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financial stability

What Explains Comovement in Stock Market Returns during the 2007–08 Crisis?

Maria Soledad Martinez Peria's picture

The 2007–08 financial crisis was one of historic dimensions—few would dispute that it was one of the broadest, deepest, and most complex crises since the Great Depression. Initially, however, the crisis seemed to be of rather limited scope, and many thought countries would be able to “decouple” from events in the United States. But after Lehman Brothers collapsed in September 2008, the crisis spread rapidly across institutions, markets, and borders. There were massive failures of financial institutions and a staggering collapse in asset values in developed and developing countries alike. Nonetheless, the reactions of stock markets varied widely around the globe, with some countries showing greater comovement with the US market than others (figure 1).

Together with Tatiana Didier, we empirically investigate the factors that determine comovement between stock market returns in the United States and those in 83 other countries in a recent paper. In particular, we evaluate the extent to which comovement with US stock market returns during this recent turbulent period was driven by real linkages, was driven by financial linkages, or was the consequence of “demonstration effects” (see Goldstein 1998 and Masson 1998), in which investors became aware of vulnerabilities present in the US context and reassessed the risks in other countries, reevaluating the value of their stockholdings.

The AAF Virtual Debates: Charles Calomiris's Response on State-Owned Banks

Charles Calomiris's picture

I have to admit, I am a bit puzzled by my friend Franklin Allen’s first entry in this debate. There simply is no evidence—none—in support of his statement that mixed systems of state and private banking tend to be a good idea. And his mention of China is doubly puzzling. China’s state-owned banks have been a disaster, fiscally, allocatively, and socially. They cost the Chinese people hundreds of billions of dollars in bailout costs a decade ago, and, according to most informed observers, may very well soon repeat a similar magnitude of losses. Allocatively, they are famously wasteful of resources, as they have been a political tool for propping up the unproductive state-owned sector, which explains their continuing huge losses (recognized and unrecognized). The internal corporate governance of these unwieldy institutions is a nightmare. The financing arrangements that have succeeded in attracting private capital are well understood to be a political deal between global banks and the Chinese government; global banks invest in the state-owned sector as part of the price they must pay for entry into the Chinese market. And these banks are the central nexus of corruption and influence peddling in Chinese society. China’s growth has occurred in spite of these banks’ distorted lending policies, not because of them.

Some observers have wondered how it was possible for China to grow despite the lack of a deep private formal lending sector. The answer is simple: If a country’s basic economic development is constrained for centuries, then when economic liberalization finally occurs, the marginal product of capital is huge and high returns can be generated from almost any reasonably well-managed enterprise. If retained earnings can reliably earn high annual returns irrespective of how they are invested, growth will be rapid even without a banking system. But that initial bank-independent growth is not sustainable. The Chinese government’s recent financial policy initiatives show that it is well aware that China’s continuing growth is highly dependent on its ability to develop the legal, political, and institutional foundations that will support increasingly selective, private, arms-length lending for productive investments. That transformation of the Chinese banking system is a future prospect, not a current reality, and it is by no means a certainty (see, for example, Minxin Pei’s book, China’s Trapped Transition, or the contributions to my edited volume, China’s Financial Transition at the Crossroads).

The AAF Virtual Debates: Franklin Allen's Response on State-Owned Banks

Franklin Allen's picture

Charlie and Nachiket Mor raise very good points about the problems posed by public banks. India illustrates many of these difficulties—there is much too much political interference, regulations are designed to help state banks, and so forth. But India’s mix of banks is about four-fifths state-owned and only one-fifth privately owned. I’m suggesting precisely the inverse: about one-fifth of the banking sector would be state-owned and four-fifths would be privately owned. Reducing the share of state-owned banks to this minimal level should help alleviate many of the political economy issues. The state-owned commercial banks would need to compete with private banks in normal times as discussed in the blog and this should also act as a constraint on the problems.

The real advantage would come when there is a crisis. Rather than having central banks intervene in commercial credit markets where they have little expertise, the state-owned commercial bank can temporarily expand its role both in terms of assets and loans. This should considerably improve the functioning of the economy and overcome some of the credit crunch problems that Charlie has identified in his research and discusses in his post. The government should also find it easier to avoid bailouts and allow private banks to fail, which is an issue that recurs with every financial crisis. The most recent crisis is a clear case in point: at the moment large banks are not really privately owned. Large banks are privately owned until they get into trouble, at which point the state takes over ownership.

The AAF Virtual Debates: Charles Calomiris on State-Owned Banks

Charles Calomiris's picture

Editor's Note: The following post was submitted by Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University, as part of the AAF Virtual Debates. In this opening statement, Professor Calomiris gives a negative answer to the question: "Can state-owned banks play an important role in promoting financial stability and access?"

It is quite correct to say, as Asli’s introduction to this debate noted, that academic work strongly supports “a growing consensus that the track record of state-owned banks has been quite poor” and has been associated with “inefficiencies, increased risk of crises, and less inclusion and greater concentration of credit,” and support for “cronies.” Not only do studies of the performance of state-controlled banks confirm these findings over and over again, the presence of state-controlled banks is so clearly understood to be a poisonous influence on financial systems that measures of the presence of state banking are often used as control variables when evaluating the performance of private banks. These studies indicate powerfully the negative effects of state-controlled banks on the banking systems of the countries in which they operate. The winding down of state-controlled banks was rightly celebrated in many countries in the 1990s as creating new potential for economic growth and political reform.

Why are state banks such a disaster? There are three main reasons:

The AAF Virtual Debates: Franklin Allen on State-Owned Banks

Franklin Allen's picture

Editor's Note: The following post was submitted by Franklin Allen, the Nippon Life Professor of Finance and Economics at the Wharton School, as part of the AAF Virtual Debates. In this opening statement, Professor Allen gives an affirmative answer to the question: "Can state-owned banks play an important role in promoting financial stability and access?"

The prevailing view in the academic literature holds that private banks are much superior to state-owned or public banks. In many emerging-market countries public banks have been corrupt and inefficient. In contrast private banks have performed much better in terms of efficiently allocating resources over the long run.

However, the crisis has underlined the fact that public banks enjoy several advantages over private banks, and their merits may need to be reevaluated. At the height of the crisis in the fall of 2009, the three largest banks by market capitalization in the world were all state-owned:  the Industrial and Commercial Bank of China, China Construction Bank, and Bank of China. Although they are publicly listed, the Chinese government owns the majority of their shares. Their structure provides an interesting governance model. Perhaps more importantly, most large privately owned banks in Europe and the U.S. received government funds and guarantees during the crisis. Without this government intervention, many would have failed. The governments bore the downside risk but without full control, generating a significant moral hazard problem in these banks’ future operations.

Islamic Banking: Can it Save Us from Crises?

Asli Demirgüç-Kunt's picture

Pundits in the financial press have been asking an intriguing question: if too much debt and insufficient equity was partly responsible for the financial crisis, might Islamic banking be part of the solution? After all, Islamic principles require that financial transactions cannot include interest rate payments on debt, but rather have to rely on profit-loss risk-sharing arrangements (as in equity). For example, demand deposits that do not pay interest are fine, but savings deposits generally participate in the profits of the bank since these cannot accrue interest. Lending also generally follows a partnership model where the bank provides the resources and the client provides effort and expertise, and profits are shared at some agreed ratio. So can the heightened risk-sharing required by Sharia curb excess risk-taking by banks?

In practice Islamic scholars have also developed products that resemble those offered by conventional banks, replacing interest rate payments and discounting with fees and contingent payment structures. Nevertheless, Islamic banking still retains a strong element of equity participation. How does this affect bank risk-taking? Conceptually, the answer is not immediately clear. On the one hand, the equity-like nature of savings instruments may increase depositors’ incentives to monitor and discipline banks. On the other hand, if deposit instruments are equity-like, banks’ incentives to monitor and discipline borrowers may also be reduced since banks no longer face the threat of immediate withdrawal. Similarly, the equity-like nature of partnership loans can reduce the important discipline imposed on entrepreneurs by debt contracts.

The Challenges of Bankruptcy Reform

Leora Klapper's picture

The 2008 financial crisis precipitated a global economic downturn, credit crunch, and reduction in cross-border lending, trade finance, remittances, and foreign direct investment, which all adversely affected businesses around the world. The increase in the number of distressed firms has made policymakers more concerned about the effectiveness of existing bankruptcy regimes, including both the laws that address reorganization and liquidation, as well as improved enforcement of laws in court.

In a recent paper with Elena Cirmizi and Mahesh Uttamchandani, my co-authors and I summarize the theoretical and empirical literature on designing bankruptcy laws; discuss the challenges of introducing and implementing bankruptcy reforms; and present examples of the most recent reforms in this area from around the world. As policymakers use the current recession as an opportunity to engage in meaningful reform of the bankruptcy process, it is important to assess experiences from previous crises.

The Chrysler Effect: The Impact of the Chrysler Bailout on Borrowing Costs

Deniz Anginer's picture

Did the bailout of Chrysler by the U.S. government overturn bankruptcy law in the United States?

Almost two years ago, the outgoing Bush and incoming Obama administrations announced a series of steps to assist Chrysler, the struggling automaker, in an extraordinary intervention into private industry. The federal government intervened in Chrysler’s reorganization in a manner that, according to many analysts, subordinated the senior secured claims of Chrysler’s lenders to the unsecured claims of the auto union UAW. As one participant interpreted the intervention, the assets of retired Indiana policemen (which were invested in Chrysler’s secured debt) were given to retired Michigan autoworkers.

Critics claim that the bailout turned bankruptcy law upside down, and predicted that businesses would suffer an increase in their cost of debt as a result of the risk that organized labor might leap-frog them in bankruptcy. A long-standing principal of bankruptcy law requires that a debtor’s secured creditors be repaid, in full, before its unsecured creditors receive anything.

Financial Access and the Crisis: Where Do We Stand?

Asli Demirgüç-Kunt's picture

Do you wonder how the recent global crisis affected access to financial services? Well I do, and a report by the World Bank Group and CGAP just provided the answer: Data show that even as countries were suffering because of the financial crisis, access to formal financial services grew in 2009.  Indeed, the number of bank accounts grew world-wide, while at the same time the volume of loans and deposit accounts dropped. The physical outreach of financial systems— consisting of branch networks, automated teller machines (ATMs), and point-of-sale (POS) terminals—all expanded.

That’s a relief. Readers of this blog know by now that I am a strong believer in expanding access. Lack of access to finance is often the critical element underlying persistent income inequality as well as slower growth. But the recent global financial crisis has led us to question many of our beliefs and re-opened old debates. It also exposed an important tension between access and stability. Were we wrong to emphasize access in the light of what happened?