1 Timeline of Relevant Events

2 Factors That Contributed to the Crisis According to IMF Staff

This annex is drawn from the IMF’s own ex post analysis. According to IMF staff, the following factors contributed to the crisis:³⁵

Macroeconomic forces. A long period of high growth, low real interest rates, and limited volatility led to excessive optimism about the future, pushed up asset prices and leverage, and prompted a search for yield and an underestimation of risks.

• Monetary policy. Short-term interest rates were low, reflecting accommodative monetary policy. Central banks and financial regulators largely focused on inflation and aggregate activity, thereby paying insufficient attention to the buildup of systemic risk associated with rapid asset price increases (particularly in housing markets) and growing leverage.

• Global imbalances. These too played a role in the buildup of systemic risk. High saving in Asia and oil-surplus countries had as their counterpart large capital inflows to the United States and Europe. This contributed to low long-term interest rates, underpinning the rise in asset prices, leverage, a search for yield, and the associated creation of riskier assets.

Global architecture. A fragmented surveillance system compounded the inability to see growing vulnerabilities/risks. Multilateral coordination and collaboration lacked sufficient leadership to achieve the needed response to systemic risks. On financial regulation, there were no ex ante rules governing cross-border resolution or burden sharing. The absence of broad liquidity insurance implied an inadequate international response when interbank markets around the world froze up.

Financial system. New structures and new instruments were riskier than they appeared. A presumption that these instruments dispersed bank risk ignored the larger fact that risk remained concentrated in entities linked to the core banking system. Market discipline failed amid the prevailing optimism, due diligence was outsourced to credit rating agencies, and a financial sector compensation system based on short-term profits reinforced risk-taking.

• Regulatory perimeter. A lightly regulated and generally unsupervised shadow banking system in the United States had grown as large as the formal banking system. Banks evaded capital requirements by pushing risk to affiliated entities in the shadow system. Regulation was not equipped to see risk concentration and the flawed incentives behind the financial innovation boom. There were shortcomings in consolidated supervision and underwriting standards.

• Market discipline. Due diligence—in assessing counterparties and collateral—failed. Supervisory and regulatory incentives led to too much reliance on credit ratings whose methodologies were inadequate and inappropriate when applied to complex structured products, and thereby failed to capture the risks. Ratings agencies were also subject to conflicts of interest. Market discipline was eroded by the “too big to fail” nature of the largest most interconnected institutions. The complexity and opacity of structured credit instruments undermined market discipline. Risk management practices of many financial institutions were deficient, reflecting shortcomings in judgment and governance: the users of risk management models used poor business judgment, and warnings by risk managers were sometimes ignored or underestimated by senior management.

• Pro-cyclicality. A constellation of regulatory practices, (fair value) accounting treatment of structured products, ratings, and incentives magnified the credit boom and exacerbated market turbulence. Some recent regulatory initiatives (such as Basel II) may have also intensified pro-cyclical behavior.

• Information gaps. Financial reporting was inadequate, understating the risks borne by the reporting entities. There were extensive gaps in regulators’ and markets’ data and understanding of underlying risks. These included risks embedded in complex structured products, the degree of leverage and risk concentration in systemically-important financial institutions, the difficulty of assessing liquidity and counterparty risk, and on-balance-sheet risks and links with off-balance-sheet risks. Shortcomings in valuation models and practices played a role.

• Crisis management. Cross-border differences in emergency liquidity frameworks and inadequacies in crisis management frameworks, including deposit insurance, played a role in propagating the crisis.

3 Country Coverage

The countries/economies covered by the evaluation are: Argentina, Australia, Austria, Belarus, Bosnia and Herzegovina, Brazil, Canada, China, Colombia, Costa Rica, El Salvador, European Union, France, Germany, Guatemala, Hungary, Iceland, India, Indonesia, Ireland, Italy, Jamaica, Japan, Korea, Latvia, Luxembourg, Mexico, Poland, Romania, Russia, Saudi Arabia, Serbia, Seychelles, South Africa, Spain, Switzerland, Turkey, Ukraine, United Kingdom, and United States.

This list includes the G-20, and those countries (excluding low-income countries) that initiated a new IMF arrangement, including contingent commitments under an FCL, in the aftermath of the crisis (through 2009). Also included are financial centers such as Luxembourg and Switzerland, and countries such as Ireland and Spain that had vulnerabilities similar to those that precipitated the crisis in the United States and the United Kingdom.

4 Early Analysis and Diagnosis of Factors Leading to the Crisis

A number of analysts outside the IMF pointed to the vulnerabilities and policy shortcomings that eventually led to the crisis. The following briefly reviews some of these contributions through 2006.

5 Weaknesses in FSAPs in Advanced Economies

This annex describes the main factors that contributed to a mixed record in the quality and usefulness of FSAPs in advanced countries. It draws on the FSAPs of advanced countries during 2004–08 and staff’s 10-year retrospective of the FSAP (IMF, 2009b).

Lack of candor and clarity. This seems to have been more of a problem in the FSAPs for advanced than for other countries, as some of the IMF’s assessments for emerging markets were pointed and direct about risks and vulnerabilities. According to IMF (2009b), lack of candor and clarity “might be symptomatic of a desire of team members to avoid conflict with national officials.” The typical tendency was to present a “balanced” view, beginning with a positive statement before acknowledging any risks.

Inadequate or lack of coverage on topics relevant to the crisis. Coverage of liquidity risks, crisis preparedness, bank resolution, and external funding risk seemed less consistent in the FSAPs for advanced countries than for emerging markets. To assess liquidity risks, for example, FSAPs sometimes reviewed only the central bank’s liquidity management instruments. Some aspects of capital markets that should have received attention in advanced countries—asset securitization, commercial paper, and short-term funding markets—were not routinely covered.

Stress test weaknesses. According to IMF (2009b), “stress tests … did not provide significant insights regarding the crisis.” Reasons include: specifying shocks that were not sufficiently severe (reflecting, in part, the sensitivity of country authorities and the difficulty in “thinking the unthinkable”); missing important sources of instability—liquidity risks, concentration of exposures in real estate, off-balance-sheet exposures; working with inadequate data, particularly regarding off-balance-sheet exposures and balance-sheet interconnectedness; as well as methodological challenges in modeling liquidity risk, contagion channels, second-round effects, nonlinearities, and correlation across portfolios.

Failure to integrate multilateral perspectives. The FSAPs for most countries did not discuss the global macroeconomy nor the developments taking place in countries with strong economic ties to the subject country. They typically focused on domestic issues and scenarios and did not look at cross-country risks or spillovers, crosscutting issues, or global economic risks. In fact, in those instances where global risks were considered, the scenario was the impact from a disorderly collapse of the dollar in line with the IMF’s focus, which is not the way the crisis impacted financial sectors.

Reassuring messages that induce complacency. Among the key messages from advanced county FSAPs in the run-up to the crisis were: “the outlook for the financial system is positive;” “financial institutions have sufficient cushions to cover a range of shocks;” “the diversification of sources of foreign wholesale funding is a source of strength;” “stress tests … suggest that the financial system as a whole is well positioned to absorb a significant fall in housing prices;” “the financial sector is generally sound and should be resilient to large, but plausible shocks;” “no weaknesses that could cause systemic risks were identified.”

6 Conclusions/Recommendations from Previous Reports and Evaluations

7 How Did Country Authorities View the IMF’s Performance?³⁶

The country authorities who were interviewed were almost unanimous in the view that the Fund failed to warn sufficiently about the risks and vulnerabilities that led to the crisis.³⁷ However, few of them blamed the Fund or the individual mission teams for this failing. They admitted that most observers (including themselves and their fellow authorities) had also been overly comforted by the prolonged benign global environment. As one interviewee put it, “Neither we nor the IMF staff exercised imagination.” The few outside voices that had expressed grave concerns (William White and Nouriel Roubini were among the most frequently cited) were typically not heeded in this seemingly “new paradigm” of a more stable global financial system, underpinned by innovation and risk dispersion.

Despite the Fund’s failure to warn of the impending crisis, country authorities, in most cases, had much positive to say about the Fund and the bilateral surveillance process. Among the positives were a high general regard for Fund staff competency and analysis. The authorities felt that discussions with mission teams were usually candid, constructive, and of high quality, bringing useful and independent third-party views to the policy debate. Furthermore, most of those interviewed believed that the Fund’s financial sector analysis had improved significantly over the years, and they had a generally high regard for the Financial Sector Assessment Program (FSAP) in particular. FSAPs had often been the catalyst to strengthen countries’ financial sector policies, including spurring countries to do their own stress testing and move toward international best practices in supervision and regulation.

At the same time, country authorities provided many criticisms regarding the Fund’s performance prior to the crisis. The subjects ranged from analytical weaknesses to political biases, the surveillance process, and organizational problems.

On the analytical front:

• The Fund’s general mindset that markets know best and financial innovation reduces risks would have made it difficult for the staff to see the buildup of systemic risks.

• Bilateral surveillance typically focused primarily on domestic policies and vulnerabilities, offering little analysis of spillovers and contagion (even in the case of small, open economies).³⁸ Where there was some discussion on spillovers or contagion, the Fund usually saw the problems as arising from emerging markets, not from the advanced economies.

• Notwithstanding improvements over the past decade, the Fund still had not adequately linked macroeconomic with financial sector analysis. This inadequacy was reflected in the heavy reliance on models that to date have been unable to adequately capture macro-financial linkages.³⁹

• Balance sheet analysis was infrequently employed. Furthermore, when it was used, it was sometimes done incorrectly.

• While the IMF had performed no worse than others in foreseeing the crisis, it had not used its comparative advantage in analyzing cross-cutting global issues and identifying risks.

• More use of cross-country analysis (particularly on countries that were facing similar issues) might have helped in identifying common vulnerabilities.

On political biases:

• A repeated theme was the apparent lack of evenhandedness in how the Fund treats its largest shareholders versus all others. Many country authorities believed that the Fund offered much more hardhitting critiques of the policies of emerging markets and smaller advanced countries. Meanwhile, even when there were obvious commonalities in vulnerabilities with smaller countries, the large advanced countries were given the benefit of the doubt that their policymakers, supervisors, and regulators would be able to steer their economies through any rough patches. The 2007 Decision on Bilateral Surveillance only heightened this sense of unequal treatment. This perception also came out clearly in the survey of country authorities for the IEO’s evaluation of IMF Interactions with Member Countries; for example, 86 percent of survey respondents from large emerging markets said that surveillance was in the interest of the “largest IMF shareholders.” In particular, some felt that the IMF was insufficiently critical of the policies of a major shareholder.

On the surveillance process itself:

• A number of country authorities recognized that the Fund had identified many of the risks and vulnerabilities but typically presented these in a “laundry list of warnings, with no prioritization.” That is, all Fund staff reports had the usual economist approach of “on the one hand (with list of economic positives first—which sets the tone), followed by on the other hand (with list of downside risks).” They asked how one should respond to such a wide-ranging list of risks, listed with no sense of probabilities nor urgency.

• Policy recommendations were often obvious (e.g., tighten fiscal policy, pursue a credible and sound monetary policy, or strengthen supervision) but lacked specificity about how to implement them. According to one interviewee, “interactions on the Article IV often feel like just any other meeting I have with all those international institutions, too formulaic.”

• As for the value added by the Executive Board to bilateral surveillance, nearly all felt this was minimal at best, as the Board’s contributions were usually very belated (coming months after the mission team’s concluding statement had been presented to the country authorities) and often superficial (e.g., Summings Up were typically a fairly generic reiteration of the staff report).

On organizational problems:

• The high turnover of staff on mission teams was often cited. This implied a considerable loss of country knowledge and a constant training of new mission members to understand country specifics, history, and culture, all of which are very important for providing relevant policy advice and gaining traction.

• The turnover problem was worsened by the IMF’s restructuring exercise, which was conducted precisely when the crisis was taking hold. In some cases, the restructuring caused countries to experience a complete turnover of mission members or even periods with no mission chief.

• Finally, the more general issue of staff resources was also reflected in the very infrequent FSAP updates. More continuous follow-up on financial sector issues might have better illuminated the problems ahead of time.

Interviewees also raised some issues that could be interpreted as having aspects which were both positive and negative regarding the Fund’s performance:

• In almost everyone’s view, the Fund must walk a very fine line between highlighting the risks of a crisis and actually precipitating one. For this reason, more sensitive messages would sometimes be communicated privately and orally to the authorities. However, on occasion, the authorities on the receiving end of such messages admitted that they did not remember what was said, because the only documented views of the mission were in the concluding statement.

• Many of the authorities agreed that the Fund teams clearly highlighted the domestic vulnerabilities and risks … but said that those were obvious to everyone.

• Finally, while the WEO and GFSR⁴⁰ pointed to many of the pertinent risks and vulnerabilities and were generally held in high regard, policymakers did not notice any warnings regarding an impending crisis. This was widely attributed to the overall upbeat banner messages that typified these documents in the run-up to the crisis.

8 Area Department Survey of Staff

In a self-evaluation of what went wrong, one of the area departments whose countries were most affected by the crisis conducted a survey of staff in October 2009. The following highlights the staff’s views on some of the issues most relevant to this evaluation.

On the substance of country work, just under half the staff members thought that the area department was strong or very strong in assessing vulnerabilities. The toolkit for macro-financial analysis was often cited as an analytical impediment.

On where the area department should place the priority in country work, a staggering 98 percent of staff thought it important or very important to prioritize work on vulnerabilities and crisis risks, more so than even fiscal or monetary policy. Write-in responses to the question of priorities repeatedly stressed the need to do more work on cross-country linkages, spillovers, and integration of regional with country-specific perspectives.

On the main problems in the area department’s surveillance work and ways to fix them:

• “relations with the authorities. We do not have the incentives to be too critical, especially publicly and to differ substantially. More support from the front office/management, less pressure to make authorities happy, more consistent ‘ruthless truth telling’ across all countries, not just a few.”

• “more formal and informal communication with functional departments, mainly MCM …” “The main problem is how to bring value added to large economies, which have large staffs of highly trained economists. The solution is to focus on the Fund’s comparative advantages, namely crosscountry work, spillovers, and global consistency.”

• “no courage to take on countries, especially G7. For years we praised [a large systemic country] for its policy framework and now we have egg on our face.”

On leadership and communication, just under half the economists agreed with the statement “your ideas and opinions are considered and listened to.”

On incentives, fewer than a third agreed that the area department gets its voice heard in the interdepartmental review process for policy papers, the WEO, the GFSR, etc. As for why this is the case, almost half believed that incentives (e.g., one gets little credit for good comments) were a serious hurdle. Meanwhile, almost three-quarters of respondents agreed with the statement that “cross-country work faces several constraints, including managerial complexity, incentives, resources, and priority of bilateral relations.” Incentives, for example, were cited by about 85 percent of respondents as a hurdle to producing cross-country work.

On the silo nature of the Fund, only one-fifth of survey respondents agreed that there was sufficient learning from peers across country teams (and this lack of collaboration within a department bodes poorly for across-department collaboration).

On intellectual leadership, well over half the respondents felt that department managers had not provided the intellectual leadership to get the job done to a high standard. Some respondents felt that the Fund’s downsizing exercise had impeded the ability to provide intellectual leadership. For example, one respondent wrote that “the [conjuncture] of the restructuring and the crisis has had disastrous consequences on the leadership provided by the department.”

Statement by the Managing Director Staff Response The Chairman’s Summing Up

Statement by the Managing Director on the Independent Evaluation Office Report on IMF Performance in the Run-Up to the Financial and Economic Crisis

Executive Board Meeting

January 26, 2011

1. I thank the IEO for putting forward many constructive ideas, which I broadly endorse. The failure of the Fund to warn about a systemic crisis in a sufficiently early, pointed, and effective way is a humbling fact that the institution has been frank about acknowledging and prompt about responding to. Indeed the focus the reform agenda being implemented is precisely on strengthening surveillance and financing for systemic stability.

2. Since the IEO’s recommendations are at a high level of generality, it is incumbent on us to ask how they can be made actionable within competing work program priorities and budgetary constraints. The reforms in train since the onset of the crisis—the early warning exercise, the vulnerability exercise for advanced economies, G20 MAP inputs, integration of WEO-GFSR messages, mandatory financial stability assessments for the systemic countries, and cross-country and spillover reports to name only a few—will go a long way to enhance the candor and traction of surveillance, and arguably already have done so. In thinking about the scope for further progress, I would like to highlight a few points.

3. First, on the promotion of more diverse and dissenting views, we should consider carefully the idea of allowing direct inputs by eminent outside experts into systemic surveillance—e.g., WEO, GFSR, Article IVs of systemic countries. This would make available to the Board independent and real time critiques of staff and member countries’ policy positions. For instance, outside experts, including those known to hold differing views, could from time to time provide commentary on staff reports on systemic issues and countries during the circulation period prior to Board discussion. Surveillance is peer review, but peer review can be made more effective with outside input, increasing the imperative, as the IEO puts it, “to speak truth to power.”

4. Second, there are several IEO recommendations aimed at allowing staff to “connect the dots” better. Integrating the analysis of the WEO-GFSR is certainly a crucial dimension of that task, but does not necessarily equate to merging the documents. Incorporating financial stability assessments in Article IVs is another one on which I expect efforts will be intensified following the Board’s recent decision on FSAPs. And yet another important initiative is the new Fiscal Monitor, which will allow a much closer look at emerging fiscal risks. The rising number of cross-departmental products—thematic reports, spillover reports, recent work on capital flows—are all signs of important progress of staff reducing silos, and on which we have to build. Meanwhile, there should be no doubt that we are committed to fostering staff diversity in all its dimensions, including diversity of opinion.

5. Third, on the delivery of clear messages on risks and vulnerabilities beyond those in the WEO-GFSR, we are now doing more via the early warning exercise to the Board and the IMFC in restricted settings. This is also increasingly the case in Article IVs, as exemplified by the recent Euro Area mission concluding statement. Nevertheless, we should think about doing more, perhaps even putting out large parts of the EWE in the public domain, with appropriate commentary and safeguards.

6. I look forward to hearing your views on the important issues raised in the IEO report.

Staff Response to the Independent Evaluation Office Report on IMF Performance in the Run-Up to the Financial and Economic Crisis

Executive Board Meeting

January 26, 2011

This report nicely complements IMF analysis about the failure of Fund surveillance to adequately anticipate and warn about the global crisis. While it could have been more specific in certain areas and staff have concerns about some methodology, inferences, and factual errors, none of this detracts from the correctness of the report’s recommendations.

The Chairman’s Summing Up IEO Evaluation of IMF Performance in the Run-Up to the Financial and Economic Crisis

Executive Board Meeting 11/8

January 26, 2011

Executive Directors concurred with the general thrust of the IEO evaluation and recommendations. They considered that the report provided a balanced assessment of the failure of Fund surveillance to adequately anticipate and warn about the global crisis, consistent with the Fund’s own reports that acknowledged these shortcomings. Directors noted that the reform initiatives undertaken since the onset of the crisis—the early warning exercise, the vulnerability exercise for advanced economies, inputs into the G20 Mutual Assessment Process, integration of WEO-GFSR messages, mandatory financial stability assessments for systemic countries, and cross-country and spillover reports—will help enhance the candor and traction of surveillance. Nevertheless, Directors agreed that further actions should be considered.