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Policies against financial crises
Learning Object Description:
Instability on financial markets can have severe economic and political repercussions.
Governments try to protect their countries by regulating markets and by reforming the
international financial architecture. This lesson explains the two main strategies against
financial crisis, crisis prevention and crisis management, and shows that they can have
paradoxical effects. As an example of a multilateral attempt to stabilize the international
financial architecture, the lesson refers to the Financial Stability Forum.

Learning Object Objectives:
To be able to name the pillars of the international financial architecture and explain why they
can help prevent and manage financial crises; to discuss some of the paradoxical effects of
policies against financial crises; and to list the functions of the Financial Stability Forum.

International finance often seems to be spontaneous or even chaotic, but this is hardly the case.
Without a stable framework, international finance would not exist. This framework consists of:

• Rules regulating the behavior of financial actors (e.g. prohibition against inside trading)
• Regulatory agencies able to enforce the rules
• Central banks providing liquidity and information
• International organizations providing coordination of international actions of various
regulatory agencies and central banks

To describe this set of key elements, we also speak of the international financial architecture .

The international financial architecture and its
reform
The discussion about reforming the financial architecture is as old as international finance itself. But
after the financial crisis of Mexico and the Asian crises, the debate about reforming the international
financial architecture was picked up with new emphasis. This debate focuses on crisis prevention and
crisis management .

Crisis prevention
seeks to reduce the probability of financial crises occurring
Crisis management
tries to limit the economic consequences of financial crises once they have already begun

PfP ADL- WG, 2005 generated from a PfPLMS 0.2 learning object

Information arrives at random. To prevent currency crises (correct match is 2) List of all matchables: 1. financial crises are an unavoidable concomitant of financial markets. 3. Exchange of information. Management of exchange rates. 4.Page 2 Crisis prevention The best way of reducing the probability of a crisis occurring is to enable the market to discipline itself. PfP ADL. The spectacular failure of the fixed exchange rate of Argentina in 2001 shows the dramatic consequences of a poorly managed exchange rate.2 learning object . A level playing field is important. Commercial banks in OECD member countries are required to keep a certain amount of money in reserve in case credits are not paid back. the banks are obliged to build their own safety nets for times of crisis. The management of exchange rates is therefore important. a certain level of transparency is the prerequisite. To ensure that market participants get the necessary information. because unequal treatment can also lead to imbalances on the markets. To ensure a level playing field (correct match is 1) 3. The capital standards of the Basle Committee for Banking Supervision are an important example of an attempt to create a level playing field for market participants across Organization for Economic Cooperation and Development (OECD) countries. To ensure that national efforts are coordinated internationally (correct match is 3) 4. Information and the paradox of early warning As financial markets are information markets. Sometimes new information shows that former assessments were wrong. an exception because it organizes regulation on a supranational level. A basic set of regulating and supervising institutions is also needed. and when it arrives. as well as on their decision to buy or sell a currency at a certain time. markets react. Financial markets are information markets. markets have to be transparent. Regulating and supervising institutions. Information is incomplete and unequally distributed. 2005 generated from a PfPLMS 0. Many financial crises start as currency crises. Market participants act because of their particular assessment of the information they have. Thus. and as information is normally incomplete. (The European Union is.) Because of the trans-national nature of capital flows and international actors. Regulation and supervision are generally organized at the national level.WG. For this. 2. The standardization of information (e. accounting rules) is one way to improve transparency. Setting exchange rates is a difficult and highly disputed task. Their decision to invest in a certain country depends on information assessment. national efforts have to be coordinated internationally. To ensure that market participants receive all the important information (correct match is 4) 2. in this respect. The exchange of information is therefore also important for reducing the probability of financial crises.g. Transparency. Question: Attribute conditions of successful crisis prevention to their strategies: 1. It's all about information. and sometimes the subsequent market reaction is so strong that it threatens the stability of the financial system.

These early warning systems are indices that portray economic imbalances that can lead to a financial crisis. it depends on the financial authorities whether or not the crisis becomes serious and whether or not it spills over to other sectors of the economy. The assessment of rating agencies. the more risks they will take when investing. Often the International Monetary Fund (IMF) acts as a lender of last resort by providing credits to governments. This means that when financial difficulties occur. The paradoxical effects of crisis management The existence of a lender of last resort. The use of early warning systems to prevent financial crises can have the opposite effect. can have a similar effect. monetary authorities usually leave some doubt as to whether they will rescue markets and banks in difficulty. can create an incentive problem. government bodies try to fill this gap. can support a market in times of crisis as a "lender of last resort". Because markets do not always provide the necessary information. Major market participants use their private early warning systems for the same purpose but would never publish the results. The more certain economic actors become that they will be helped in an emergency. the less motivated one is to be careful. Crisis management When a financial crisis happens. Especially the financial situation of the government (government debts. tax revenues or currency reserves) is often well documented by the country's central bank and by the IMF. The economic and social consequences of financial crises can be so tremendous that an inactive IMF could not stand the public pressure. The central bank and the supervisory agencies provide information about the financial situation of the financial markets and their participants. The central bank. PfP ADL. the central bank provides liquidity and prevents market participants from becoming insolvent. For this reason. The result is that it becomes more likely that the lender of last resort actually has to lend. states are also market actors who can face financial difficulties. This paradoxical situation can occur when the official institutions (either the national central bank or the IMF) published the results of their market assessment in order to warn the governments and the market participants of the likelihood of a financial crises. 2005 generated from a PfPLMS 0. however.2 learning object . which provide financial information and assessment of markets to their clients. That is why their crucial role during the Asian crises was so controversial. This official warning can be the crucial information for the market participants that finally triggers the financial crisis (and without the official warning perhaps nothing would happen).Page 3 The probability that market participants assess the situation so incorrectly that new information leads to a financial crises is higher on markets with a low level of transparency. for example. At the international level. Supervisory agencies use early warning systems in order to assess the financial stability of markets. The dilemma for the International Monetary Fund is that it cannot renounce its de facto function as a lender of last resort.WG. This problem has already been discussed as the moral hazard-principle in insurance: The more insurance one has.

Many academics. including the World Bank. It also requires that private creditors and investors bear responsibility for the risks that they take. The IMF's task is to report whether countries comply with these rules. and are involved appropriately in crisis prevention and crisis management. Furthermore. The Financial Stability Forum One of the few concrete measures adopted in response to the `Asian crisis' was the establishment of the Financial Stability Forum (FSF) in 1999 on the initiative of the G7. can use the reports to assess the stability of a country's financial system before investing there. the OECD. These institutions formulated best practices for the governance of financial markets. additional lending is like throwing money away. the IMF publishes Reports on the Observance of Standards and Codes (ROSCs). If the crisis has already gone too far. and ultimately also cultural. In these respects. Countries that fail to comply with standards are `punished' for their non-compliance by investors who demand extra-high interest rates to insure themselves against risks resulting from financial system weaknesses.Page 4 An additional problem of lending in times of crisis is that observers often cannot assess how severe a crisis has already become. the establishment of internationally- agreed codes and standards for policy-makers serves both as an incentive for better governance and as a yardstick against which to measure country risk. the G7 governments agreed that one of the main causes of the crisis had been the poor financial systems in Asia.WG. Global financial institutions and investors. This requires public authorities to provide for enhanced transparency and disclosure. A wide range of institutions contributed to the compendium. improved regulation and supervision of financial institutions and markets. and the International Organization of Securities Commissions. At a summit in Cologne in June of that year. June 1999 The FSF was to coordinate this task in a number of ways. rather than on investors and speculators that might be responsible for the instability. Critics argue that it puts the blame on countries affected by financial instability. and policies to protect the most vulnerable.2 learning object . PfP ADL. Cologne. as well as some investors themselves (notably the famous George Soros) rather see things the other way around. To this end. the IMF. 2005 generated from a PfPLMS 0. the idea goes. hegemony. including through the compilation of a compendium of Standards and Codes for financial systems. Some have criticized this procedure. the FSF initiative has been accused of spreading `Western' ideas about financial market governance around the world. Final communiqué of the G7 Finance Ministers summit. They formulated their response as follows: Our overall strategy is to identify and put in place policies to help markets work properly and to provide the public goods necessary to achieve this objective. as well as more obscure ones like the Committee on Payment and Settlement Systems. Critics see the initiative as an attempt to establish Western economic.

Sometimes new information shows that former assessments were wrong. and on `highly leveraged institutions'—a technical term for what are normally called hedge funds. Information arrives at random. and when it arrives. financial crises will always happen. much more still has to be done. and therefore a panacea does not exist. 2005 generated from a PfPLMS 0. PfP ADL. Financial crises are unavoidable. the FSF has set up a number of working groups on a variety of issues.WG. markets react.2 learning object . The dependence of economic actors on information (which is normally incomplete) makes them vulnerable. Conclusion Even though some progress has already been made in reforming the international financial architecture. there are working groups on offshore financial centres such as the Caymans and the Bahamas. But despite all efforts.Page 5 In addition to compiling the Compendium. The significance of some of these for global financial stability is poorly understood. and sometimes the subsequent market reaction is so strong that it threatens the stability of the financial system. Among others.