Transcript Document

The BIG Financial Mess:
Causes and Implications for
Financial Regulation
Ugo Panizza
The Myth of Decoupling
GDP Growth
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8
6
4
2
0
-2
-4
-6
2007
2008
2009
EmE
AFR
LAC
ASIA
IND
World
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2008
2007
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2003
9
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4
3
2
1
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-1
-2
1991-2002
Output growth in West Asia
9
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7
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5
4
3
2
1
0
1993
1994
1995
1996
1997
1998
1999
2000
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Output Growth in Jordan
Outline
• Was it a surprise?
• The role of financial innovation
• 7+1 lessons for financial regulation
A Crisis Foretold
 "I think this economy is down because we built too
many houses"
 What really went wrong:
 Weak regulatory regime
J. Stiglitz said: this is the not surprising
consequence of appointing as regulators people
who don't believe in regulation.
 Fighting the last crisis?
 Bad idea if each crisis is different from the
previous
 But are they different?
Was it a surprise?
• Certainly some new elements
– Originate and distribute model
– Financial derivatives
– Shadow banking system
• But the basic mechanism is always the
same (described by Kindleberger and
Minsky)
Was it a surprise?
• A positive shock leads to high growth, low volatility,
and low risk aversion
• This leads to an increase in leverage which further
boosts assets prices and leads to even more risk
taking
• People start thinking that asset prices can only go up
• People who say that the situation cannot continue
forever are made fun of and marginalized
– The standard answer is "This time is different"
– If they are in the financial sector they lose their jobs
• “The trend is your friend”
Was it a surprise?
• Of course things are never different
– Each time the instrument is different
(Tulips, Inexistent countries, Railways,
Internet stocks, houses)
– Nobody knows what will come next (for
sure not subprime mortgages)
– But the mechanism will be the same
Was it a surprise?
• Research by Claudio Borio of the BIS shows
that two or three variables (credit growth,
stock prices growth and housing prices
growth) can predict financial crises 2-4 years
in advance with considerable precision
– (not the exact time of course)
• A few people (Robert Shiller, Nouriel Roubini)
and institutions (UN, BIS) were screaming,
but nobody listened to them
Was it a surprise?
• Policymakers did not do anything because
the operated under the assumption that
markets know best
• I made a mistake in presuming that the self-
interest of organizations, specifically banks
and others, were such is that they were best
capable of protecting their own shareholders
and their equity in the firms. It shocked me. I
still do not fuIly understand why it
happened…
• They also thought that cleaning up the mess
was easy and cheap
Was it a surprise?
• Academic economists where seduced by
policymakers
– …we were in sync with policymakers… lured by
ideological notions derived from Ayn Rand novels
rather than economic theory. And we let their...
rhetoric set the agenda for our thinking and … for
our policy advice. Acemoglu (2008)
• Incentives also matter, both in business
schools and econ departments (Eichengreen,
2008)
Outline
•
•
•
•
Was it a surprise?
The role of financial innovation
7+1 lessons for financial regulation
Topics for discussion
The role of financial innovation in
the subprime mess
• How did NINJAs get all these loans
– In the old system, bankers carefully evaluated
loan applicants and used a lot of soft information
– With securitization, bankers can sell the loans and
care less and less about creditworthiness, soft
information became irrelevant
• (type of shoes cannot be packaged)
• But why would anybody buy crappy loans?
• Enters the law of large number and the magic
of CDOs
CDO?
• A CDO is a structured financial product which takes
risky financial instruments and supposedly transforms
them in less risky instruments.
• Transformation of risk is achieved with a two-step
procedure involving pooling and tranching.
• Pooling consists of assembling a large number of
assets (for instance mortgages) into a debt instrument.
– Pooling can achieve something in terms of risk diversification
• if the payoffs of underlying securities are negatively correlated with
each other
– However, the expected payoff of the whole portfolio is the same
of the expected payoff of the underlying securities.
– The credit rating of the new instrument would be similar to the
average credit rating of the underlying securities.
• There is no credit enhancement with pooling.
CDO?
• Tranching produces credit enhancement.
– With tranching, the original debt instrument is
divided into parts (tranches) which are prioritized
in the way in which they absorb losses from the
original portfolio
– CDOs are usually divided into 3 tranches
• The bottom tranche (often referred to as "equity" or even
toxic waste) takes the first losses
• The mezzanine tranche starts absorbing losses after the
bottom tranche is completely exhausted
• The senior tranche starts taking losses only after the
mezzanine tranche is exhausted.
CDO?
100
20
CC
80
25
60
BBB
100
40
BB
55
20
AAA
0
Plain Vanilla
Senior
Mezzanine
CDO
Toxic waste
PV
CDO?
• With this mechanism, it is possible to start
with a pool of assets which is not investment
grade and transform part of it into investment
grade tranches of CDOs.
• The process does not necessary stop here.
– By tranching the equity tranche of regular CDOs,
asset managers can generate CDO-squared
which extract AAA assets from the toxic waste
component of the original CDO.
– In 2007, about 60 per cent of structured products
were AAA-rated while only about 1 per cent of
corporate bonds received AAA rating
CDO?
• Rating a CDO is more complex than the rating a
single name debt instruments
– It requires the knowledge of both the average
probability of default of the various instruments
included in CDO and the correlation between these
probabilities of default.
• In other words, one needs to know the joint distribution of
the payoffs of the various instruments included in the CDO
– Small mistakes (which are almost irrelevant in the
rating of single name instruments) in estimating such
distribution can lead to large rating errors
• (these rating errors are compounded in CDO-squared).
CDO?
• More important:
– Investors and regulators did not understand
that risk enhancement came at the price of
transforming diversifiable risk into
concentrated risk which is strongly correlated
to overall economic performance.
• It is now clear that AAA ratings of CDO
were based on assumptions that turned
out to be wrong.
Crazy assumptions
• FPA: “What are the key drivers of your rating model?”
• Fitch: "FICO scores and home price appreciation of low single
digit or mid single digit…"
• FPA: “What if home price appreciation was flat for an
extended period of time?”
• Fitch: "Our model would start to break down."
• FPA: “What if home price appreciation were to decline 1% to
2% for an extended period of time?”
• Fitch: "The models would break down completely."
• FPA: “With 2% depreciation, how far up the rating’s scale
would it harm?”
• Fitch: "It might go as high as the AA or AAA tranches."
Conference call between First Pacific Advisor (FPA) and Fitch Rating (Coval,
Jurek and Stafford, 2008)
…ooohhh yeah…
But at least the banks were
safe…
• Not really because they went back in
the game with lightly regulates SIV
– (more on regulatory arbitrage later)
Who was right
• “There is growing recognition that the dispersion of credit risk by
banks to a broader and more diverse group of investors … has
helped make the banking and overall financial system more
resilient … commercial banks may be less vulnerable today to
credit or economic shocks”
IMF Global Financial Stability Report, Spring 2006,
• “Assuming that the big banks have managed to distribute more
widely the risks inherent in the loans they have made, who now
holds these risks, and can they manage them adequately? The
honest answer is that we do not know.”
BIS 77th Annual Report, June 2007
Outline
• Was it a surprise?
• The role of financial innovation
• 7+1 lessons for financial regulation
1
Focus on the Right Definition of
Financial Efficiency
• Information arbitrage efficiency
– In a market that is efficient according to this definition, prices reflect
all available information and, without insider information, it is
impossible to earn return that constantly beat the market.
• In technical parlance, in an informational efficient market the best asset
pricing model is a random walk.
• Fundamental valuation efficiency
– The price of a financial asset is completely determined by the
present value of the future stream of payments generated by that
asset.
• Full insurance efficiency
– According to this definition, a market is efficient only if it can produce
contract under which agents can buy and sell insurance contracts
covering all possible states of nature
• Often referred to as Arrow-Debreu contracts
1
Focus on the Right Definition of
Financial Efficiency
• Transactional efficiency
– It refers to the market's ability to process a large number of
transactions at a low cost.
• Functional efficiency
– It relates to the value added of the financial industry from society's
point of view (it could thus also be called social efficiency).
• Functional efficiency essentially boils down to two things:
consumption smoothing and economic growth.
• From the point of view of a regulator, social efficiency should be the only
relevant definition of efficiency
• Several financial products can yield large private returns but have no
social return
Source: Johnson (2009)
Source: Johnson (2009)
Large Private Returns, But Where
Are the Social Returns?
• In 1983, the US financial sector generated 5 per cent
of the nation's GDP and accounted for 7.5 per cent of
total corporate profits.
• In 2006, the US financial sector generated 8 percent of
GDP and accounted for 40 per cent of total corporate
profits.
• In the meantime, the US financial sector had to be
bailed out 3 times in three decades
– Tobin (1984) “There must be something wrong with an incentive
structure which leads the brightest and most talented graduates to
engage in financial activities remote from the production of goods and
services”
– Rodrik (2008) “What are some of the ways in which financial
innovation has made our lives measurably and unambiguously better”
There can be too much finance
Figure 1: Financial Development and GDP Growth
5
GDP Growth (1975-1998)
4
3
2
1
0
0
0.1
0.2
0.3
0.4
0.5
0.6
-1
-2
Private Credit over GDP (1975)
Source: Panizza (2009)
0.7
0.8
0.9
1
Pure Gambling
Figure 2.3
OUTSTANDING CREDIT DEFAULT SWAPS, GROSS AND NET NOTIONAL AMOUNT
16,000
14,000
12,000
$ billion
10,000
8,000
6,000
4,000
Net exposure
2,000
Gross minus
net exposure
0
October 2008
November 2008
December 2008
January 2009
Source: UNCTAD secretariat calculations, based on data from the Depository Trust and Clearing Corporation.
Who buys insurance against US default?
1
Focus on the Right Definition of
Financial Efficiency
• Key objective of regulatory reform:
– Do not stunt financial innovation but weed out
financial instruments which increase risk but
have no social return
• Avoid regulatory cycles
– Learn from near misses
2
Market-Based Regulation Does
Not Always Work
• There are flaws with the assumption that markets
know best and regulators should not try to second
guess them
– Regulation is necessary because markets sometimes do not
work.
– How can one avoid market failures by using the same
evaluation instruments used by market participants?
– Market-based risk indicators (such as high-yield spreads or
implicit volatility) tend to be low at the peak of the credit
cycle, exactly when risk is high
3
Avoid Regulatory Arbitrage
• Deposit-taking banks are special because the
main source of their success --the provision of
liquidity-- is also their main weakness.
– The stereotypical bank collects demand deposit
and grants illiquid loans.
– Through this maturity transformation process,
which provides small savers with the liquid
instruments they prefer, the banking system can
direct vast resources towards potentially
productive investment projects.
3
Avoid Regulatory Arbitrage
• In normal times, this system works well because only a small
fraction of savers ask for their cash back at any given moment
of time.
• Thus, banks can satisfy any "reasonable" demand for cash
withdrawals by holding small cash reserves.
• If a large number of savers were to approach their bank and
ask for their money back (a thing they have the right to do
because they hold demand deposits), the bank would soon
exhaust its reserves and would have to recall its loans in order
to pay back its depositors.
• But since loans are illiquid, the amount of money that the bank
would be able to recover would be smaller than the face value
of the loan, making the bank insolvent.
• Thus banks are subject to crises of confidence and selffulfilling runs
3
Avoid Regulatory Arbitrage
• Given the importance of the banking system, few
policymakers are willing to tolerate the possibility of a
self-fulfilling run
• Especially because there is a simple method to prevent
such runs.
– A lender of last resort with a deposit insurance scheme can
prevent self-fulfilling runs by guaranteeing that solvent banks
always have enough liquidity to honour their deposits and
protecting each depositor, up to a certain amount, even if the
bank becomes insolvent
• Like all insurance schemes, deposit insurance and the
presence of a lender of last resort may lead the insured
bank to take too much risk
3
Avoid Regulatory Arbitrage
• This is the classic moral hazard problem,
which is also the main justification for
regulating banks.
• Normally, banks take more risk by
reducing capital ratios and thus
increasing leverage.
• As a consequence, modern prudential
regulation revolves around the riskadjusted capital requirements established
in the Basel I and Basel II Accords
3
Avoid Regulatory Arbitrage
Figure 2.1
LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR
30
Leverage
25
20
15
10
Banks
5
1981
1983
1985
1987
1989
1991
1993
1995
Financial services
1997
1999
2001
Life insurance
2003
2005
2007
Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream.
Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average.
3
Avoid Regulatory Arbitrage
Figure 2.2
THE SHADOW BANKING SYSTEM, 2007, Q2
18
16
14
$ trillion
12
Government
sponsored
enterprises
7.7
10
8
6
Finance
companies
1.9
Brokers and
dealers
2.9
Commercial banks
10.1
4
2
Asset backed
securities
issuers
4.1
0
Market based
Source: Shin (2009).
Savings
institutions
1.9
Credit unions 0.8
Bank based
Each institution can be a source
of systemic risk
Providers of financial products
should be supervised on the basis
of the risk they produce
If an investment banks issues
insurance contracts like CDS, it
should be supervised like an
insurance company
If an insurance company is
involved into maturity transformation,
it should be regulated like bank
Broker-Dealers
2006Q1
0.30
ABS Issuers
0.20
Commercial
Banks
0.10
Asset Growth (4 Qtr)
Avoid Regulatory Arbitrage
3
0.50
0.40
2007Q1
0.00
-0.10
2008 - Q3
2007 - Q4
2007 - Q1
2006 - Q2
2005 - Q3
2004 - Q4
2004 - Q1
2003 - Q2
2002 - Q3
2001 - Q4
2001 - Q1
2000 - Q2
1999 - Q3
1998 - Q4
1998 - Q1
1997 - Q2
1996 - Q3
1995 - Q4
1995 - Q1
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• Bank regulation tends to be micro-prudential and
concentrates on the behaviour of individual banks.
• This assumes that policies aimed at guaranteeing the
soundness of individual banks can also guarantee the
soundness of the whole banking system
• This is a fallacy of composition because actions that
are good and prudent for individual institutions may
have negative systemic implications
– Problems with mark-to-market accounting
– Problems with ratings
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• Consider the case of a bank that suffers large losses on
some of its loans
– The prudent choice for this bank is to reduce its lending activities
and cut its assets to a level which is in line with its smaller capital
base.
– If the bank in question is large, the bank’s attempt to rebuild its
capital base will translate into a massive drainage of liquidity from
the system.
– Such drainage of liquidity will be amplified by the fact that banks
lend to each other in the interbank market.
– Less lending by some banks will translate into less funding to
other banks
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
– As a consequence, a bank's attempt to do what is
prudent from its own point of view (i.e., to maintain an
adequate capital ratio) may end up causing problems
to other banks and have negative systemic implications
• (this is the "interconnection" or "credit crunch"
externality).
– In fact, banks with problems may even have an
incentive to make the crisis systemic, because a large
crisis will increase the probability of a bailout
• (this is the "bailout externality").
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• Another channel through which the current regulatory system may have
negative systemic implication relates to "mark-to-market"
– Consider again the example of a large bank that realizes losses and
needs to reduce its risk exposure.
– This bank will sell some of its assets and may thus depress the price
of these assets.
– This will lead to "mark-to-market" losses for banks that hold the
same type of assets.
– If these losses are large enough to make capital requirements
binding, banks will need to reduce their exposure and amplify the
deleveraging process
• (this is the "fire sale" externality).
– The opposite process happens in boom periods and it is one of the
main sources of leverage cycles.
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• By thinking in this way, one realizes that some of the
assumptions at the basis of the Basel Accords do not
make much sense.
• The risk weighted capital ratios of the Basel Accords
impose high capital charges on high-risk assets and
low capital charges on low-risk assets.
• From a systemic point of view this is problematic for
at least two reasons.
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• First, it is likely that during good times some assets
will be deemed to be less risky than what they
actually are and during bad times the same assets
might be considered more risky than what they
actually are.
• This amplifies the leverage cycle because it leads to
a required capital ratio which is too low in good times
and too high in bad times.
4 Guaranteeing the Safety of
Individual Banks Is Not Enough
• Second, relatively safe assets may be those with the highest
systemic risk.
– If there is continuous of debt securities, going from super-safe
assets (e.g., AAA German bunds) to high-risk junk bonds, and
there is a sudden downgrade in ratings linked to a systemic crisis,
which assets are more likely to be downgraded?
– Not the super safe (because of flight to quality) and not the very
high risk (because they cannot be downgraded by much).
• The assets that are most likely to be downgraded are those on the safe
side of the spectrum, but not super-safe (AAA-rated tranches of CDOs
come to mind).
• But these are exactly the assets that had low regulatory capital during
the boom period and, because of the downgrade, will need a much
higher regulatory capital in the crisis period.
4
Guaranteeing the Safety of Individual
Banks Is Not Enough
• Macroprudential regulation needs to
complement microprudential regulation
– It can work like a system of automatic
stabilizers which is also good for political
economy reasons
5
International Cooperation
• Data sharing
– No data on cross-border exposure among banks and
derivative products
– Need to develop a system for evaluating cross-border
systemic risk
• Need to agree on regulatory responsibility for banks
and other financial institutions with an international
presence
• Avoid races to the bottom
• But no common regulatory system
– Increase the participation of developing countries in
standard-setting bodies and agencies in charge of
guaranteeing international financial stability
6
Adjust Incentives in The
Financial Industry
• Pay structure
– Seeking alpha
– How do you measure alpha?
– You can't year over year, people have incentives
to hide risk taking and claim it's alpha
• Credit rating agencies
– How do you create incentives for truthful rating in
a world where the rated pay the raters?
7
Lessons for Developing
Countries
• Protect yourself
– Avoid appreciations
– Accumulate reserves
• But they are never enough
– Avoid currency and maturity mismatches
– Remember that it may be true that an open
capital account can deliver the goods with
a well-regulated financial system
• But who has a well-regulated financial system?
7
Lessons for Developing
Countries
• Developing countries are often characterized by a
non-competitive financial system in which banks
make good profits by paying low interest on deposits
and charging high interest rates on loans, which they
only extend to super-safe borrowers
• Financial development is good
– But it can also increase vulnerabilities because it alters the
incentives structure of the various players within the financial
system (Rajan, 2005)
– Developing country regulators should develop their financial
sectors gradually to avoid boom and bust cycles
7
Lessons for Developing
Countries
• There is no one-size fits all financial
regulatory system
– We now realize that good financial regulation is
very difficult to implement.
– Thus, there may be a trade off between financial
sophistication and stability
• Countries with more ability to regulate and that are better
prepared to absorb shocks may want to adopt a more
aggressive process of liberalization
• Other countries may want to be more cautious
• The right approach is the one of Deng Xiaoping
+1
The role of state-owned
banks
• Two views
– The scarcity of capital was such that no banking system
could conceivably succeed in attracting funds. . .Supply
of capital for the needs of industrialization required the
compulsory machinery of the government
• Gerschenkron (1962)
– Whatever its original objectives, state ownership tends
to stunt financial sector development, thereby
contributing to slower growth
• The World Bank (2001)
+1 The role of state-owned
banks
• What do the data say?
– The World Bank is right
• La Porta, Lopez de Silanes, and Shleifer (2002)
– It is impossible to say about growth and financial
development
• Levy Yeyati, Micco, and Panizza (2006); Rodrik (2004)
– But public banks can help stabilizing the economy during
periods of crisis…
• Micco and Panizza (2006)
– ..and increase the efficiency of the banking system in low
income countries
• Detragiache, Tressel, and Gupta (2008)
• Gerschenkron might be right, after all
+1 The role of state-owned
banks
• Governance is key
– Some countries have excellent state-owned banks
– Some countries have bad state-owned banks
– Some have both types
• A clear objective function is also necessary to
avoid Sisyphus's syndrome
• But remember, in bad times all banks are
state-owned
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