Sunday, August 30, 2009

Simple explanations for global financial instability and the cure: Keep it simple

13 August 2009

Why is there so much disagreement about the causes of the crisis? This column says that lax monetary policy and excessive leverage are to blame. It argues that many alleged causes are simply symptoms of these policy errors. If that is correct, then the recommended corrective is remarkably simple – there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments.
A remarkable feature of the burgeoning literature on the global financial crisis is vast disagreement about its main causes. Symptoms are often treated as autonomous developments requiring separate correction. There is thus a high risk that the legitimate pursuit of a more stable financial system will lead to a potpourri of excessive and damaging regulatory restrictions. In hope of reducing that risk, we offer a simplified reading of the factors leading to the financial crisis and accordingly simple policy recommendations (Carmassi, Gros, and Micossi 2010).
The ingredients of speculative bubbles
Recent events feature three main ingredients that are persistently observed in bubbles. First, there was abundant liquidity in world capital markets, fed by large payment imbalances, notably a large and persistent current account deficit in the US financed by ample flows of capital from emerging and oil-exporting countries. These “global” imbalances fostered an unsustainable explosion of financial assets and liabilities.
The second main ingredient was a credit boom leading to unsustainable leverage (the ratio of debt to equity), and the third was financial innovation, including the explosion of securitisation and derivatives and the “originate to distribute” model, which led to a significant deterioration in lending standards. The key point is that the innovations were instrumental in allowing an increase in leverage, as they moved risks still borne by the originators off of their balance sheets, reduced capital requirements with risk mitigation techniques such as credit derivatives, and embedded leverage in the “equity” tranches of structured products.
Leverage in Europe
Higher aggregate leverage generally indicates less capacity to absorb losses. It is not possible to establish a universal benchmark for excessive leverage, as different financial systems can support quite different ratios of credit to GDP. However, rapid increases in this ratio have been identified as reliable predictors of financial crises.
This warning signal was certainly audible in Europe before 2007-08. First, the increase in economy-wide leverage (measured by the debt-to-GDP ratio) was higher in the euro area than in the US. The increase between 1999 and 2007 amounted to 100% of GDP for the euro area, while in the US it was “only” 80% of GDP. Households’ leverage increased strongly in the US (40% of GDP) and much less so in the euro area. Financial sector leverage, however, increased more in the euro area (about 70% of GDP compared to 40% in the US).
As may be seen from the upper quadrant of Figure 1, large EU cross-border banks had an average leverage ratio close to 35; there were peaks of 70 and even 80 for some British, German, and Swiss banks.

Figure 1. Leverage and exposure to market risk of the largest EU and US banks, 1998-2008

Leverage: total liabilities/net tangible equity. Exposure to market risk: total securities/net tangible equity. Data on 2008 are estimates. Source: R&S - Mediobanca 2009.
Monetary anchors for ever-rising asset prices

Monetary policy in the US was accommodating throughout the 1990s and became aggressively expansionary in the 2000s; nominal interest rates fell below levels recommend by the Taylor rule (and below the inflation rate in 2003-04).

A key feature of a speculative bubble is the attendant anomalous convergence of expectations that occurs when a growing share of investors believes that prices can only go up and that the risk of reversal somehow disappears. The phenomenon of convergent expectations in the stock market was documented by Robert Shiller’s surveys of investor sentiment. Shiller believes that convergence of expectations is a natural, endogenous phenomenon engendered by such things as a long-established benevolent economic environment and economic innovations announcing a new era of prosperity. In his view, monetary policy is driven by the same psychological forces that feed the bubble and cannot be considered exogenous (Shiller 2000).

However, a straightforward alternative is that monetary policy itself provided the anchor for the convergence of expectations, based on the consistent record that any decline in asset prices would be countered by the Federal Reserve with vigorous monetary expansion. Indeed, Alan Greenspan had just arrived at the Federal Reserve at the time of the 1987 stock market crash; he promptly reacted by aggressively lowering policy interest rates. He did it again in 1998 at the time of the LTCM crisis that followed the East Asian and Russian crisis, and even more aggressively after the end of the bubble in 2000. In all these episodes, there were no adverse effects of falling asset prices on economic activity and subsequently stock prices recovered.

The pattern is clear – the Fed repeatedly and systematically intervened to counter “negative bubbles”, while it remained passive when confronted with accelerating credit and asset prices. This policy approach, long established and clearly announced for over a decade, must have played an important role in bringing about convergent expectations of ever-rising asset prices, which eventually destabilised financial markets and the economy. Such an asymmetric monetary policy creates a gigantic moral hazard problem, whereby all agents expect to be rescued from their mistakes. This is where excessive leverage and excessive maturity transformation become relevant.

Banks and leveraged credit booms

A feature of banks that has traditionally justified special regulation is that deposits can be withdrawn on demand at par value. Banks normally do not keep sufficient liquidity to pay back all depositors at the same time, which exposes them to the risk of a run when depositors start to doubt their solidity. Bank runs are contagious and may generate systemic instability.
Non-bank intermediaries do not pose an equal threat to financial stability, since their liabilities are not redeemable on demand at par. They are not exposed to the risk of customer runs since their liabilities are market-priced like their assets. When financial intermediaries that raise money from capital markets by issuing securities make wrong investment decisions, their investors will lose their money without further repercussions for the financial system at large.
US investment banks raised a growing share – eventually, up to a quarter of their total liabilities – of their funds in the wholesale money market but without banks’ public safeguards and prudential constraints. When confidence collapsed, their liquidity evaporated and pushed them over the brink, without much regard for the quality of their assets.

An apparent puzzle is the behaviour of European universal banks, which combine commercial and investment banking activities within the same organisation, that managed to become not only overleveraged, but also overexposed to toxic assets as much as the riskiest Wall Street investment banks, despite prima facie more stringent regulation (Figure 1). This was partly due to lax oversight by national regulators who wanted their national champions to take larger market shares and participate in the great gains of finance. However, the key factor in explaining EU banks’ leverage was risk-mitigation techniques made possible, and indeed encouraged, by the Basel capital rules.

The fundamental problem with these rules is that they create room for reducing capital requirements by choosing counterparties or tailoring operations to legal features so as to economise capital; moreover, once Basel requirements were met, management felt exonerated from any further scrutiny of actual risks. Capital requirements came to be wholly misinterpreted; during the long upswing in stock prices, keeping a buffer of capital over the minimum was seen as a waste of resources, so that the floor became a ceiling.
anagement demands for tools to reduce capital requirements were met by Wall Street – eager to find outlet for the new breed of structured securities – by multiplying the offer of credit default swaps on those securities and securing Triple-A rating for their senior tranches. Besides, Basel capital rules directly encouraged the explosion of the interbank market, later a major source of instability, since they assigned a low ranking to assets such as interbank deposits and bonds held vis-à-vis other banks.

The problem was compounded by a definition of capital that made as many items with little resemblance to equity – such as subordinated debt and other hybrid capital instruments – eligible instruments. As a result, while the target ratio between regulatory capital and risk-weighted assets for European banks was 8%, the ratio between cash and equity and the same assets did not exceed 2%.

Therefore, the key to avoiding repeating this crisis is setting adequate capital requirements that cannot be circumvented for all intermediaries able to raise funds redeemable on demand at par. The simple way of doing it is to set capital requirements with reference to total assets, with no further distinction – 8% should be 8% in cash and equity, with no gimmicks allowed. All risks effectively borne by a bank, regardless of their legal attribution or geographical location, should be included in the asset definition, and accounting principles should be modified accordingly.
Legally separating commercial and investment banking activities or prohibiting banks from undertaking particular activities would not be necessary, which is advantageous considering the enormous hurdles involved in implementing such separation for large cross-border banking groups. At most, one could instead envisage higher capital charges on proprietary trading and lending to highly leveraged financial organisations, so as to reduce their profitability, as currently explored by the Financial Stability Board.


We have argued that the massive financial instability of 2007-8 was primarily the result of lax monetary policy, mainly in the US. The regulatory system compounded this error by tolerating excessive leverage and maturity transformation by banks in the US and Europe. Innovation did contribute to credit expansion and instability, but in all likelihood, without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced.
The logical conclusion is that a repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments. Our main message in designing the new rules for the global financial system is “keep it simple”.

Carmassi, Jacopo, Daniel Gros and Stefano Micossi (2010). “The Global Financial Crisis: Causes and Cures”, forthcoming in the Journal of Common Market Studies, Vol. 48, No.1, January 2010, Special Issue on Europe and the Global Financial Turmoil.

Shiller, Robert J. (2000). “Measuring Bubble Expectations and Investor Confidence” Journal of Behavioral Finance, 1542-7579, Volume 1, Issue 1, 2000, Pages 49 – 60.

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