Tuesday, July 22, 2008
A year after the U.S. financial crisis surfaced, the Bank for International Settlements (BIS) has explained its causes and ramifications. The BIS has for long spoken of the dangers in unbridled credit expansion and asset price inflation, two interrelated factors that are at the heart of the crisis. The current market turmoil in the main financial centres is without precedent in the post-war period. There is a significant risk of recession in the United States, while many c ountries are ravaged by inflation. There are genuine fears that the global economy might be at some kind of a tipping point. The factors responsible for the crisis are well known: loans of increasingly poor quality were made and sold to “the gullible and the greedy.” The latter relied on leverage and short-term funds to boost their profits. The sheer opacity of the process has made it difficult to determine the final location of the risks. The loans were securitised and widely distributed. In many instances, it is difficult to determine who owns them and how much these are worth. Obviously internal governance and outside regulation failed. Even so it is surprising that such a huge “shadow banking” system that should normally cause concern could emerge and stay out of sight of any regulatory body. There are still substantial risks from the crisis. The world economy is poised between deflation caused by the financial crisis in the U.S. and an inflationary global commodity price boom. There are heightened uncertainties everywhere and no one seems to have the right answers.
It is the view of the BIS that central banks should tighten monetary policies even if that causes some slowdown. The trade-off between price stability and growth is easily understood in the current Indian context. It might be less clear in some other countries. A direct fallout of the crisis is the massive re-rating of risk. At a time of high inflation this is bad news for India and other emerging economies. The BIS urges policy makers and the financial sector participants to recognise reality. Specifically, asset prices cannot remain high all the time. Debts that cannot be serviced must be written off. The modern financial system is prone to some degree of instability. Regulators need to look at the system as a whole. Altering regulatory rules and tightening control over specific institutions will help only up to a point. Needed are “macro prudential policies” that focus not on misbehaviour of individual institutions but on minimising, if not avoiding, systemic risks that might arise from their shared exposure to common shocks, among others.