Transcript Financial crisis and economic downturn: Where did they come from

Financial crisis and economic
downturn: Where did they come
from and where are they going?
Presentation by Charles (Chuck) Freedman
Scholar in Residence, Economics Department,
and co-director, Centre for Monetary and
Financial Economics, Carleton University
Halifax Initiative Conference, October 15, 2009
Introductory remarks
• Many elements in explanation of the current
financial and economic crisis
• Complex interactions among the various
elements
• Most notably, the financial crisis and the
economic downturn fed on each other, with the
deterioration in the financial sector worsening
economic situation and deterioration in the
economy intensifying financial crisis
Subprime mortgage markets
• Begin with problems in US subprime mortgage
markets
• Many weaknesses and lots of blame to go around
• First, perhaps in part as a result of the originate
to distribute model, decline in lending standards
and monitoring of mortgages
• Second, financial institutions should have been
much more aware that housing prices typically do
not rise forever
Subprime mortgage markets
• Third, some of the practices of originators and brokers
worsened outcomes
(a) encouraged borrowers into variable rate mortgages
(b) initial “teaser” interest rates
(c) compensation of agents arranging such mortgages
• Fourth, in the United States, view of governments and
governmental authorities that homeownership should be
encouraged and subsidized
• Fifth, legal situation of no recourse in most states in the
United States
Derivatives
• Risk with derivatives that “the inherent
complexity of the instruments raises the
concern that management will not understand
or be able to control effectively the amount or
type of risk being taken on by the firm”.
• In many cases, either companies did not
understand the underlying risks that they
were taking and/or underestimated
probability of tail events
Derivatives
• For many years, mortgage-backed securities
operated very effectively
• Then came collateralized debt obligations (CDOs)
with tranches that could be tailored to the needs and
desires of purchasers
• Credit rating agencies played important role in
providing ratings to the various tranches of these
instruments
• But neither rating agencies nor purchasers of these
instruments had a very clear understanding of the
probabilities with respect to the outcomes of the
payment flows from these instruments
Derivatives
• Purchasers rarely did due diligence themselves,
relying excessively on the CRAs
• Among the problems that the CRAs had difficulty in
addressing were – default probabilities (in absence of
long history with subprime mortgages); sensitivity to
small errors in estimation of riskiness of tranches of
CDOs and especially CDO-squared; underestimate of
correlations of returns on assets backing the CDOs
• And some concerns have been expressed about the
CRAs’ conflicts of interest
Derivatives
• Credit default swaps (CDSs) also played important
role in the development of the financial crisis
• In many cases, sellers of CDSs underestimated
the probability of unlikely negative outcomes
(“tail events”) occurring
• And purchasers frequently underestimated or
ignored the risk that the counterparty (e.g., AIG,
monoline insurers) would be unable to pay off
the insurance if the insured event occurred
Derivatives
• A fundamental problem in this and other areas was
the failure of risk management
• Either risk management units did not recognize the
extent of risk involved in the strategy being
followed or senior management did not pay
sufficient attention to the concerns of risk
management units
• Problems with compensation arrangements that
took insufficient account of what might happen in
coming years
Regulation/supervision
• Either authorities did not recognize the risks being
undertaken or pressures from governments to provide
light regulation outweighed any concerns they might
have had
• Some financial entities that did not appear to fall under
safety net less supervised than those that did fall under
the safety net
• In practice, it turned out that a number of such entities
were either too large to fail or too complex to fail or too
interconnected to fail and therefore in the end did fall
under a form of safety net provided by the authorities
Assumptions about liquidity
• Another problem was the assumption that
there would always be liquidity in the markets
for the financial instruments and therefore
arrangements for dealing with potential
liquidity problems insufficiently robust
• Indeed, the business case of some financial
institutions based on the assumption that
they would always be able to access wholesale
markets for funding
The unfolding of the financial crisis
• Housing prices started to fall and default rates began
to rise sharply in mortgage markets, particularly
subprime
• With little past experience, great uncertainty as to
value of mortgages and even more so as to the value
of complex derivatives based on such mortgages
• Markets began to dry up, with investors unwilling to
purchase instruments whose value was so uncertain
• Lack of transparency also meant no-one was sure
who was holding the “bad assets”
The unfolding of the financial crisis
• Liquidity of interbank lending markets in turn
began to dry up -- increasing desire to hold
liquid assets and concerns about
counterparties’ solvency because of increased
uncertainty about the value of assets held by
financial institutions in general
• Spreads between interest rates faced by
“risky” borrowers and those faced by
“riskless” borrowers began to increase, at
times sharply (have declined in more recent
period and are currently back to normal)
The unfolding of the financial crisis
• Also, concern about quality of household and
business loans on balance sheets of financial
institutions
• Decline of capital as losses spread
• Absence of markets for certain kinds of assets
and uncertainty regarding the quality of those
assets made it very difficult to gauge whether
liquidity or solvency problem
Macroeconomic developments and
interaction with financial crisis
• Before the onset of the crisis in 2007, the global
economy had had a long period of fairly steady growth
• Low inflation
• Globalization
• Nonetheless, concerns about the “quality” of the
economic expansion
• Large imbalances in the world economy
• Concerns about the increase in the ratio of household
debt to personal disposable income
Macroeconomic developments and
interaction with financial crisis
• Persistence of low real interest rates in the context
of stable growth and low inflation led to a
willingness to take on more risk as part of a search
for yield
• The resulting asset price bubble in turn
underpinned the economic expansion on the part of
both households and businesses
• Turnaround in house prices and the onset of the
financial crisis began to change the economic
situation
Macroeconomic developments and
interaction with financial crisis
• Over time, the real-financial linkages interacted in
a way that caused deterioration in both the
financial sector and the real economy
• Problems in the financial sector led to
weaknesses in spending while weaknesses in
spending led to further problems in the financial
sector
• Concern of authorities was to prevent downward
spiral and to break these linkages
Reaction of the authorities
• Authorities faced multiple challenges – liquidity
problems; solvency problems; rapidly weakening
macro situation; and, in longer run, how to
restructure/reregulate the financial system to avoid
future such crises
• Principal objective of authorities was initially to avoid
a meltdown or implosion of the financial sector, as
this was seen to be one of the major factors in
bringing about the Great Depression of the 1930s
(Bernanke) and subsequently to provide support to
the macro economy
Reaction of authorities to financial
crisis -- liquidity
• Initial issue desire by banks for increased liquidity
• Central banks carried out traditional lender of last resort
function by supplying the increased liquidity desired by banks
• Over time, this part of central banks’ support function
broadened in a number of ways
• First, term loans
• Second, loans to non-traditional institutions
• Third, purchase of riskier assets
• Fourth, higher risk collateral
• Fifth, foreign exchange swap arrangements
• Sixth, securities lending facilities
Reaction of authorities to financial
crisis -- solvency
• Focused on financial entities believed to be
either “too big to fail” or “too complex to fail”
or “too interconnected to fail”, i.e., the
institutions that were believed to pose risks to
the entire system (systemically important
financial institutions)
• Governments bailed out a number of
institutions
Reaction of authorities to financial
crisis -- solvency
• Four principal approaches were taken –
assisted mergers, injections of equity capital
or preferred shares, purchase or guarantee of
“toxic assets”, guarantee of liabilities
• While each of these had the effect of
preventing losses to depositors, their
implications for non-deposit creditors and
shareholders differed
Reaction of authorities to financial
crisis -- solvency
• There is not very much literature on the
advantages and disadvantages of these
various techniques, and governments have
been using “seat-of-the-pants” approach to
decision-making in this area
• Need more study as to which approaches are
best in different circumstances
Reaction of authorities to financial
crisis
• Other issues have arisen in context of liquidity and
solvency problems
• Proper coordination among the various authorities
responsible for financial stability
• Division of responsibility for financial stability in the
euro area (ECB versus national central banks)
• Countries in which banks have grown very large
relative to the size of the economy (Iceland, Ireland)
• Role of international organizations
Reaction of authorities to
macroeconomic downturn
• Principal concern to avoid self-reinforcing
downward spiral that would turn fairly sharp
downturn into much deeper and more prolonged
contraction, possibly including deflationary
pressures that could intensify the downturn
• Both monetary and fiscal tools were used
• Moreover, once policy interest rates approached
zero lower bound, central banks began to consider
unconventional measures
Monetary easing
• Unconventional monetary easing means different things to
different people
• Recent practice has been to distinguish between quantitative
easing and credit easing or qualitative easing
• One set of definitions is as follows (Buiter)
• Quantitative easing is an increase in the size of the balance sheet
of the central bank through an increase in its monetary liabilities
(base money), holding constant the composition of its assets
• Credit or qualitative easing is a shift in the composition of the
assets of the central bank towards less liquid and riskier assets,
holding constant the size of the balance sheet and the official
policy rate
Quantitative easing
• In my view, quantitative easing so defined will have
relatively little effect on the economy
• In circumstances where many assets already yielding
zero return and in which loans seem very risky, the
banks may be perfectly happy to simply hold excess
reserves
• Example from Japan from the 1990s – high base
growth, moderate money growth, negative loan
growth
• Of course, part of the problem in Japan was the
continued weakness of financial sector
250
250
230
230
210
210
MONETARY
BASE
190
190
170
170
150
150
M2
130
130
110
110
NOMINAL GDP
90
BANK LENDING
20083
20073
20063
20053
20043
20033
20023
20013
20003
19993
19983
19973
19963
19953
19943
19933
19923
70
19913
70
90
Qualitative easing
• Qualitative easing has the potential of having
considerable effect
• It could work through reductions of risk
premiums of various sorts and perhaps
through its effect on expectations
• Also, could improve functioning of markets
that were in difficulty
Fiscal policy
• In face of continued weakness of global economy,
focus of macro policy turned to fiscal policy
• Questions with respect to the effectiveness of
temporary fiscal stimulus and with respect to the
preferred mix of policy
• Research at the IMF in which I was involved
concluded that certain types of global fiscal
measures along with accommodative monetary
policy can make an important contribution to
underpinning the global economy
34
Fiscal policy
• Fiscal policy has taken important role,
especially during the period in which
monetary policy constrained by the zero lower
bound (even with quantitative and credit
easing) and in which financial sector not able
or willing to extend credit to the normal
extent
• Important that fiscal stimulus is global and
that monetary policy is accommodative
35
Fiscal policy
• But danger if stimulus packages being
considered create a perception of lack of fiscal
discipline, and more so if lack of fiscal discipline
is not just perceived but also realized
• Credibility concern could be addressed through
appropriate and credible medium-term fiscal
frameworks such as the introduction of fiscal
rules (e.g., long-run targets for ratio of fiscal
deficit or fiscal debt to GDP)
• Also important to avoid protectionist elements
in fiscal packages
36
Exit strategy -- macro
• Aggressive monetary and fiscal strategies along with
support for the financial sector have prevented even
worse outcomes
• Appears that the recovery has started (“green shoots”) but
still hesitant in industrialized economies
• Also, because of the ongoing weakness of the financial
sector and some continued underlying macro problems,
likely to be a more gradual recovery than is typical at this
stage of the cycle
• In many of the emerging economies, downturn was much
less severe and recovery has been more robust
Exit strategy -- macro
• Importance of reversal of both monetary and fiscal easing
as economies come out of recession and settle into
stronger phase of the recovery
• On the monetary policy side, the very high level of stimulus
that is currently in place will have to be removed
• And at least some of the special initiatives introduced by
central banks in the form of credit easing and to deal with
liquidity problems will likely be withdrawn
• However, consideration may well be given to retaining
some of these initiatives as part of the restructuring of the
financial system
Monetary stability and financial
stability
• The interrelationship of monetary stability and
financial stability and the possible role of financial
stability issues in the conduct of monetary policy will
undoubtedly receive considerable attention
• Should monetary policy respond to asset price
bubbles? “Lean or clean?”
• Or, as I would argue, should instruments other than
interest rates be the main mechanism in avoiding
excessive credit growth and asset price booms?
• In case of the latter, how do they affect transmission
mechanism for monetary policy?
Exit strategy -- macro
• On the fiscal side, it will be essential to return
to a credible track for the debt to GDP ratio
• In the absence of such measures, we can
expect to see higher long-term real interest
rates (and hence lower growth of potential
output) than otherwise
• Consideration should be given to the
introduction of fiscal rules as a way of
facilitating appropriate budgetary behavior
Exit strategy -- macro
• Of course, the main challenge to both monetary
and fiscal policy is to get the timing “right”
• Premature tightening could slow down an
incipient recovery
• Excessive delays in tightening could eventually
result in inflationary pressures developing
• As is always the case, the monetary and fiscal
authorities will have to rely upon forecasts, but in
the current circumstances of both financial and
macro uncertainties, forecasting is especially
difficult
Financial sector restructuring and
regulation
• Governments will have to find ways to exit from bail-outs of
financial sector (capital injections, guarantees, and holdings of
toxic assets)
• Much attention is being paid and will continue to be paid to
changes in regulation and supervision of the financial sector
• But will want to avoid regulation that will stifle useful
innovation
• G20 work plan grouped reform efforts under three headings –
improving domestic regulation; cross-border regulation and
cooperation; and IFI reform and refinancing
• My own listing of possible reform efforts is as follows
Financial sector restructuring and
regulation
CAPITAL AND LIQUIDITY
• (1) Higher capital and better quality capital
• (2) Unweighted leverage ratios
• (3) Countercyclical leverage of some sort
• (4) Consolidation of off-balance-sheet entities
• (5) Possible limitations on proprietary trading
• (6) Liquidity requirements of some form
Financial sector restructuring and
regulation
MARKET PRACTICES AND ARRANGEMENTS
• (7) Increased use of strongly risk-proofed
clearing and settlement systems with central
counterparties for clearing and settlement of
derivative transactions of various kinds
• (8) Possible reorganization of the originate to
distribute model to ensure that originators
have incentive to monitor underlying loans
• (9) Role of credit rating agencies
Financial sector restructuring and
regulation
COMPENSATION ARRANGEMENTS
• (10) Attention to incentives at all levels of
organizations in the financial sector – may lead to
compensation arrangements with increased focus
on the medium term and even longer term
• Whether this will be done by boards themselves or
with government involvement remains to be seen
• Boards will likely come under pressure by
shareholders in setting of compensation
Financial sector restructuring and
regulation
SUPERVISORY ARRANGEMENTS
• (11) If entities previously unregulated turn out to be too
large to fail or too complex to fail or too interconnected to
fail and likely to fall under safety net if run into serious
difficulties , essential to bring them under some form of
regulation.
• (12) Attention to financial sector that is large relative to size
of the country
• (13) Much more attention to the role and influence of risk
management units
• (14) Increased regulation of mortgage markets
• (15) Greater transparency (reduced opacity), particularly in
the case of derivatives
Financial sector restructuring and
regulation
• (16) More and higher quality (better paid) supervisory staff
• (17) Legislation should not be overly rigid yet should
provide sufficient safety and stability to avoid repeat of
financial crisis
• (18) Possible reorganization of entities responsible for
supervision
• (19) In some countries, need for better mechanisms for
closure of financial institutions and for crisis resolution
• (20) Possible reconsideration of mark to market
accounting, but not necessarily elimination
Financial sector restructuring and
regulation
MACRO PRUDENTIAL
• (21) Macro prudential supervision will receive
greater attention. Central banks likely to play a
leading role in this area.
• (22) Relatedly, the concept of systemically
important financial institutions will play a
greater role in regulatory and supervisory
arrangements
Financial sector restructuring and
regulation
SUPERVISORY COORDINATION DOMESTICALLY
AND INTERNATIONALLY
• (23) Need for better coordination across the
authorities in a given country and across
countries
• (24) In terms of cross-border regulatory
arrangements, there will undoubtedly be much
discussion of how to deal with financial
institutions with a worldwide footprint
Future macro and financial sector
policies
• More generally, focus on implications of the
policy decisions on incentives and potential
behavior of financial institutions and financial
market participants, as well as the authorities
• Essential to address moral hazard concerns
• Roles and inter-relationships of G20, IFIs
(especially IMF), standard setting bodies (such
as Basle Committee), domestic authorities (e.g.,
peer review) will have to be worked out
Concluding remarks
• Financial sectors and economies worldwide have been
under enormous stress in the last couple of years
• Unprecedented actions by the authorities appear to have
prevented the situation from becoming even worse than it
has been
• Looking forward, important decisions will have to be made
regarding what is needed to restructure the financial
system to avoid a recurrence of the problems that it has
faced and whether some of the innovative techniques
introduced by the authorities to combat the crisis should
be retained for the longer term