Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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Author(s)
RICHARD FREEMAN

One of my favorite discoveries as a graduate student was a book entitled Rats, Lice, and History, by Hans Zinsser—a classic, early treatment of the episodes in which medieval Europe periodically was swept by disease, decimating the population, remaking the social and political fabric, and arguably putting history on a different course. A particularly telling point that I remember still was that, despite desperate efforts by authorities and scientific thinkers of the time to grasp the causes of these scourges and somehow to forestall their recurrence, solid understanding eluded them. The primitive public health policy of the day fell back on a few crude rules (supported by myth and prayer), and prevention was not achieved. In fact, echoes of the original plagues typically recurred at intervals until some version of natural immunity emerged in the surviving population, mainly through the harsh combination of exposure and attrition. For those concerned with financial market crises, obvious sobering analogies to market processes come to mind here.

Another memorable point in the book was that, even after some insight into the nature of major epidemics had been gained, Europe still was visited periodically by other “mystery” diseases. Some of these came and went without a trace, and historians of epidemiology still argue today about exactly what happened. This raises the unsettling question, again with clear connections to recent financial market problems: how do we best make ourselves ready for yet unknown scourges, perhaps with entirely new symptoms and pathologies?

A similarity between public health calamities of an earlier age and recent problems in global financial markets is not a new thought. Indeed, the term “contagion” has taken on a special meaning for economists in recent years. Such analogies perhaps can be overdone. It is worth pointing out, however, that in the modern version, public health authorities now have much more detailed, reliable knowledge of the origin and vectors of disease, a quite well-developed database and information system to detect and identify emerging epidemics, an arsenal of specific procedures and treatments for containing most outbreaks, and—perhaps most important—clear standards for good practice in hygiene and public health to keep such occurrences from happening at all.

So, where are we in financial crisis prevention nowadays? Certainly, we have moved out of the Dark Ages. Although it is no time for overconfidence, conditions obviously look a lot better now than they did, say, five years ago—or even two. Clearly, the international financial and policy communities are well into a challenging postcrisis stage. Crisis containment and resolution have been largely achieved, and we now have a great deal of insight into factors that produced the latest round of problems and a far better sense of what to watch for. With a considerable expenditure of effort, numerous codes of good (or best) practices have been drafted. What is needed now is a reliable system of regular, comprehensive assessment of compliance and further progress on implementation of these standards.

A theme in the general public criticism of the international policy response to financial crises is that it has been long on analysis, debate, and proposals for reform, but relatively short on implementation of concrete, preventive measures. Against this background, the FSAP framework stands out as a truly significant step that surely will contribute importantly to the health of the international financial system. In fact, although still in an early stage, it already has. This paper is a very useful, thorough summary and guide to exactly how the program works and, particularly, how FSSA reports are likely to be integrated into IMF surveillance. It also raises several important issues that come under the category of “unfinished business.”

Setting up a program of this scale and scope—as summarized in Box 18.1 of the paper—obviously constitutes an enormous challenge. The list of issues and practical problems in its implementation is potentially quite long. A number of these have been addressed very effectively in the pilot program. Although the FSAP framework is still a work in progress, the FSSA reviews completed so far deserve quite high grades for their breadth, thoroughness, and detail. Even allowing for the fact that the initial trial group of countries included a high proportion of those where compliance could be expected to be high and where data are relatively extensive, timely, and reliable, their usefulness looks quite promising. And of course, one should not forget that financial crises can happen anywhere.

Consistency of the examination process is an important broad objective, but to the IMF’s credit the FSSAs have not succumbed to a one-size-fits-all approach. They have been sensitive to a need for flexibility, and they have involved a healthy, two-way give-and-take with national authorities. This has blunted some critical commentary that reform of global financial architecture inevitably will turn into a process whereby rigid, and possibly unrealistic, standards will, in effect, be dictated to emerging market countries by a combination of international organizations, standard-setting bodies, and powerful industrial countries. Responses evidently have been quite candid and the level of cooperation high. The reviews also appear to have been usefully informed by their linkage to broad assessments of national economic developments as part of the consultative process associated with Article IV reviews—thereby helping to link the process of assessing financial soundness at the more microeconomic level to broader conjunctural developments and macroeconomic policy, and vice versa.

The fact that FSSAs are objective and periodic, and eventually will cover a wide subset of the IMF membership, defuses a potentially troublesome side effect that could arise under different arrangements where markets might come to perceive examinations as indicative per se of serious problems. Their implementation by the IMF—and counterpart reviews by the World Bank (both with wide emerging market representation)—along with endorsement by organizations such as the G-20 with broad global membership—surely has helped instill a sense of greater involvement, control, and “ownership” of the process among the emerging market countries likely to benefit most.

The successful use of outside expertise from other international financial institutions, standard-setting bodies, central banks, and supervisory organizations is an additional strong point and constitutes an important investment in human capital. One has the sense that all participants—including both the examiners and examinees—have benefited from the process so far and are moving rapidly along relevant learning curves. The process also has respected the understandable reluctance among the international standard-setting bodies to become assessors themselves. That sensitive role has fallen to the IMF and World Bank, which are at this point the natural choices for coordinating and implementing the program.

Perhaps most important, the FSAP exercise has generated a great deal of extremely useful information not previously available. This should help identify exposures more accurately, better anticipate crisis scenarios, and guide policymakers in both prevention and crisis management. The reviews also have suggested where better data provision is needed. Sharing all this information within the broad policy community can only accelerate the global reform process. It is also important not to forget that the FSAP process puts the spotlight on strengths, not just weaknesses—a clean bill of health should bring a number of positive benefits to a country, not the least of which are the improved market access and more favorable borrowing terms that flow from improved reputation and market confidence.

Having noted all these strong points of the FSAP program, however, I feel an obligation to qualify this general blessing with several important caveats or at least unsettled issues. At the top of this list is a concern for conservation of resources. The harsh reality is that FSAPs are very resource-intensive and expensive. I think that we are only beginning to appreciate the scale of the potential burden imposed on the IMF and World Bank as they expand their activities beyond areas of traditional core competence. As the pilot project demonstrates, to be effective, regular comprehensive assessment of financial market structure and performance in a wide variety of contexts will involve an enormous draw on scarce skills. Even with greater involvement of outside experts and some cost saving (from additional preparatory work, efficiencies from cooperation, and accumulated experience), there likely will be a need to prioritize and/or perhaps limit the scope of coverage in some respects. Accordingly, some difficult choices may be coming.

In part because of resource constraints, a program of comprehensive, detailed reviews at fairly high frequency for every one of the IMF’s more than 180 members—while politically attractive—probably is not realistic. On the other hand, to be effective in detecting vulnerabilities, a certain minimum frequency (or at least regular updating) would seem to be essential. Accordingly, one has to ask how an appropriate balance can be struck. To what extent, for example, can the process be usefully supplemented in some way, perhaps by self-assessments or outside assessments? In this connection, there may be an important distinction to be made with regard to the extent and intensity of review between those countries where the financial and supervisory system is still evolving and ones with more developed financial markets that already are supported by an effective national supervisory structure. Alternatively, it may be that a subgroup of systematically important countries needs to be designated for primary attention.

It is important—essential really—that assessments at their core retain their qualitative, judgmental character. If nothing else, the experiences of the past several years proved that problems in the area of global finance are by their nature complex and likely to become even more so. Moreover, best-practice codes and standards typically are not quantified, but instead require balanced assessments about whether processes and institutions are functioning effectively. Thus, a simple checklist approach is not likely to work. The wisdom of “the rule” is not a perfect substitute for informed judgment.

As we have seen in other earlier presentations in this seminar, there has been a burst of interest in quantitative modeling and other related tools to support risk management and early warning technology, for example. While these approaches have some promise and can be a useful check on more qualitative, judgmental approaches—serving as “amber lights,” for example—there is some danger in their inherent tendency toward oversimplification. Inevitably, they rely heavily on historical patterns and data that are far from current. One of the disturbing lessons of the past several years is that correlations among various categories of risk can shift quickly in surprising ways, particularly in periods of market volatility, and that patterns of exposure and vulnerability in crisis countries have varied from case to case. It is encouraging, therefore, that—as the paper highlights—an effort has been made in the FSAPs done so far to include stress tests and scenario tests, especially to the extent that such exercises include scenarios beyond those observed historically. To continue the medical analogy, tests that provide frequent false positives are troubling and costly, but in most cases we can live with those errors. A testing technology that delivers incorrect negative readings and a false sense of security can be fatal. Thus, it would be exceedingly bad policy to pronounce portfolios sound or a system healthy based on quantified measures of doubtful reliability without the benefit of in-depth examination and a realistic assessment of contingencies.

Perhaps the most difficult balance to strike with regard to the FSAP program relates to the appropriate degree of openness or transparency for the reviews. A key benefit to an emerging market economy from its certified compliance with standards should come in the form of lower cost of funds in international markets as investors appreciate that the risks of financial crisis have been lowered. One could anticipate that a country receiving a positive review would want to make the result widely known, and countries should have that option. But a harder question is, should there be a general presumption that results of all reviews be published immediately? As we all know, information asymmetries typically give rise to problems of adverse selection and moral hazard. Market participants need information to make sound investment decisions, and ultimately it is the power of market discipline that should provide the best guidance for the evolution of economic systems. But, as a practical matter, one has to recognize that national authorities are less likely to be frank with IMF staff if candor risks adverse external comment and strong market reaction. Thus, the potential benefit of full openness has to be balanced against the cost of impairing the consultative process between the IMF and national authorities, as well as other supervisory relationships. Accordingly, I think that it is appropriate to regard publication as an evolving standard. Full publication should be the ultimate objective but with due sensitivity to countries’ interest in maintaining some degree of confidentiality during a transition until all participants (including the markets) become familiar and comfortable with the process. But even in the transition, regular, frequent provision of information is preferable to disclosure at widely dispersed intervals that carries a greater risk of provoking market volatility.

A final point—and one that I think that the authors of the paper might consider for further development—is how the results in the FSAP process should be integrated with technical assistance programs. Obviously, it is difficult in many cases for countries with deficiencies to bootstrap themselves into compliance. Thus, the way in which such technical assistance programs are structured to provide incentives and the necessary tools to close compliance gaps may be critical for real progress. It would be good to know a bit more about how this will work, what the likely costs might be, and how technical assistance can be integrated with the FSAP to be most effective.

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