79th Annual Report, 2008/09

The 2008/09 Annual Report from the Bank for International Settlements reflects on the dramatic events affecting the world's financial system and economy over the preceding two years. The essential and complex system of finance has been critically damaged; trust has been lost. There were both macroeconomic and microeconomic causes of the collapse. The former included imbalances in international claims and a long period of low real interest rates, while the latter consisted of problems with incentives, risk measurement and regulation. Some are inherent in human behaviour, while others represented policy failures. There were danger signs that led to warnings; some were accurate, others were not, and most were in vain. It is easy to see why. Understanding the nature of many of the problems would have required a history of events which are by their nature infrequent. And, when the existing policy apparatus appeared to be working so well, making what would have been wholesale changes to the monetary and regulatory policy frameworks in many countries would have presented nearly insurmountable political and intellectual difficulties. More...

The story of the financial crisis is divided into five stages:
1. the prelude, leading up to the March 2008 takeover of Bear Stearns;
2. the gradual deterioration in financial conditions from mid-March to the failure of Lehman Brothers on 15 September 2008;
3. from mid-September to late October, a global loss of confidence, a massive flight to quality and the near collapse of the financial system;
4. from late October, the severe decline in the global economy; and
5. beginning in mid-March 2009, the deepening downturn and the first signs of stabilisation. More...

The analysis of the crisis in this chapter leads to a variety of conclusions and highlights a number of risks for the financial system. In a modern financial system, bank-based finance and market-based finance should be viewed as complementary rather than as rivals or substitutes. The crisis revealed that the presumed benefits of diversification derived from the creation of financial conglomerates - the hypermarkets of the financial system - were an illusion. When the crisis hit, all business lines were affected. Similarly, the benefits of slicing risk into its smallest components through financial engineering were oversold. However, reducing the size of the bloated financial industry should not be confused with a recommendation of financial autarky. The retreat of finance back inside national borders must be resisted. If left unchecked, the process would result in protectionism. More...

For industrial economies, a powerful interaction between the financial sector and the real economy began to take hold in the last quarter of 2008. A dramatic loss of confidence was combined with the unwinding of imbalances that had built up on household, industrial and financial system balance sheets in the industrial economies since the beginning of the decade. The outcome has been a severe downturn in both real activity and inflation. But since leverage has only begun to adjust - credit in both the financial and non-financial sectors of the economies that have had credit booms remains well above the level of only a few years ago - it is reasonable to anticipate both a protracted downturn and a slow recovery. More...

Emerging market economies initially exhibited a great deal of resilience to the financial crisis. The high degree of economic and financial integration that supported an extended period of rapid growth has left them exposed to sharp reversals in capital flows and declines in demand for their exports. Countries that maintained prudent policies and low public debts, such as those in Asia and parts of Latin America, still have flexibility to respond. However, some countries with large current account deficits, and some where banks were making foreign currency loans, have run into difficulties requiring external official assistance.
Two issues are now of particular concern for emerging market economies: risks that the severity of the downturn could deter a recovery in capital flows and further impair growth; and whether new initiatives to improve access to external finance through official channels could help reduce reliance on costly reserve accumulation. More...

Policymakers have implemented a wide array of responses aimed at restoring confidence in large banks and repairing the financial system. Interest rates in most industrial economies were cut until they were at or near the zero lower bound. A number of central banks expanded their balance sheets massively to ease the acute tensions in financial markets. But even though governments have taken on large commitments, they continue to be unwilling or unable to fully address the impaired assets on bank balance sheets.
Traditional and unconventional central bank actions have been matched in many places by equally aggressive fiscal expansion. Clearly, different countries have different needs and capacities for increases in government spending. In any case, an assessment of the various spending programmes will have to wait until they take full effect. More...

Financial regulators, fiscal authorities and central bankers face enormous risks. To avoid deepening and prolonging the crisis, they must act quickly while guarding against policies that hinder adjustment or create additional distortions in financial flows. For financial rescue and repair, there is a need to persevere until the job is done. For fiscal policymakers, there is a need to ensure that policy is on a sustainable long-run path. And for monetary policymakers, there is a need to plan their exit from unconventional policy actions, and then to execute it in a timely fashion.
Looking further ahead, ensuring sustained financial stability requires a redesign of macroeconomic as well as regulatory and supervisory policies with an eye to mitigating systemic risks. For macroeconomic policies, this means leaning against credit and asset-price booms; for regulatory and supervisory policies, this means adopting a macroprudential perspective. Importantly, reform must focus on identifying systemic risks arising in all parts of the financial system - risks that arise from the complexity, opacity and ownership concentration of financial instruments; from the counterparty risk and margining practices in financial markets; from the risk of joint failure created by interconnections and common exposures; and from the procyclicality that is inherent in financial institution management and can be compounded by microprudential regulation. More...

This part of the Annual Report reviews the organisation of the Bank for International Settlements, summarises its activities for the financial year 2008/09 and presents its financial results.

The work of the Bank during the financial year was dominated by the need to deal with the challenges posed by the intensifying global financial crisis. Financial stability issues became a main focus and work programmes were redirected to concentrate on this, both in support for the committees hosted at the BIS and in the Bank's research activities.

The market turmoil confronted the Bank with sustained demand to accept deposits and made it difficult to place funds profitably at an acceptable level of risk. As a result of actions taken by the BIS in its banking and risk management practices to address these challenges, the Bank's currency deposit base decreased by 16% during the financial year 2008/09 and the balance sheet total decreased by 18%. The net profit for 2008/09 amounted to SDR 446.1 million, 18% lower than for the previous financial year.

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