Financial crisis and the Great Recession
04/10/11
Overview
How did we get here? The Great Recession And what next ?
p.2
04/10/11
Paul Myners, HM Treasury (UK)
“A banking sector that only works in good times is not competitive at all” “Our banks are only alive because the government has taken decisive action…” “Banks” – Misjudged risk – Failed to hold enough capital – Were obsessed by short-term results p.3
3
04/10/11
Paul Myners, HM Treasury (UK)
Ambition= – Make future crises less likely – Ensure the tax payer will never again be asked to step in when banks and traders get into trouble
Living wills Deferred compensation Higher & better capital standards p.4
4
How did we get here?
04/10/11
What went wrong?
A) Extreme risk positions in products one didn’t understand B) Excessive leverage C) Excessive reliance on wholesale market financing
p.6
6
04/10/11
Asset exposures
p.7
7
04/10/11
Was risk priced adequately?
A joint default probability the likelihood that any two members of the pool (A and The probabilities of how B) will both default. long A and B are likely to survive. Since these are not certainties, they can be dangerous: Small The all-powerful miscalculations may correlation leave parameter, which you facing much more reduces risk correlation to a single than the formula constant—something that indicates. should be highly improbable,
The amount of time between now and when A and B can be expected to default.
This couples (copula) the individual probabilities associated with A and B to come up with a single number. Errors here massively increase the risk of the whole equation p.8 8 blowing up.
04/10/11
Leverage positions
p.9
9
04/10/11
Loans to deposits ratio (2007)
p.10 10
04/10/11
Transaction-based financial capitalism
Anonymous capital market, i.e. disintermediation – Originate and distribute model – Securitisation – Off-balance vehicles Facilitates risk trading Flexible Discourages long-termism & commitment Creates Principal-Agent problems in gathering & disseminating information and monitoring behaviour of ultimate borrowers Funded mainly through wholesale capital markets p.11 11 Vulnerable to market illiquidity/instrument
And what next?
04/10/11
Financial products less regulated than foods?
Financial products less regulated than foods?
p.13 13
04/10/11
Banks too big to save? Hello Europe?
p.14 14
04/10/11
Banks too big to save? Hello Europe?
p.15 15
04/10/11
Too big to fail= unsustainable
Privatising gains, socialising losses Moral hazard Tax payers money used to take over small banks? “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ p.16 problem is too important to ignore
04/10/11
Regulators promise they will be better next time “A macro-prudential approach, major changes to capital adequacy regulation and major changes in the regulation of liquidity." Many economic analysts are wary of microregulation: they propose structural changes: – Higher capital requirements and “living wills”: if sufficiently demanding, then: same outcome as the separation involved in narrow banking – Mervyn King called for banks to be split into separate utility companies and risky ventures, saying it was “a delusion” to think tougher regulation would prevent future financial crises. p.17 17
04/10/11
Key ingredients
First, make it possible to bankrupt any and all institutions, even in a crisis. Second, make financial institutions safer, with much higher capital requirements, against all activities. Third, prevent off-balance-sheet activities. Fourth, impose dynamic provisioning. Fifth, require huge cushions of contingent capital. Finally, cease to favour debt-finance, throughout the economy. p.18 18
04/10/11
Pigs can’t fly: better split utility from casino
‘Too big to fail’ is too dumb an idea to keep There are people who believe that better regulation, co-ordinated, will prevent failures =There are also people who believe that pigs might fly It is impossible for regulators to prevent business failure, and undesirable to pursue that objective. We need to… setting up firewalls between activities, within companies and across sectors, and by breaking down large institutions into parts so that problems of individual elements do not jeopardise the whole. p.19 19
04/10/11
Pigs can’t fly II
"Mervyn King called for banks to be split into separate utility companies and risky ventures “Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.” Many believe that the governor will get his way on separation, but by default rather than by design, because proposals for tighter capital regulations on risky parts of banking will make these unprofitable and banks will choose to ditch them. p.20 20
04/10/11
Narrow banking
Repealing Glass Steagall Act of 1933 in 1999
Uitstellen consumptie
Uitstellen investeringen
p.21 21
04/10/11
Large banks have big trading books
p.22 22
04/10/11
Crisis caused by bad regulation? Not through the CRA
Revisionist view that the crisis was caused by bad regulation. It was not: the crisis was caused by greedy and inept bank executives who failed to control activities they did not understand Did CRA Cause Mortgage Market Crisis? Nope, Says Fed : Governor Randall S. Kroszner, December 3, 2008 p.23 23
04/10/11
Crisis caused by bad regulation? Yes: bad prudential policy
Banks being too big to fail; the lack of responsibility that can follow securitization; imperfections in credit ratings; capital requirements which accentuate boom and bust; A few years ago: – regulators, with few exceptions, wanted big banks to have lower capital requirements if they had sophisticated risk models; – they were cheerleaders for securitization and asset sales by banks because, they said, this spread risks; – they hard-wired credit ratings into bank risk assessment; – they promoted home country regulation over host country control – they dismissed that regulation was dangerously pro-cyclical. p.24 24
04/10/11
Risk profile statement of financial institution X General Risk Profile X’s core business is retail banking based on simple product offers. It is not involved in Investment banking, corporate banking, structured finance or trade finance. Its treasury and financial market activities are limited as X maintains a very conservative approach to market risks, Asset & liability management and interest rate risk management. As such, being a retail bank, X’s risk management policy is based on following key principles: A qualitative retail credit risk portfolio A high quality sovereign, local authorities, international institutions and bank counterparties portfolio Standard operational risks Prudent market, asset & liability and interest rate risk p.25 25
04/10/11
Central bank principles
Liquidity = a public good The degree of liquidity depends on confidence and trust. These are more easily undermined when the instrument is complex and poorly understood by one or both sides of the market.
Solvency= a private good
What we really need is a Special Resolution Regime (SRR) p.26 26
04/10/11
Greenspan doctrine is dead= CB have to prick bubbles
Greenspan: “I found a flaw”, “…that's precisely the reason I was shocked” George Soros: Detecting bubbles is no exact science, nevertheless authorities have to accept the assignment. This implies: control credit by margin requirements and minimum capital requirements (instructing banks, LTV…) p.27 27
04/10/11
Capital ratios for UK and US banks
p.28 28
04/10/11
Rebalancing of the world economy
China ea maintaining a mercantilistic policy Macroeconomic imbalances here to stay for a long time – Asian crisis 1997=hoarding forex reserves – Funelling liquidities to Western world – Sovereign Wealth Funds
p.29
04/10/11
Macroeconomic imbalances TBC
US saving more and China consuming more?
p.30
04/10/11 04/10/11
A: Digested legacy?
p.31
04/10/11
B: Deleveraging long way to go
p.32 32
04/10/11
C: More stable financing? Loans-deposits ratio
p.33 33
04/10/11
Hedge funds: the dog that has not barked
Most Hedge funds operated with a leverage 10 times less than largest banks Large number of small players Partnerships with unlimited liabililty
p.34
04/10/11
Goldman Sachs apologizes & risk management
“We participated in things that were clearly wrong and have reason to regret. We apologize.” Lloyd Blankfein: “I live 98 per cent of my time in the world of 2 per cent probabilities. I live always in the worst case.” “If I had to focus on a key failure in this crisis, it was the failure of risk management” at other institutions
p.35
04/10/11
Regulation to save capitalism Adam Smith: WN,Book II: “Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order
p.36 36
04/10/11
Het antwoord tot nu toe:
Brandweer verhuizen Staatswaarborgen plaatsen Internationale regelgeving (Bazel…) Microregulering p.37
04/10/11
Expliciete waarborgen (maar impliciet…)
p.38 38
04/10/11
De Ierse catastrofe
Insolvabele banken Ierse regering stelt bevolking garant voor alle verplichtingen van banken “Goedkoopste bankenredding ooit” = Ierse slavernij p.39
04/10/11
Tweede bankencrisis onder andere gedaante: schuldencrisis
Dexia; KBC > 100% kapitaal
p.40 40
04/10/11
Internationaal antwoord: Bazel
p.41 41
04/10/11
Nog steeds onbeantwoord:
Systeembanken: progressieve kapitaalbuffers Liquiditeit Internationale resolutie: grensoverschrijdende banken
p.42
04/10/11
Sommige landen willen hun bevolking beter beschermen
IJsland : inkrimpen van banksysteem Zwitserland : banksysteem moet risico’s zelf dragen VK: structuurwijziging bankstelsel
p.43
04/10/11
IJsland: banken = te groot voor het land
p.44
04/10/11
Zwitserland
UBS + Credit Suisse= 50% hogere kapitaalvereisten dan Bazel (100% als winsten hoog zijn) + leverage ratio Dus 19% kapitaal waarvan 9% contingent convertible capital p.45
04/10/11
UK
Afsplitsen van spaar –en investeringsbank In België was lobby zelfs sterk genoeg om banktestament tegen te houden
p.46
04/10/11
Conclusies
Cognitive capture: weinig bankexperts kijken niet door ogen van bankbelangen zelf Roekeloos risicogedrag ook bij niet-vermoede partijen (cf. Gemeentelijke Holding: dividend + puts)
p.47
04/10/11
Sleutelprincipe om Japans/Iers scenario te vermijden
Solvabele banken met tijdelijk tekort bijstaan Insolvabele banken ordelijk ontbinden – Gemakkelijk voor kleine banken (US) – Ook noodzakelijk voor grote banken (Ierland)
p.48
04/10/11
Adviezen voor civiele maatschappij
Laat u niet intimideren door: – Zij die er trots op zijn dat “Ze meer verdienen op een uur dan jij op een maand” en het dus (??) beter weten – Bewindslui die wel “in jou plaats oordelen wat goed is voor ons allen” – “Experts” die met zogenaamd gesofistikeerde modellen afkomen
En doe beroep op gezond verstand.
p.49
Questions?
