Transcript MSc Law & Accounting Seminar

The Financial Crisis:
Who’s to blame?
Howard Davies
Director, LSE
HSE Cultural Centre, Moscow
14 December 2009
Rolling Stone described Goldman Sachs as “a great vampire
squid wrapped around the face of humanity, relentlessly
jamming its blood funnel into anything that smells like money.”
Who is most to blame for the current
financial crisis?
%
Bank executives
28
Governments
24
Financial regulators
10
The media
2
Central Banks
3
Thatcher and Reagan 1980s deregulatory
reforms
11
Consumers for borrowing too much
9
Everyone (democratic society for its collective
failure to policy the above)
Other
Source: Thisismoney.co.uk, June 2009
12
1
Some suspects
•economists - “if anything needs fixing, it’s the sociology of the
profession” – Dani Rodrik (Harvard)
• business schools – the Guardian
•testosterone – Scientific American: “risk-taking in an investment
game with potential for real monetary pay-offs correlates
positively with salivary testosterone levels and facial masculinity”
•video games – Professor Susan Greenfield of Oxford
• human greed – Rowan Williams
•Jews
Who blames “the Jews” for the
financial crisis?
Source: N Malhotra, Y Margalit: State of the Nation. Boston Review, May/ June
2009.
Views of Members
of the European Parliament
% blaming
49
29
29
28
25
23
6
US banks
Investment banks
Credit Rating Agencies
US regulators
Hedge funds
EU banks
EU regulators
……and the answer?
…66% recommend deeper political
union in Europe, as a key response
to the crisis
Russians trust their government more
than
British
do..
What is the
your level
of trust in
the government to manage the financial situation?
Average response, scale from 1.0 (no trust) to 10.0 (full trust).
Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.
But the social impact is large
Projected impact of the crisis on the poverty rate, percentage of people with
income level below minimum subsistence, 2007-2009
Source: Russian Economic Report No. 19, World Bank.
The impact of the crisis on the long-term development objectives in
Russia: dynamics of GDP level in Russia 2007-2020, (q1-2006=100)
Source: World Bank Projections, Strategy 2020.
Russians are more confident in banks
What is your level of trust in the stability of the banks?
Average response, scale from 1.0 (no trust) to 10.0 (full trust).
Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.
Russia is one of the countries where
level of optimism is above the average
Source: Worldwide Barometer of the Financial Crisis – August 2009, BVA.
“ Bank failures are caused by
depositors who don’t deposit
enough money to cover the
losses due to mismanagement”.
Dan Quayle
The Credit Crisis: A Five-Act
Shakespearian Tragedy
Act One:
Subprime
Act Two:
Liquidity
Act Three:
Unravelling
Act Four:
Meltdown
Act Five:
Pumping
Real GDP % growth forecast, October 2008
Source: Financial Times European Economic Forecast.
Real GDP % growth forecast, July 2009
Source: Financial Times European Economic Forecast.
The IMF forecast a modest recovery
next year
Gross domestic product forecast (% change), constant prices, 2007-2014
4
3
2
1
France
0
-1
2007
2008
2009
2010
2011
2012
2013
2014
-2
-3
-4
-5
-6
Source: IMF World Economic Outlook Database, October 2009.
Germany
Japan
UK
US
But global unemployment is
likely to continue to rise
Unemployment (Million) and unemployment rate (%), 1999 - 2009
Source: ILO, Trends Econometric Models, December 2008.
What are the underlying causes?
•global imbalances
•loose monetary policy, leading to
•mispricing of risk
•credit bubble
•‘excess’ leverage, facilitated by procyclical
regulation, and regulatory arbitrage
•‘excess’ unmanaged growth of the financial sector,
which magnified risks, rather than diversifying them
Global current account imbalances
grew rapidly from 2003
Estimates of account balances for selected countries ($ Billion), 1993-2007
Source: Datastream, FSA Calculations.
Monetary policy was loose,
especially in the US
Deviation of policy rates from Taylor rule (%), 2000-2009
Source: Bank of England, Speech of Charles Bean at the Annual Conference
of the European Economic Association, 25th Aug 2009.
Household debt rose sharply
Household debt as % of GDP, 1987-2007
Source: FSA, ONS, Federal Reserve, Eurodata, Datastream
US house prices doubled in five years
Case-Shiller Home Price Index (2000 Q1 = 100), Jan 1987 - 2005
Source: Silverlake, Case-Shiller Price Index.
House prices rose rapidly in much of
Europe also
Real house price changes over the last ten years (%), 1996-2006
Source: ECB, National Statistical Offices, IMF, EMF, Italian Ministry of
Infrastructure, Morgan Stanley Research.
Bank Balance Sheets expanded
Large-cap banks’ aggregate assets rose to 43x tangible book equity
Source: Silverlake, Capital IQ.
UK banks leverage grew sharply from 2003
onwards
Major UK banks’ leverage ratio, %, 1998 - 2008
Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.
Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.
As did the securitised credit market
ABS – volumes outstanding, $ Billion, 1996 - 2007
Source: The Turner Review, March 2009.
And the outstanding credit default swaps
Credit default swaps, $ Trillion, H2 2004 – H1 2008
Source: The Turner Review, March 2009.
Resecuritisation magnified credit
creation
Capital Structure Containing
Subprime Loans
Subprime Mezzanine CDO
Containing BBB Subprime Bonds
100%
100%
11%
SUPER
SENIOR
CUMULATIVE
LOSSES
AAA
AAA
8.6%
40%
AAA
28%
20%
11%
7%
0%
AA
AA
A
BBB
Residual/
Equity
Source: Morgan Stanley.
A
11%
7%
BBB
7%
Equity
0%
Private Equity Leverage Multiples grew
Debt/EBITDA, 2002 - 2007
7X
6.2
6
5
4.6
4.8
2003
2004
5.3
5.4
2005
2006
4
4
3
2
1
0
2002
Source: Silverlake, Morgan Stanley, Capital IQ.
2007
Growth in Hedge Fund Assets &
Leverage accelerated
Source: Silverlake, Through Q308 – HFR industry report; Q408 projections
based on CS analysis.
This points to the need for monetary policy to focus
more on
- credit growth
- financial intermediation, and
- asset prices
…with a stronger emphasis on the risk of financial
instability
Weak regulation may not have been the main
cause of the crisis, but it is important to reform it
• trust in markets, and in regulation, has been
affected, which damages investment and economic
growth
•the global system does not meet the needs of
global markets
Trust
Average response on a scale from 1 to 5 to the question, “How much do you
trust…”, where 1 means “I do not trust at all” and 5 means “ I trust completely.”
4
3.33
2.95
3
2.13
2.19
2.6
2.37
2.22
2
1
0
k
oc
t
S
ke
ar
M
t
r
ke
o
Br
s
e
rg
a
L
io
at
r
o
rp
o
C
ns
T
he
v
Go
en
m
n
er
Source: The Financial Trust Index.
t
e
nk
a
B
rs
nk
a
B
s
Ot
rp
e
h
pl
eo
e
Trust in financial markets,
and government, has fallen
Average response to the question, “How has your trust in some of these
institutions changed in the last three months?” “Would you say your trust
in…has 1) increased a lot; 2) increased a little; 3) decreased a little; 4)
decreased a lot; or 5) has there been no change in your trust.”
0
-0.2
Stock Market
Banks
The Government
-0.4
-0.6
-0.69
-0.8
-1
-1.04
-1.2
Source: The Financial Trust Index.
-0.63
The crisis revealed problems with
the existing regulatory architecture:
• Hopelessly complex global structure
• Lacking a central authority to drive co-operation and
make changes happen
• US system balkanised and ineffective
• European system a fudge – neither truly European
nor truly national
• No two national systems the same
Global Committee Structure
- A Regulator’s View
G-20
(Gov’ts)
IMF
World Bank
(Gov’ts)
OECD
(Gov’ts)
WTO
FATF
(Money Laundering)
IASB
(Accounting
Financial Stability
Board
IAASB
(Audit)
Bank for International
Settlements
(Central Banks)
G-10
(Central Banks)
CGFS
Basel Committee
(Banking)
CPSS
IOSCO
(Securities)
Joint Forum
IAIS
(Insurance)
PIOB
IASC
Monitoring
Group
IFIAR
(Audit)
Source: Adapted with permission from Sloan and
Fitzpatrick in Chapter 13, The Structure of
International Market Regulation, in Financial
Markets and Exchanges Law, Oxford University
Press, March 2007.
IOSCO Structure
Presidents’ Committee
Co-ordination
Committee (with Basel
and IAIS)
Chairs’ Task
Force
Technical
Committee
Executive Committee
Principles
Implementation
Committee
Standing Committees
•Multinational Disclosure and
Accounting (SC1)
•Secondary Markets (SC2)
•Market Intermediaries (SC3)
•Enforcement & Cooperation (SC4)
•Investment Management (SC5)
Specific issue Task Forces
E.g. CPSS-IOSCO
Internet Task Force
Regional Committees
• Asia-Pacific
• Europe
• Interamerican
• Africa-Middle-East
Emerging
Markets
Committee
Working Groups
• Disclosure and Accounting (WG1)
• Secondary Markets (WG2)
• Market Intermediaries (WG3)
• Enforcement & Cooperation (WG4)
• Investment Management (WG5)
Specific issue Task Forces
SRO Consultative
Committee
Source: Adapted with permission from Sloan
and Fitzpatrick in Chapter 13, The Structure of
International Market Regulation, in Financial
Markets and Exchanges Law, Oxford University
Press, March 2007.
A new European Framework for
Safeguarding Financial Stability
European Systemic Risk Council (ESRC)
(Chaired by President ECB)
Macroprudential
supervision
Members of
ECB/ESCB
General Council
(with alternates
where necessary)
+
Chairs of
EBA, EIA
& ESA
Information on micro-prudential
developments
+
European
Commission
Early risk warning
European System of Financial Supervision (ESFS)
Micro-prudential
supervision
European
Banking
Authority
(EBA)
European
Insurance
Authority
(EIA)
European
Securities
Authority
(ESA)
National Banking
Supervisors
National Insurance
Supervisors
National Securities
Supervisors
Source: De Larosière Report, February 2009.
National Regulatory Structures
57
3
Other bank
regulators
49
35
Central
banks as
banking
regulator
7
54
28
No Central
Bank
interest
10
Central
Bank
39
Non-Central
Bank
Central
bank as one
pillar
2
Tripartite
Dual
'Twin Peaks'
Unified regulator
Source: How Countries Supervise their Banks, Insurers and Securities Markets
2007: Central Bank Publications.
And there were a number of
regulatory failures
US Financial markets regulation was
uncoordinated and overlapping
- Promoted regulatory “competition”
European Regulation also at fault: complex mix
of European and national rules
In the UK, weak FSA regulation of Northern
Rock, and the Bank of England too distant
from financial markets
More regulatory failures
Key markets were unregulated
– Non-bank private mortgage industry
– Credit Default Swaps
• No exchange, central clearing or capital requirements
Insurance industry in the US was lightly regulated
– No federal regulator
– Missed “one-sided” credit insurance & CDS risks taken on by
AIG and others
Basel II capital requirements were flawed
– Allowed too much leverage, over-reliance on credit ratings, and
didn’t encompass liquidity
– Pro-cyclical: as asset prices rose, banks seemed to need less
capital
G20 Summits
“Reshaping the global financial and regulatory
System”
• Enhance corporate governance and risk management
• Strengthen prudential regulation, but with a ‘managed
transition’ to avoid exacerbating the downturn
• Regulate financial activities according to their economic
substance and ensure regulation is consistent in all
jurisdictions
G20 Summits
“Reshaping the global financial and regulatory system”
• Financial Stability Board with standing committees
• Membership of FSB, Basel etc extended to BRICs and
others
• Expanded coverage of regulation to include systemic
hedge funds
• Tighter controls on offshore centres
• Tighter regulation of credit rating agencies
• More and better quality capital in the banking system
• Macro-prudential mechanism to respond to asset price
bubbles
• Regulatory controls on bank remuneration
What about the bankers themselves?
Failures in the financial firms themselves may
have been even more important
• Poor risk management
– excessive reliance on Value at Risk Models
– herding behaviour
– inadequate hedging
• Flawed capital allocation mechanisms
– trading strategies under-capitalised
• Incentive structures which reward short-term
risk-taking
• Weak corporate governance: boards ignorant of
the risks management were taking on
And, finally, there are major problems
with Economics – and efficient markets
Much of the past 30 years of macroeconomics was
“spectacularly useless at best, and positively harmful at
worst”
Prof. Paul Krugman, Princeton
“The unfortunate uselessness of most ‘state of the art’
academic monetary economics”
Prof. Willem Buiter, LSE
“The modern risk management paradigm held sway for
decades. The whole intellectual edifice, however,
collapsed in the summer of last year”
Alan Greenspan
The Global Financial Centres Index
Financial Centre
GFCI Rank
GFCI Rating
London
1
790
New York
2
774
Hong Kong
3
729
Singapore
4
719
Shenzen
5
695
Zurich
6
676
Tokyo
7
674
Chicago
8
661
Geneva
9
660
Shanghai
10
655
Source: City of London Corporation, Global Financial Centres Index, Report - 6, September 2009.
Such a complex failure
has many parents
• Macro imbalances, loose monetary policy and
financial innovation
• Rapid credit growth, asset price bubbles,
overborrowing
• Global finance without global government
• Flawed assumptions about market efficiency and
investor rationality
The Financial Crisis:
Who’s to blame?
Howard Davies
Director, LSE
HSE Cultural Centre, Moscow
14 December 2009