Why was it so hard to anticipate what would happen if there were losses on large numbers of bonds insured by monoline insurers which had relatively small amounts of capital? One reason why such risks may not be appreciated ex ante is over-reliance on local risk measures such as VaR (Value at Risk) or other historical average correlations, and not enough on severe stress tests over different horizons. For example, in the United States it was widely believed that house prices would not fall significantly nationally (it had never happened after the Great depression in the 1930s). We assert that, if one had stressed bank capital in the US with the explicit assumption that national residential real estate prices could go down 30 to 40%, and in some local markets more, most of the losses for US banks could have been correctly predicted (at least if the complexities of structured credit products were properly assessed6). The collapse of functioning inter-bank money markets and other “runon-the-bank” phenomena obviously added further costs, but the first-order effect was caused by residential house prices falling. The key, however, was to correctly predict what that kind of price drop would do to other market participants, and market structures, as well as to the individual firm. Extreme stress tests have served a crucial purpose after the crisis to re-establish confidence in banks, and might usefully play a wider role in more aspects of on-going bank oversight.
And, above all, it seems to me that this is the wrong question or solution given our current challenges: while the issue at stake here is improving dialogue with a view to achieving concerted and operationally-applicable solutions, I do not believe that anyone really asserts that the optimal way to enhance the future of our financial cooperation is to alter the composition of the 24- or 25-strong IMF Executive Board by 3 or 4 members. Nevertheless, I consider that a number of principles should guide this desired reform: governance today should be adapted to a multipolar financial world. While all members should be represented in proportion to their involvement and responsibilities, more than the complex calculations of quotas and voting rules, we should fundamentally focus on the functioning and mandate of the IMF. In this respect, senior officials should be appointed strictly on the basis of their expertise and the IMF’s mandate should be expanded. Focusing on exchange rate developments alone is no longer sufficient, and if the IMF is to be able to contribute to ensuring international financial stability, it must pay greater attention to capital account developments. Furthermore, this contribution cannot simply be a matter of complying with a rigid and uniform body of rules. It must take account, in a balanced manner, not only of each country’s level of development but also the systemic risk that it constitutes within the global financial system.