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

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

Jacopo Carmassi Daniel Gros Stefano Micossi © voxEU.org

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 dot.com 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.

Conclusion

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”.

References
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.

Naked Capitalism: Geithner's Plan to Have a Reform Plan Skewered by Senate

Geithner's Plan to Have a Reform Plan Skewered by Senate

What amounted to a statement of principles and a very few stakes in the ground from Timothy Geithner on financial reform got a largely hostile reaction from Congress (see Ed Harrison here and here for further detail) [these links work -A].

The main criticism was that the notion of making the Fed the uber stability regulator/financial system overseer (officially, the systemic risk regulator, or SRR). was misguided. We agree with this concern, but even this criticism fails to engage the deeper issues, namely the lack of critical expertise anywhere in the regulatory apparatus, and the failure to do enough examination of the roots of the crisis to devise sound measures.

Those shortcomings are almost certainly features, not a bugs. As we have observed repeatedly, Obama is not inclined to spent his political capital engaging still-powerful financial lobby to push for root and branch reform. And picking Geithner and Summers, both badly captured by the industry, assures that outcome even if he were not predisposed to take at most modest steps here.

First to the role of Fed. Members on the Senate Banking Committee from both parties were unusually pointed in questioning whether the Fed as the right candidate for the job. For instance:

Mr. Dodd described himself as “open on the issue.” But, borrowing a quote from an economics professor, he went on to wonder aloud if giving the Federal Reserve more authority “is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.”

Similarly:

"The Federal Reserve system was not designed to carry out the systemic risk oversight mission the administration proposes to give it," Senator Richard Shelby, the top Republican on the U.S. Senate Banking Committee, said at a hearing.

Concluding that the Fed is better qualified than any other government agency to handle such a job "represents a grossly inflated view of the Fed's expertise."

Shelby, unlike many other Republicans (at least until recently) has the sensibilities of an old-fashioned banker and believes in regulation to assure bank soundness. And his key point is well taken. The Fed is full of economists who worry about interest rate policy. What little enforcement and supervisory culture the Fed ever had was killed via neglect under Greenspan. Even the bank-friendly Office of the Comptroller of the Currency was far more serious about implementing the few and far between strictures imposed on banks pre-crisis, such as the Home Owners' Equity Protection Act.

I am far less troubled by the skill gaps at the Fed (considerable) than its culture and priorities. It is, as Willem Buiter tartly observed, a victim of cognitive regulatory capture. Just as the Treasury-led stress tests were a charade, obviously too thinly staffed to make an independent assessment of what the banks served up, it's almost a given that oversight by the Fed would be largely a matter of form. Supervisors at the Fed would continue to be second-class citizens, and too few in number to boot.

The second line of criticism of the idea of expanding the Fed's powers is that it would compromise the Fed's independence. This concern would be more accurately stated as "further compromise the Fed's independence." Greenspan traded on his Fed chairmanship; Bernanke constrained Fed autonomy further by allowing th Fed to be used by the Administration to circumvent budgetary limits and the need to seek Congressional approval for expenditures to rescue banks. Again, per Buiter, the Fed became a quasi-fiscal agent of the Treasury.

Former Fed economist Richard Alford wrote earlier about how much times had changed:

We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted. ....

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Yves here. One must presume it was reappointment. Back to Alford:

Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

While these are legitimate concerns, the contretemps about the Fed masks more serious issues. The first is, as mentioned above, the powers that be lack the competence to supervise the industry well. That is not insurmountable, particularly now that that Wall Street has shed jobs, particularly in the complex products that were the source of the trouble. But pretending the Fed as it is is competent will assure the needed skills are not developed. Note that regulators do not have to be state-of-the-art, but they do need to be sufficiently well versed to know where the dead bodies might lie, and confident enough not to be deterred by less than complete answers.

But the biggest gap is that the US is embarking on a program of reform without having done sufficient diagnosis of where the problems and vulnerabilities lie. By contrast, the securities laws passed in 1933 and 1934 were based on a detailed understanding of the chicanery and follies of the Roaring Twenties, and provided many specific mechanisms to prevent their recurrence. By the time the Bear Stearns crisis hit, it was clear that the financial system was not going to heal quickly, and that the eruptions were symptoms of far deeper problems. Yet every time, the authorities tried patching the patient up and hoping for the best in place of making a real diagnosis.

For instance, one of the assumptions of the current programs is that Something Must Be Done about too-big-to-fail institutions simply because we've just had to throw a lot of money at them. That may be a necessary part of any reform program, but is is complete? Doubtful. Bear Stearns would not have been on any list of systemically important institutions (it did not make the grade in the Bank of England's April 2007 roster of "large complex financial institutions" deemed crucial for credit market intermediation). Yet the concern that it might be a big enough credit default swaps writer to take down a lot of the financial grid along with it led to Fed backstoping of its unwind. LTCM and AIG would not have been on a TBTF list prior to their implosions either.

That suggests that there needs to be not just an institution-based view of the financial markets, but probably also a product-based persepctive and increased attention to system dymanics. For instance, repos are very big source of non-bank funding for the investing community, and there is evidence that suggests that much higher haircuts on repo collateral played a significant role in the contraction of liquidity. Yet there are no official figures on the size of the repo market, and perilous little consideration of how it played into the crisis. As I read them, the proposals would not address this funding source, which some experts estimate at $10 trillion, comparable in size to the total assets of regulated banks (note there may be some double counting in the repo market size estimates, since it probably includes reverse repos).

Similarly, despite the rosy view we now have of exchanges being great ways to create separate centers of activity that can fail without taking down the financial system (yes, Virginia, exchanges do fail), that idea isn't accurate. Fro instance, in the 1987 crash, the Chicago options exchange was within three minutes of failing, saved only by the personal intervention of Chase CEO Tom Theobald, who authorized a badly-needed overdraft. The equity exchanges, which were separate organizations, came to function as a single market in the crisis. If Chicago had failed, it is pretty certain the NYSE would not have opened. And many observers believed that if it did not open, enough specialists would fail, it might never open (this is a simplification of a discussion from Donald MacKenzie's book An Engine, Not a Camera).

But economists don't do systems dynamics. Nor do they have a theory of financial systems (they have theories that address particular elements, like financial economics, and some relevant constructs, like principal-agent and information asymmetry).

It's bad enough that policy is typically made by looking at a rear-view mirror. But in this case, the authorities haven't even bothered adjusting it to get a good look at the roadkill behind them.

Naked Capitalism: Do the Treasury Proposals on Securitization Reform Go Far Enough?

This is a nice outline of the incentives for securitizing debt instead of making traditional loans:

Do the Treasury Proposals on Securitization Reform Go Far Enough?

The Treasury Department's plans for securitization reform are being bandied about in the press. A key question is whether it can or will fix the now-broken private securitization process.

Credit became more dependent on securitization than many realize. By pretty much any metric, the role of banks relative to other players has declined since 1980, by some measures as much as a 50% drop in market share. Securitization, which is the process of putting loans into pools and often slicing and dicing the cash flows to create instruments that are more appealing to investors, has been the big culprit.

In case you missed it, securitization has slowed down to a trickle. In the US, non-agency securitization was $900 billion in 2007, $150 billion in 2007, and a mere $16 billion through April. Now some of that was dodgy CDOs and other subprime spawn that is better off not coming back. However, if the securitization machine remains impaired, the alternative is on-balance sheet bank lending, and the authorities do not appear interested to going back to banking circa 1980. As the Financial Times notes today:

Securitised markets – which financed more than half of all credit in the US in the years immediately preceeding the crisis – are essential for the US economy. Without a recovery in these markets, the flow of credit will not return to more normal levels, even if US banks overcome their problems.

The reason securitization became so widespread is that it is cheaper than on-balance-sheet bank lending. Traditional lending requires banks to recoup their cost of equity and FDIC insurance premiums. For assets that can be packaged, securitization is more attractive.

From a policy standpoint, therefore, the desire to restart securitization is two-fold. First, it in theory produces more abundant and cheaper credit (although any reduction in yield depends on whether the banks and other participants keep all the cost savings in the form of increased profit or pass some of them on to borrowers). Second, going back to old-fashioned lending wold require banks to have much larger balance sheets, hence more equity. The banks are having enough trouble coming up with enough capital to support their current footings that raising even more equity would seem to be a non-starter.

However, it is not clear that the ideas floated by the Treasury will do the trick. It has two components: the first is requiring that the party that originates the loans to be securitized retain 5% of the deal. The second is to eliminate gain-on-sale accounting, which increased the attractiveness of securitization considerably. Again, from the FT:

The authorities plan to force lenders to retain part of the credit risk of the loans that are bundled into securities and to end the gain-on-sale accounting rules that helped spur the boom of the markets at the heart of the financial crisis...

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared. The proposed elimination of “gain on sale accounting” is to prevent financial companies from booking paper profits on loans – packaged into securities – as soon as they were sold to investors.

Banks would only be able to record income from securitisation over time as payments are received. Brokers’ fees and commissions would also be disbursed over time rather than up front, and would be reduced if an asset performed badly due to bad underwriting.

The US authorities also plan to stop credit rating agencies from assigning the same types of ratings to structured credit products that are assigned to corporate and sovereign

The proposal to change accounting and allow for clawing back of profits if a deal goes bad is probably far more meaningful than having banks retain 5%. 5% is simply not significant enough, in and of itself, to change behavior much.

However, there is an unrecognized contradiction here. The reason securitization became pervasive was both a real improvement in economics (bona fide cost savings per above) which were then compounded by efforts of banks to streamline costs further by scrimping on vetting loans (why bother if all you needed to on-sell the stuff was FICO scores and other simple metrics?). And the favorable accounting also was a considerable impetus.

Thus any activity that changes the incentives meaningfully will also reduce the attractiveness of the economics to banks. Some of this is salutary and necessary. The point is to discourage banks from selling dreck. But effective measures may reduce the size of the securitization market more than the powers that be anticipate. There may be no free, or even cheap lunches here. For instance, it might take a more meaningful retention (20%? 30%) to change originator incentives, but a proportion that lare would make securitiation a far more marginal activity and might require the move the powers that be are hoping to avoid, namely considerably more on-balance sheet lending.

Personally, I'd stick with the changes in accounting treatment proposed, but would increase liability considerably in the event of deficient due diligence and mis-selling (ie, burned investors could go after banks and rating agencies tooth and nail). However, it would take some effort and thought to come up with the right framework.

Sadly, the US seemed able to do that in the Great Depression. The provision of the securities laws of 1933 and 1934 were astute and durable. I wonder why devising good regulatory regimes has become a lost art.