The Causes and Consequences of the Financial Crisis

Raghuram Rajan Chicago Booth School of Business

Outline

 The causes of the financial crisis  What needs to be done?

 Regulatory changes  The consequences

The Financial crisis: The Proximate Causes

 Bad Investments  Financed with short term debt

Bad Investments

 Child of past crises − Emerging markets => Industrial country corporations => Industrial country household  Sophisticated Financial Sector − Effectively sold mortgages from Phoenix, Arizona to buyers around the world  $ 100 sub-prime mortgages generated $ 80 AAA − Originate to distribute spreads risks but   Quality of originations weakened Depended on house price rising

Bad Investments contd.

 Banks held on to poor quality assets − Signal?

− Inventory?

− Pieces they could not sell?

− Poor governance and risk management   At the top Through the organization − Tail risk − Writing earthquake insurance − Where were the risk managers?

Financed with short term debt

 Short term secured debt cheaper because lenders better protected  Illiquidity (inability to roll over financing) seems remote in good times.

 Market capital requirement low because losses remote.

 Aided and abetted by Fed policy − Greenspan “put”

Credit markets freeze

 Only overnight credit available − Worries about borrower credit risk?

− Worries about own liquidity if lenders want money back?

− Worries about lost opportunities if others dump securities?

 Credit risk and liquidity premia shoot up.

 “Deleveraging” − To households?

− To passive financial institutions?

− To banks?

− To government.

When will credit markets find a bottom?

 When the risk of large institutions collapsing is small.

− Guarantee borrowing in the short term − Audit institutions − Clean up bank balance sheets by isolating/selling problem assets − Recapitalize banks through a mix of private and public funds  When the likelihood of financial assets being dumped on thin markets is small.

− Allow “deleveraging” to run its course  Audit, clean up, recapitalize, private sector participation − Ring fence vs asset purchase − Nationalization

Regulatory questions for the future

 Are countercyclical capital requirements the answer?

 Is Basel II broke?

 Are changes to the structure of compensation the answer?  Sprinklers, not just more firecode.

 How do we deal with “too big to fail”?

Five consequences of the crisis

1) Discredited financial capitalism – Notion that financiers were smart & because of that deserved their wealth • Simple strategies -- at the limit, Bernie Madoff. Suspicion that a lot of Madoffs – Worries about capitalism’s ability to allocate resources and wealth 2) Tremendous shrinkage in wealth and of the middle class – Less support for property rights and low taxes – Focus on inequality

Five consequences of the crisis contd.

3) Political unrest − Those who are losing and have lost − Where is the unrest in the United States? Thus far channeled into the election campaign and the rise of Obama − Appeal for strong government to help.

− Particularly problematic for emerging markets that have been growing fast and expectations are high.

 Safety nets weak – unemployment /health insurance

Five consequences of the crisis contd.

4) Fiscal and policy short-termism – – Fix the problem, the future be damned – the appearance of doing something More money is the answer, regardless of the efficiency of the spending – only about $150 billion of the $ 800 billion plus package in the US will be spent by end of fiscal year 2009. 5) Protectionism – every country for itself and damn the foreigner.

– Trade – Financial – guarantees, now liquidity – – Employment Fiscal – crowd out thy neighbor

Which countries will suffer most in the short run?

• Those that have become most dependent on foreign trade or capital inflows and have the least government capacity and resources.

• Emerging markets – Running large current account deficits – – Dependent on foreign trade and with limited domestic demand With limited buffers such as reserves • More risks as recession endures • Emerging from recession – accentuation of existing problems –export led strategies to build reserves by some, and sustained deficits by others.

Changes in global architecture

1) Need international dialogue in a legitimate and representative setting – – – – – G-20? Not fully representative of small countries or even large ones (Spain). But cannot have UN at table.

Eliminate the permanent IMF Board and replace it by the IMFC, which will meet quarterly at the ministerial level and biannually at the level of head of state. Peer pressure initially to make policies more consistent Eventually once trust is established, possible penalties – perhaps not needed then.

IMF staff can serve to prepare the agenda and background for these meetings.

Changes in global architecture

2) Need changes in IMF – Excessive focus on quotas and votes – – Management No new ideas from emerging markets. Need more buy-in.

3) Need more money to be deployed by IMF especially for the coming year – – Borrowing by Fund from governments over and above quota.

Reserve pooling by emerging markets under a separate governance structure, but advised by the Fund.

– Deals with stigma and conditionality

Conclusion

 Many challenges  Greatest challenge is to the integrated world.

 Time is ripe to push to fix international architecture in a way that is more equitable and effective.

 International organizations should facilitate economic dialogue rather than be seen as the tool of foreign policy of a few advanced countries.