The financial turmoil of 2007-?: a preliminary assessment and some policy considerations

Abstract:

The unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century. This essay seeks to provide a preliminary assessment of the events and to draw some lessons for policies designed to strengthen the financial system on a long-term basis. It argues that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the subprime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences that follows the build-up of financial imbalances in good times. The significant idiosyncratic elements, including the threat of an unprecedented involuntary "reintermediation" wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes. The policy response, while naturally taking into account the idiosyncratic weaknesses brought to light by the turmoil, should be firmly anchored to the more enduring factors that drive financial instability. This essay highlights possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.

JEL Classification Numbers: E44, G10, G20, G28, E30, E50

Keywords: Financial turmoil, risk, liquidity, prudential regulation, accounting, ratings, monetary policy