Managing financial crisis in an interconnected world: anticipating the mega tidal waves

Per Jacobsson lecture by Zeti Akhtar Aziz - 29 June 2014


It is my very great honour to be invited to deliver the Per Jacobsson Foundation Lecture to this most distinguished audience here at the BIS in Basel. This lecture series commemorates the lifelong contributions of Per Jacobsson to the international financial system. While his contributions have been extensive, important to mention is his role in the early years of the BIS where he served for twenty five years as the Economic Advisor. We are now the beneficiaries of this contribution. It is my privilege to be part of this lecture series.

The focus of this lecture will be on the new challenges in the management of financial crises that arise from the increased interconnectivity in national financial systems that have also become increasingly internationalised and thus internationally integrated. In my career of more than three decades at the Central Bank, I have had the experience of being close to three major financial crises; the first when I was based in London during the ERM crisis in the early 90s, then the Asian Financial Crisis in the late 90s in which I was directly involved in its management, and the third is the recent global financial crisis. The observation is that the manifestation of a financial crisis is highly dynamic, evolving not only with the changes in the financial landscape but also with the changes in the circumstances during different stages of the crisis. This lecture will identify the different phases in the evolution of a crisis, each phase demanding for a different policy solution. The paper sets out to suggest the indicative thresholds in the transition of a crisis to its next phase. The aim is to anticipate the next eventuality of the crisis, and allow for its effective management.

The world has continued to experience successive financial crises with its reach now extending both to the emerging and developed economies. The cost of such financial crises has been immense. It has drawn significant research on the subject. The literature has for the most part focussed on explaining the causes of such financial crisis, the lessons that might be drawn and the debate on the solutions for containing and managing the crisis. And yet, financial crises have continued to happen, and with it new challenges for its management. While it may not be possible to avoid a financial crisis, it will certainly be possible to enhance our management of the crisis to minimise its costs on the financial system and the economy. This paper therefore takes the crisis as a given and focusses on its management during the different stages of its evolution.

The literature distinguishes between different types of crisis, including currency, banking and debt crisis1. To take into consideration the role and implications of interconnectivity in financial crises, I will look at the underlying financial and economic conditions behind the factors that explain the crises. These conditions can be grouped into three categories. The first relates to financial crises that are set off by an unexpected development. The shock could be financial, economic, social or political. Examples include sudden changes in the terms of trade arising from disruptions in the commodity markets or from contagion effects in another jurisdiction. The second set of factors relates to financial crises that follow the build up of excesses over an extended period of time. These include the build up of financial imbalances such as unsustainable levels of leverage and indebtedness, formation of asset bubbles, or from the pursuit of policies that fuel exuberance and encourage asset prices or exchange rates that do not reflect underlying fundamentals.

The third set of financial crises are those that are a consequence of structural deficiencies in the financial system. These deficiencies may exist within the legal framework, regulatory and supervisory regimes and incentive systems or in the international financial architecture that have not kept abreast with the fundamental changes taking place in the national and the international financial systems. Over time, the system may no longer able to cope with the developments that are taking place. Financial crises may also be the result of the combination or cumulative effects of these conditions. The analysis of the underlying conditions prevailing in a financial crisis is important and valuable for our understanding of the nature of the crisis and how it might evolve and thus provide implications for its effective management.

1 Claessens and Kose (2013) provides an extensive review of the analytical and empirical explanations of the different types of financial crisis.