.

Lessons of the Crisis For IMF Surveillance

The root cause of this crisis was the buildup of systemic risk due to regulatory and supervisory failure that was not adequately captured by the Fund's surveillance framework. The crisis has clearly demonstrated the need to improve the existing framework for assessing financial stability and to reinforce early warning capabilities in the advanced countries as well as globally. The global reach of the crisis also gave rise to calls for improved monitoring of cross-country spillover risks and their potential macroeconomic impact. At its October 2009 meeting, the International Monetary and Financial Committee (IMFC) recognized that a reassessment of the Fund's role was in order and called on the Fund to review its mandate "to cover the full range of macroeconomic and financial sector policies that bear on global stability, and to report back to the Committee by the time of file next Annual Meetings" in 2010 (IMFC, 2009a). At the Committee's request, the Fund distilled the initial lessons even as the crisis was still unfolding (IMF 2009a) and is in the process of revising its policies and governance accordingly.

Global Financial Stability

The Fund's Global Financial Stability Report (GFSR), published semiannually since 2003, assesses key risks facing the global financial system highlighting policies that can help mitigate systemic risks and enhance financial stability. In the Run-up to the crisis, the GFSR warned about rising credit and market risks associated with the growth in subprime mortgages embedded in complex, hard-to-price structured products (IMF 2006 and 2007a). Similarly, the World Economic Outlook (WEO) flagged some early concerns about the risks of house price bubbles in the United States and the dangers from large current account deficits in emerging Europe (IMF 2007b). However, the focus of this advice was not sharp enough to prompt policy action, and policymakers in the still-booming global economy were less receptive to the warnings. The fact that the crisis originated in the advanced countries, normally outside the purview of the Fund's crisis prevention efforts, contributed to complacency. A more evenhanded surveillance would have enhanced the Fund's effectiveness and legitimacy by bringing about a better balance between peer protection and peer pressure.

After the onset of the crisis, the Fund provided valuable policy recommendations for policymakers, regulators, and standard setters based on sharp analysis of the origins and likely consequences of the global financial crisis. The priorities identified in the GFSR were explicitly recognized in the G20 Communique at the Pittsburgh summit in September 2009. Proposed solutions were geared to resolving conflicts of interest, improving risk management, reducing procyclicality, filling information gaps, dealing with distressed assets, and unclogging the credit channel. The Fund stressed the need for policymakers to follow up on emergency policy responses to the crisis with macro-prudential and regulatory reforms aimed at malting the global financial system less crisis-prone. (1) The key objectives are to broaden the perimeter of regulation to include all systemically important institutions (both banks and nonbanks), to keep track of leverage in the system, and to make monetary policy more responsive to asset bubbles. (2)

The Fund helped shape the policy response by analyzing the relative roles of demand and supply factors in explaining the sluggish pace of credit growth, estimating bank write-downs by region based on a common methodology, and assessing the impact of extraordinary government support through guarantees and recapitalization. Its analysis showed that the "originate and distribute" model of credit creation was a sound business model that stumbled on poor implementation, as the risks were kept in structured investment vehicles (SIVs) instead of being widely spread. Restarting securitization markets would help unclog the credit channel by freeing-up bank balance sheets, while helping central banks exit from exceptional liquidity support provided by swapping (or buying outright) asset-backed securities. At the same time, the Fund 'also warned that the process of financial sector and household deleveraging has yet to run its course and that further write-downs are in store as losses are not yet fully recognized (IMF 2009b, 2009e).

Macro-Prudential Framework

The failure of regulation to address the buildup of risks in the shadow banking system has amply demonstrated the need to expand the perimeter of regulation to a wider range of systemically important institutions and markets, including off--balance sheet derivatives that turned out to be so important in the recent crisis. The Fund has made important analytical contributions to the measurement of "interconnectedness" and systemic risk that can help define the perimeter of regulation, while warning against a "rush to...