80th BIS Annual Report 2009/10

28 June 2010

In its 80th Annual Report the BIS notes that the steps taken by governments and central banks prevented a financial system meltdown and helped bring to an end the great contraction in global economic activity. The policy tasks that lie ahead, which are no less daunting than they were a year ago, are analysed in the Annual Report.

Overview of the economic chapters

80th Annual Report by chapter

I. Beyond the rescue: exiting intensive care and finishing the reforms
The financial crisis has left policymakers with a daunting legacy, especially in industrial countries. In setting policies, they must adopt a medium- to longterm perspective while they cope with the still fragile and uneven recovery. Households have only just begun to reduce their indebtedness and therefore continue to curb spending. Extraordinary support measures helped to contain contagion across markets, preventing the worst. But some measures have delayed the needed adjustments in the real economy and financial sector, where the reduction of leverage and balance sheet repair are far from complete. All this continues to weigh on confidence. The combination of remaining vulnerabilities in the financial system and the side effects of ongoing intensive care threaten to send the patient into relapse and to undermine reform efforts. More...
II. From the emergency room to intensive care: the year in retrospect
While some emerging market economies are in danger of overheating, GDP in most advanced economies is still well below pre-crisis levels despite strong monetary and fiscal stimulus. The rapid increase of government debt raises urgent questions about the sustainability of public finances. More...
III. Low interest rates: do the risks outweigh the rewards?
Central banks cut policy rates sharply during the crisis in order to stabilise the financial system and the real economy. Those essential cuts, reinforced by unconventional policy measures to address financial market malfunctioning, helped to forestall an economic meltdown. But there are limits to how long monetary policy can remain expansionary. Low interest rates can distort investment decisions. The financial stability risks that could arise from a prolonged period of extremely low policy rates also need to be very carefully weighed. An extended period of such low policy rates can encourage borrowers to shorten the duration of their debts, facilitate the increased leverage of risky positions and delay necessary balance sheet adjustments. While policymakers can and should address such risks with other tools, they may still need to tighten monetary policy sooner than consideration of macroeconomic prospects alone might suggest. More...
IV. Post-crisis policy challenges in emerging market economies
Emerging market economies (EMEs) are recovering strongly and inflation pressures there are rising. Given low policy rates in the major financial centres, many EMEs are concerned that their stronger growth prospects could attract destabilising capital inflows, leading to currency appreciation. Some continue to keep policy rates low and resist exchange rate appreciation by conducting large-scale intervention in foreign exchange markets. Such policies tend to be associated with a sizeable expansion in bank balance sheets, rapid credit growth and asset price overshooting. The risks of domestic overheating thus increase. To promote more balanced domestic and global growth, some EMEs could rely more on exchange rate flexibility and on monetary policy tightening. In addition, prudential tools have an important role to play in enhancing the resilience of the financial system to domestic and external financial shocks. In contrast, while capital controls may have a limited and temporary role, they are unlikely to be effective over the medium term. More...
V. Fiscal sustainability in the industrial countries: risks and challenges
The level of public debt in many industrial countries is on an unsustainable path. Current budget deficits, partly cyclical but also swollen by policy responses to the crisis, are large in relation to GDP. And expenditures related to ageing populations are set to increase considerably over the next few decades. Recent events in Greece and other southern European countries have shown how quickly investors' doubts about the sustainability of public finances in one country can spill over to others. In addition, high levels of public debt may lower long-term economic growth and ultimately endanger monetary stability. More...
VI. The future of the financial sector
The crisis revealed that some business models of financial firms were seriously flawed. For a long time, financial firms earned comparatively low returns on assets but used high leverage to meet targets for returns on equity. They also took full advantage of cheap short-term funding. This strategy made their profits more volatile, especially during periods of market stress. Since the crisis, investors have become more discriminating in their treatment of financial firms, rewarding those with more prudent and resilient models. The priority of policymakers now is to incorporate in the regulatory framework the stronger standards being imposed by the marketplace. Higher-quality capital, lower leverage and more stable funding should buttress the sector's future resilience. This need not undermine medium-term profitability, particularly if restructuring continues and excess capacity is progressively eliminated. In addition, more sound business models should restrain funding costs, thus contributing to strong, stable and sustainable performance in the sector. More...
VII. Macroprudential policy and addressing procyclicality
The stability of the financial system is undermined by distorted incentives and procyclical feedback effects. Macroprudential policy, which broadens the perspective of traditional prudential policy, can readily strengthen the resilience of the financial system to procyclicality by adapting conventional prudential tools. Countercyclical capital buffers, for example, can be built up when credit growth rises above trend during a boom, and released during the downturn. Other measures such as ceilings on loan-to-value (LTV) ratios for mortgage lending can act as automatic stabilisers because they will bind more during a boom when banks typically seek to expand property loans by accepting high LTV ratios. Such approaches could help to restrain credit and asset price excesses and thus mitigate the build-up of systemic financial vulnerabilities. More...