Pro-Cyclicality of Financial Systems and the Crisis: Should Emerging Markets (EMkts) Be Bold or Extra-Cautious in their Policy Responses?

Some macro-financial pro-cyclicality is inherent to financial systems, how should EMKts deal with it?

In last month’s piece, I suggested that risk-evaluation techniques played a perverse role in amplifying the financial accelerator in mature financial markets. That problem is part of a broad on-going re-assessment of the relationship between the financial sector’s regulations (especially those around Basel II[1]) and its inherent pro-cyclicality (see Taylor and Goodhart (2006)).  An emerging analytical work (see Borio (2008)), focusing on a “risk-taking” channel, could help to explain “persistence” in the transmission of monetary policy. It seems to indicate that minimum capital requirements can lead to an increase in pro-cyclicality, when higher risk-sensitivity of capital results in a lending pattern that amplifies booms and busts with real economy effects. The jury is still out to examine the combined results of theoretically stronger supervision and market disclosure rules (the other two pillars of the new Basel regulatory framework) [2]. Can supervision do its role well using inadequate risk-measurement tools? For example, perhaps if the (minuscule but not zero) probability of a single extreme event was computed in “through-the-cycle” ratings covering the true exposure of banks’ balance sheets, supervision and disclosure might have played their expected cycle-moderating role.

Is this global financial crisis just old stuff amplified or have we seen the burst of the first “rational bubble” in economics?

Three months and a half into the revelation of the size of the iceberg, the global financial crisis gives me a sense of “déjà vu” at a much larger scale (this is “all past crises combined” at a power of X), somehow mixed with a feeling of something new, “recursive”, like Borges’ non-linear, labyrinthic, fractal/Mandelbrotian novels, snapshots of many possible contingent pasts and futures: each with its crystal-clear logical unfolding path.