The financial system, measured by assets, profits, contribution to GDP, stock market capitalization, employment etc, has expanded rapidly since 1990. For example, global financial assets were about 50 trillion in 1989 and increased to about 200 trillion by 2007, during the same period financial depth increased from 200% of world GDP to 400% in 2007. The financial crisis has raised a plethora of issues, many of which are inter-twined. There have been failures on all fronts – market failures in the form of financial firms innovating new instruments while neglecting risk management practices, credit rating agencies failing in rating assets without much thought to risk, private auditors not checking Lehman Brothers’ assets and liabilities, government failures in the form of central bank keeping interest rates low in the run up to the crisis, and government entities such as Fannie and Freddie involved in mortgage lending and making enormous losses, and failure by regulators for not checking the books of financial firms such as Lehman Brothers that were moving toxic assets of the balance sheets, and last but least the financial economists who failed to foresee to crisis. There is plenty of blame to go around but one thing is clear: State ownership of financial firms is back. After decades of rising foreign ownership of banks (shrinking state ownership) in almost all regions, except the Middle East and South Asia, the trend could be reversed especially in the developed countries.
The crisis has shifted focus from foreign private ownership to some state ownership, from micro to macro prudential regulations, to re-assessment of deposit insurance, lender of last resort, and implicit guarantees, to consumer protection and taxpayer protection, from mark to market accounting to mark to funding, to revamping of credit rating agencies, to crisis in corporate governance and questioning of remuneration in financial firms, and to strengthening of supervision. These and a number of related issues of interest to policy makers are discussed below.
Given the large set of issues arising from the crisis, the major challenges facing countries are essentially two: (i) Government entities which are subsidizing directed credit (e.g. Frannie and Freddie in USA; similar type of ‘chaebol’ lending to industrial firms triggered the Asian crisis of 1997); and (ii) universality of too big to fail entities, where systemic important firms, often politically powerful conglomerates that are controlled by elites, have to be bailed out, which in turn leads to the moral hazard problem, where the large entity is considered worthy saving at all costs, including use of lender of last resort facilities from the Central Bank and tax payers money from the Treasury. The too big to fail entities also then knowingly max-out on leveraged lending (40 to one in case of USA) and ‘gamble’ on financially innovative instruments (e.g. mortgage-backed securities and credit default swaps in case of USA). The large entities also have the political clout to suppress regulations and/or evade regulations. Successful regulation requires that the regulator should have information on exposure to systemic risks. Too big to fail institutions were exposed to CD swaps (e.g. AIG in USA) and we knew little about its exposure. The reason is that there is data on a firm by firm but there is no agency that can put it all together. But policy makers and politicians are reluctant to address these two problems head on. Instead the focus on a large set of problems, as detailed below, and obfuscate the issues.
Early Response to the Financial Crisis. Policy makers understood early-on that the current global downturn was far from your normal garden-variety recession. The central banks were the first to react, while commercial banks were curtailing credit sharply in the face of global deleveraging – interest rates were cut dramatically, emergency liquidity provision was stepped up, limits to deposit insurance were expanded, and special credit lines were set up for use by troubled banks.
The size of governments expanded overnight. Several crisis-affected and crisis-prone countries directly supported their financial sectors by injecting funds to recapitalize banks, insurance companies and investment banks, especially those deemed ‘too big to fail.’ The International Monetary Fund (IMF) staff estimate that advanced G-20 economies spent about 3.5% of their GDP in such financial support. Hungary, Poland, and Ukraine also took similar steps.
Is the financial crisis over and could it happen all over again? National supervision and regulatory systems were inadequate to manage transnational institutions, such as Lehman Brothers, Citibank, AIG, Dexia Bank among others. Yet, national authorities have to pay more attention to risk taking, limit leveraging, tighten capital regulation, and attend to liquidity supervision as well as supervision of complex cross-border financial institutions, and improve transparency of transactions. Very little has changed in terms of regulating the US and European financial system. If anything, the US financial system has become even more concentrated around Goldman Sachs, JP Morgan, AIG, Citibank and a few others, transparency in transactions has not much improved, and financial firms are continuing their merry ways of the past. Many of these large financial firms have received large bail-outs and could still go under. Directed credit to housing is still continuing. Many countries are in a state of denial about the likelihood of another run on financial firms in advanced economies.
National policies are leading to economic and financial fragmentation and working at cross-purposes with global policies. The crisis has revealed deficiencies in international coordination (e.g. weak IMF surveillance of advanced economies and lack of enforcement authority). Yet global solutions are needed to regulate capital flows, rein in financial firms and conglomerates to prevent systemic and global risks, ensure higher international standards of credit rating agencies (as needed for Basel II implementation), and to eliminate inconsistencies in national legal frameworks. There is talk of creation of ‘a global college of supervisors.’
Incentives. If there is one thing that all economists – right, left and center – agree on, it is that incentives matter. But in the US and UK particularly, incentives contributed to short-termism and financial excesses. Financial firms instead of managing risks and efficiently allocating capital put more effort and resources in politicking and state capture. In return, ex-post, one can say that they got a good rate of return because
- They got ‘self-regulation’ which implied a de-regulatory framework that trusted the financial firms to monitor and regulate themselves on the rationale that they had a lot of money at stake and self-interest and self-preservation will be a powerful incentives for ‘peer pressure’ to check the excess. What the believers in self-regulation such as Alan Greenspan did not understand was that self-regulation combined with an implicit state guarantees such as deposit insurance and tax-payer bailout in case of systemic failure only encouraged firms to aim for short-term profits to maximize their bonuses. This was the underlying reasons as why financial firms were charging fees for every financial transaction, including fees for withdrawing your own money through an ATM machine. De-regulation let them privatize profits but implicit guarantees by state let them socialize their losses. The result was that even during 2009 when they were bailed out profits were unprecedented and bonuses were quite high. Moreover, the bailouts were on generous terms with AIG and others not having any hair-cut and get a dollar for dollar when their ‘toxic assets’ were worth less than sixty-six cents to a dollar.
- To generate more profits, the financial firms needed large volumes, which comes with higher leverage ratios and this led to higher risk-taking and financing against lower quality assets. They got to be too big to fail as they could combine regular banking with investment banking as financial firms could make money both by lending to individuals and corporations and by under-writing and trading in risky assets, while charging fees for every financial services. So financial firms made money and got bonuses if the stock markets went up or if stocks went down and if lending expanded rapidly. This too good to be true environment let them go wild in innovating new financial instruments, such as mortgage backed securities, and grow into large financial firms.
Implicit Guarantees and Role of Government. The state acts as a lender of last resort and there is an implicit guarantee for banking safety nets, such as deposit insurance and liquidity provision and capital injections when needed. For example, during recent crisis, the US, UK, and Euro area governments pumped in $14 trillion or 25% of world GDP in the form of deposit insurance, asset purchase, contingent liabilities, debt guarantees and capital injections. The cost of default insurance is higher for some G-7 governments than for McDonald or Campbell Soup. The budget risk for government solvency comes from the banks and financial firms because of this ‘moral hazardous’ problem. Therefore, the state needs to be an active player in regulating the financial sector, particularly risk-taking and banking safety net because its only solvency is tied to the health of the financial sector1. For example, during 2008-09 the FDIC in US has used up $54 billion from its coffers and has only $3 billion left to bailout depositors in case of bank failures. As a response to crisis, Australia and New Zealand introduced deposit insurance schemes, and over 40 countries expanded the coverage of this insurance. Governments set up these privileges to protect depositors and banks, not to protect hedge funds and private equity funds. Meanwhile, the banking system has been becoming more concentrated – in 2000, the top five largest banks had about 8% of global bank assets but by 2008, the largest five had about 16% of assets. In US as well, 2009 saw fewer large banks than prior to the crisis so the ‘too big to fail’ problem has been exacerbated during this crisis2. The state may say ‘never again’ when bailing out banks but the bankers know that they can game the state.
Too big to fail. The bank-centered financial system was questioned during the Asian crisis because crony-capitalism was under pricing risk. Market-based Anglo-Saxon model was propounded as a better model for stability, accountability, and governance. This 2008 crisis has raised once again the role of the financial sector relative to the real sector and that while banking needs will increase there is no seamless transition to a bank-less market based financial system. Large cross-border financial institution needs regulation. This will need definition of systemic importance or what is too big to fail
The size of its assets or deposits, the complexity of its activities, its role as a counterparty in derivatives or some other measure could be a workable definition of systemic importance. Systemic importance would involve (i) a large bank dominating in financial markets and payment systems; (ii) inter-connectedness if firm is dominant player in the inter-bank market, derivative markets etc. The issue is how to contain the inter-connectedness and discourage ‘too big to fail’ institutions. Large inter-connected institutions are encouraged all over the world, often because of efficiency gains. The mega-institutions are politically powerful and take excessive risks that propagate throughout the system. Large increases in capital ratios commensurate to their contribution to systemic risk or leverage ratios that apply to the entire conglomerate rather than individual bank and intensifying their prudential oversight should be considered to discourage mega-companies which may be too big to fail but may also be ‘too big to save’ by taxpayers.
In case of a failure, there should be procedures and methodologies in place. Common equity holders should take losses, others such as creditors and providers of debt capital should also share in losses. Emerging Markets face the additional problem of managing capital inflows.
Policy responses should focus on (i) how to reduce the probability and suspect of failure of a systemically important financial firm; (ii) making the financial system better able to deal with such a failure. This would need (i) higher capital and liquidity requirements for systemically important firms; (ii) contingent capital in case of failure; (iii) legal structure and business model link to capital requirement in case of complex or not; (iv) self-will transparency in information about its own “demise” plan; (v) moving all over the counter derivatives markets onto an electronic exchange trading platform; (vi) separate out traditional banking business which supports the real economy from the investment banking. There are some practical issues in doing this, so a transitional hybrid approach may have to be followed; and (vii) stopping unregulated firms that developed special investment vehicles which collaterized assets which were illiquid and risky.
Financial Regulatory Paradigms. Whatever the underlying causes of financial crises in developed and developing countries, the most fundamental problem is the widening gap between financial intermediaries’ assets and liabilities. For example, the housing prices declined steeply during the run-up to the 2008 financial crisis in US and Europe, and led to the subprime crisis, which was exacerbated by high leverage ratios and liquidity demands. How can regulation avert or minimize the losses arising from future financial crises.
Three regulatory paradigms coexist in the financial world today. First, under the agency paradigm, the managers of financial intermediaries (agents) intentionally or unintentionally take risks as they focus only on private benefits and costs and not on the impact on society (i.e. externalities are not considered). The market failure here is that managers would be betting with someone else’s money, be it the money of principal depositors or tax payers because there are implicit or explicit guarantees. In the case of subprime crisis, the managers who originated special investment vehicles and credit default swaps to distribute risks had no skin in the game. They were the masters for all the profits and not liable even for one percent of the risks. The solution is for agents to bear the burden of the risks and align the incentives with potential losses arising from the managers’ actions. Risks should be priced and supervisors/securities commission should serve as ‘crime police’ to prevent abuse.
Second, under the collective welfare paradigm, the managers have difficulty in understanding the internal workings of modern finance (e.g. the quantification of securitization and associated risks). Here the managers of most financial institutions engage in a behavior that is opportunistic to them but detrimental to the society. There is a ‘free-rider’ problem in all collective actions. As such, there is a certain amount of ‘systemic herding’ behavior and the ‘financially innovative’ instruments are marketed as the best thing that happened to the world since the ‘sliced bread.’ The solution is to internalize the externalities but pricing of this possible ‘wide-spread failure’ is like insuring against a 100—year flood. It is a rare tail-event or ‘black swan’ event.
Third, under the asymmetric information paradigm, at the level of whole financial system, information on solvency situation of financial intermediaries and their management is of value to depositors and investors but this is kept out of public domain. Informational asymmetry limits rationality to one of bounded rationality. Moreover, there are insufficient incentives and penalties on owners of financial firms and banks, their board of directors and supervisors are likely to raise moral hazard problems that result in non-performing loans and bank failures. The financial system is an ‘elite club’ that tends toward ‘oligopoly’ in its structure as potential entrants are kept out because of informational barriers and there is a need to limit competition so as to have larger profits and limit risk. Information is a public good and the regulatory agency should push for full disclosure, tame the excess creativity and profits, and limit the oligopolistic structure.
The bottom line is that the three paradigms lead to different policy prescriptions, which are often inconsistent. No matter which paradigm the financial regulators appear to be operating in, the fundamental problems of tail-risks, free-rider, informational asymmetry and Knightian uncertainty about unknown-unknowns remain to be addressed. Systemic risk can be minimized by limiting regulatory arbitrage but imposing same regulations on all financial firms that take deposits or borrow in the market place. Intermediaries should not be regulated differentially. Unregulated firms should be allowed only to borrow from regulated firms. A liquidity tax should be considered that penalizes short term borrowing or lending, not penalize the mis-matches as is commonly proposed. The ‘herding’ behavior has to be contained by counter-cyclical prudential norms that central bank fine-tunes depending upon the circumstances in each country at that time.
Limiting Leverage. Leverage allows firms to do business beyond a direct investment of its deposits or own funds. One dimension of leverage is when a firm’s assets exceed its equity base as firms borrow to acquire more and more assets with the aim of increasing their return on equity. Economic leverage is the use of an implicit or explicit guarantee (which does not show up in the firm’s balance sheet) to expand business and that loan guarantee may or may not lead to a contingent liability in the future. Embedded leverage is when a firm holds a security or exposure that is itself leveraged. One way to calculate leverage is the ratio of Tier 1 capital over adjusted assets, where Tier 1 capital is (equity + reserves – intangible assets) and adjusted assets is equal to total assets – intangible assets. The leverage ratio can be used as a macro-prudential and micro-prudential indicator.
Banks’ leverage ratios tend to rise during boom times and falls in downturns (procyclical). The reason is that banks manage leverage by expanding their business, which involves borrowing during boom times, when monetary policy is loose, and lending to achieve higher profits. When monetary policy is tight, banks contract their balance sheets. Leverage ratios could be monitored by Central Banks and managed in an anti-cyclical approach. The leverage ratio has its shortcomings as it does not distinguish between different types of assets, and is too focused on balance sheet. It does not detect embedded leverage. Moreover, it has to be used along with other macro- and micro-prudential indicators.
Credit Rating Agencies. A credit rating agency provides an informed opinion on the creditworthiness of a financial debt issue or issuer. Each credit rating has its own methodology and in some countries they are treated as free as financial journalists to opine. The credit agencies are not regulated but financial regulators have depended on them extensively in assessing capital requirements or securitization exposure of financial firms, identifying investments (e.g. mutual funds), evaluating credit risks of assets, and disclosure requirements for rated firms. Credit rating became indispensable for new financial instruments, while at the same time, the issuing firm was paying for or working in collusion with the credit rating agency to improve the rating of the new instruments to an investment grading. Moreover, Standard and Poor and Moody dominate the US market. The concentrated structure, the subjective but critical ratings, and the conflict of interest in the issuer-pays model contributed to inability of rating agencies to foresee the sovereign debt crises in Latin America, the accounting/financial problems of Enron, Worldcom, Parmalat, Bear and Stearns, Lehman Brothers or any of the major corporations that went under in recent years.
The originate and distribute model of risk dispersion were all given investment grade, including AAA rating to mortgage backed securities, and failed to predict the default of structured debt and default swaps. Several flawed instruments were upgraded leading to financial excesses while the going was good, and the subsequent downgrading when the crisis hit in 2008 only made the crisis worse.
Policy responses warrant that the privilege of credit agencies be re-thought, introduce more competition in ratings and make them liable for their ratings, and stop the use of issuer-pays model. There is a need for a global supervisory agency that could establish global standards for rating agencies and for bringing in global competition in rating agencies, but the tension between a global regulator and a national regulatory body should be resolved with the host country having authority to over-ride the global regulators.
Optimal regulation. The financial systems need a thorough over-haul. While over-regulation may have some adverse affect on financial innovation, self-regulation has been globally damaging and the costs have far exceeded the benefits of financial innovation, and under-regulation may not avoid future systemic crises. Politicians in both advanced and emerging markets have been captured by the financial sector and this problem needs urgent attention. Governments should encourage financial firms to self-insure among themselves and not rely on state or central banks for liquidity provision or bail-outs. Rules and criteria when the government intervenes in abnormal times should be made clear. Government should move towards risk-based deposit insurance premia, and encourage co-insurance and re-insurance among the banks. A large number of changes as detailed below are discussed and debated.
Macro-prudential regulations. Until the crisis, capital ratios of individual banks are assumed to be adequate for the stability of the entire financial system. But in an inter-connected and leveraged financial world, selling of an asset because it is deemed risky by one financial firm may be good for that firm but if all firms sold the ‘toxic asset’ around the same time, the price of this asset will plummet and lead to wide-spread liquidity problems, losses, and heighten the uncertainty in the system. A macro-prudential approach is needed to look at risky assets taking into consideration the existence of liquidity risks, market risks, credit risks, insolvency risks, and other forms of risks. The recent crisis has shown that market discipline is not a defense against macro-risks. During booms, securitization appears to help improve the safety of financial firms, and most financial firms show good assets and strong balance sheets but when crises follow the booms these very firms have bad assets and bad balance sheets. For example, in March 2010 it was revealed that short-sellers in September 2008 were worried about the Lehman Brothers book-keeping, who were parking their bad assets with mutual funds while showing good assets on their books. In this case, market players knew more than regulators, but neither the market players nor the regulators were able to assess the macro risks. Therefore, differentiation of good versus bad banks and good versus bad assets is very poor.
The G-20 meetings of March 2009 recommended that during booms capital buffers be built so that during busts these buffers can be drawn down. For example, financial stability committees that exist in a number of countries could recommend that capital requirement ratios be kept relatively low during bad economic times but increased to twice as much during periods of a boom. Similarly, mismatches between maturity of assets and liabilities can be regulated through capital requirements. The Geneva report of 2009 recommends that a two-year asset that cannot be posted with the Central Bank should be matched with a two-year liability. Any mismatch should be prone to increase in capital ratios, over and above the boom-bust capital requirements. It is hoped that stacking of capital requirements would prevent systemic failures.
Financial Policy should be mandated first to deal with credit booms. Given the limitations of monetary policy, such as interest rate increases in dealing with booms, prudential and administrative measures may be better targeted and less-costly. For example, minimum regulatory capital requirements should be increased during booms and lowered during downturns. Similarly, limits on sectoral loan concentration, tighter eligibility and collateral requirements for booming sectors, limits on foreign exposure etc could have been deployed to contain risks associated with credit booms and busts.
Booms and busts are inherent to the financial world, and the aim is to moderate the risks during the cycles using micro and macro prudential regulations, as well as other measures such as strengthening supervision. Supervisors need to focus on both micro and macro analysis and oversight, work more closely with Central Bank regulators, and be more proactive in restricting specific firms that are lending too much against housing or properties or other risky assets.
Another regulation that is being discussed is the introduction of mark to funding accounting to complement the current mark to market or fair value accounting. In a liquidity crisis, the market price of assets fall more precipitously below the present value and this triggers the need for capital requirement. Under mark to funding approach, a weighted average of market price and present value of asset could be used, with funding institutions proposing the value of the weights. This may moderate the risks to the financial system.
Furthermore, the interaction between macroeconomic policy and financial sector should be improved. In every country, macroeconomic and financial stability is generally separated. While macroeconomic policy is focused on low inflation and high growth, financial sector is focused on bank-by-bank supervision of formal sector banks. Past crises and the current one again show that shadow financial and non-financial sector (e.g. investment banks, hedge funds, housing societies, government-secured enterprises etc) carry large risks connected with credit growth, leveraging and asset prices. Several prudential measures are needed to deal with these set of issues. In addition, the macroeconomic policy is concerned with corporate sector and how it finances the investment spending, including the public private infrastructure. Monetary theory and policy is concerned primarily with credit channel as the transmission mechanism. Such an approach is based on past thinking of credit rationing and crowding out among competing demands of public and private sectors. Meanwhile, the financial system has become too innovative and revolutionized investment financing mechanisms. For example, the private investors are interested in maximizing their profits but this is not taken into account in defining the objective function of the Central Bank.
Financial Innovation presumes that it will improve financial intermediation and these will be welfare improving while keeping risks low. Greenspan’s ‘self-regulation by private sector’ because the private financial firms have a lot at stake to lose and will do the correct thing for their own self-preservation. This approach of self-regulation resulted in de-regulation and under-regulation in domestic and international financial markets which led to high exposure by the tax payers and resulted in higher costs of bail outs.
The troubles of several American financial firms in 2008 was partly due to financial innovation where in new instruments were created under the ‘originate and distribute’ model and where the originator had no stake in the newly created instrument once it was sold. Therefore one of the recommendations is that there be a regulation requiring the originator of any securitized assets or cash flows to retain a sizeable fraction of the equity tranche or first-loss tranche of the securitized instrument. Volcker recently said that the only great financial innovation that occurred in recent decades is the innovation of ATM machines, and that too it is more a ‘mechanical innovation’ and not a financial innovation.
Quants and Risk Models. Following the October 1987 stock market crash, the value at risk (VaR) was introduced as a risk management tool. In early 2001, stress-testing methods gained momentum as the IMF introduced it in a number of countries. Market failures abound while dealing with risk. For example, there is “disaster myopia” where drivers slow down just for enough time period to watch an accident, and once the accident scene is passed, they drive along and very soon the memory of the accident fades away and soon they would be driving at high speed. In other words, the financial disaster of 2008 will soon be forgotten and financial firms will be back to their old tricks and continue to under-estimate risk.
In recent decades, the mathematical whiz kids (called “quants’) were dominating the financial markets. The quants were in an elusive quest for universally unseen patterns in the financial markets and they felt that their mathematical prowess only can discover this hidden patterns. By 2004, they were giddy with exuberance as they had tamed ‘financial volatility’ and made the financial system a smooth, humming machine that works like clockwork, that is a deterministic system. This sentiment is also reflected in the Great Moderation speech by Federal Reserve Chairman, Ben Bernanke, in February 2004. Financial volatility was conquered and there was a Goldilocks Economy – neither too hot nor too cold. The efficient market hypothesis was totally believed by the quants and their models could completely predict the future, just like in physics. But then, human behavior is hard to model. Men and not machines and that is why some of us gravitated to economics. The result of this delusion in not understanding the difference between models and reality was that there was an underestimation of the risks and dangers of possible breaking of asset bubbles. The quants made assumptions that were not valid and they had no respect to Mandelbrot’s work on fat tails at the edges of the bell-curve and paid no heed to possible occurrence ‘black swan’ events. As Warren Buffet wrote to Berkshire Hathaway Fund stakeholders in 2009, “beware of geeks bearing formulas.’
Risk management is about avoiding the mistake of betting so much money that you can lose it all. Therefore, risk models are based on many assumptions and generate results based on the data inputs provided into them. Banks too excessive risks and the events of 2008 identified serious deficiencies in risk models, which was categorized as Philip Jorian (2009) as (i) known-knowns, where all known information about factors affecting risks are incorporated and only bad luck brings about losses; (ii) known-unknowns, where there are model-risks because of ignoring important risks arising from not knowing much about volatility , mark-to-market risk as has happened in the 2008 crisis and credit default swaps (CDSs) that protected the mortgage backed securities were exposed to very different risks in reality, while in modeling both were assigned the same risk because one was an insurance for the other; (iii) unknown-unknowns, where the events are beyond the scope of most scenarios, such as Lehman Brothers’ collapse because they did not know the counterparties risks to the counterpart – also called Network Externalities. Risk management needs experienced people who can effortlessly have back-ward looking risk measures and move toward forward-looking scenarios.
1. As Haldane (2009) details, over the past century, in UK, capital-asset ratios have fallen steadily from 25% of total assets in 1880 to about 6% in 2000 and for US the capital ratio fell from 17% in 1880 to 4% in 2008. Liquidity ratios have also decreased from 30% of total assets in 1968 to close to zero now. Therefore, the banking systems in US and UK are becoming more risky for the states while returns received by banks was closely to 30% and volatility of returns has also increased since 1970.
2. Haldane (2009) points out that the largest bank has over 3 trillion dollars in assets while the largest hedge fund operates with $40 billion in assets, and hedge funds are small, specialized, with high entry and exit compared to the banking system.
Haldane 2009. The State of Banking, Bank of England.
Jorian, Philip. 2009. Risk Management Lessons from the Financial Crisis. European Financial Management Journal.
World Bank, FPD Crisis Response Policy Briefs, 2009-10.
LAC Crisis Briefs, various.