Transcript The big bank breakdown of 2008

The Big Bank Breakdown
of 2008
The global financial crisis and its
implications for the world economy
Financial and economic Armageddon
Failure of Lehman Brothers provokes a massive loss of
confidence worldwide
Financial markets melt down
Stockmarkets crash worldwide by as much as 50 %
Bank failures and government rescues on a huge
international scale
World GDP falls by an unprecedented amount
Real fears of a repeat of the Great Depression
Economic rescue packages on massive scale
Signs of recovery…. and Armageddon avoided ?
The largest financial crisis in human
history
 ..this is a once in a lifetime crisis and possibly
the largest crisis of its kind in human history
 Charles Bean Deputy Governor of the Bank
of England October 2008
The whole world banking system
close to breakdown
 Not since the beginning of the First World
War has our banking system been so close to
collapse
 Mervyn King Governor of the Bank of
England October 2008
The crisis is a significant moment in
the history of the world economy
 Huge, fast and uncontrollable
 Global
 Systemic
 International response unprecedented
 Historic
Credentials of Professor Brown
 Long term interest in crisis management in
banking
 University – academic study
 The Bank of England – banking supervision
debt crisis of mid 80’s
 IMF- international response to debt crisis
 Price Waterhouse-attempted rescue of BCCI
Outline of lecture
 Chronology and causes of the crisis
 The financial crisis
 The economic crisis
 Some questions answered
 Consequences of the crisis
 Ukraine
Terminology of the crisis
 toxic assets
 credit derivatives
 subprime mortgages
 CDO
 ABS
 CDS
 Leverage
 capital adequacy
 liquidity ratio
 credit crunch
ядовитые активы
кредитные деривативы
высокорисковые ип кред
смеш облигации
ценн бум обеспеч актив
своп по дефолт по кредиту
рычаг
коэф дост основ капитала
коэф ликвидности
кредитный кризис
Terminology of the crisis
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IMF
межнар монетар фонд
US FED фед рез банк
Bank of England банк англии
ECB
евро цертрал банк
Bank regulators банк регуляторы
Basle Committee базел комитет
Financial Stability Forum форум фин стаб
Liquidity support поддержка ликвидности
Recapitalisation вливание капитала
Quantitative easing послабл кол требов
Fiscal stimulus package фиск стимул пакет
Countercyclical policies антициклическая политика
 CHRONOLOGY AND CAUSES OF THE
CRISIS
The problem builds up: from credit
derivatives to toxic assets
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Ten years ago – the problem builds up
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Chinese financial surpluses and lax monetary policy make the banking system
very liquid
Banks expand rapidly; lend to lower quality borrowers ; and seek more
sophisticated money earning products ( including credit derivatives)
Late 1990’s credit derivatives market begins and grows enormously
Derivatives are thought to be almost risk free and a “good thing” but when
problems arise this proves to be wrong mainly because they include mortgage
lending to sub prime borrowers in the US. They are now called toxic assets
2007 – the problem breaks
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Early 2007 US housing market turns down
H2 2007 derivatives market seizes up; banks face huge losses
H2 2007 interbank market seizes up; banks will not lend to banks
September 2007 Northern Rock fails in UK
Authorities treat the problems as a liquidity issue; but solvency is in question
The problem becomes a crisis; from
illiquidity to insolvency
 Autumn 2008 -the problem becomes a crisis
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Summer 2008- in the US Fannie Mae Freddie Mac
rescued.
September 2008 - Lehman brothers allowed to
collapse. Markets panic
September 2008 US 700 bn $ rescue plan to buy bad
assets
October 2008 European governments guarantee bank
deposits and rescue major banks
Crisis recognised as a major solvency problem
Need for systemic and systematic solutions
The crisis goes global and economic
 October 2008-January 2009 – the crisis deepens
 It is evident that the huge rescue packages provided
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to the banks are not stabilising the banks or solving
the credit crunch
Further rescues needed- now comprehensive support
for all aspects of bank balance sheets
Clear signs that the world is entering a deep
recession
Governments create massive fiscal stimulation
packages to counter recession
Crisis spreads to emerging economies including
Ukraine
Economic impact of banking
breakdown- the world economy
 Credit dries up and confidence collapses
 Global equity prices fall more than in 300 years
 Brazil – car sales contract by 25%
 Japan – industrial production falls 8.5% in Nov
 United States – one million jobs lost Nov and Dec
which is worst in 60 years
 Germany – exports decline by 10%
 World economy – forecasts for growth in 2009 fall
from 3% to 1%
Economic impact of banking
breakdown- the individual
 Stock market savings fall by 30%
 Pension values collapse
 House prices down by 20%
 Savings rates down from 6% to almost zero
 Pound devalued by 30%
 Lack of confidence
 Fear of unemployment
 UNCERTAINTY ABOUT THE FUTURE
 THE FINANCIAL CRISIS
What causes financial crises
 New product or business model; risks not understood
 Herd instinct; everybody wants a share of the action
 Rapid expansion of banks and the market
 Mismanagement; management put reward before risk
 Evasion of supervisory rules
 Supervisory failure; supervisors do not understand
the risks especially the macro prudential risks and
are unwilling to intervene
 Unsystematic crisis management; turns a problem
into a crisis
Big Bank Breakdown
 The near collapse of the world banking
system was caused by the total breakdown of
banks’ balance sheets both the individual
components and the key ratios between them
so that when the toxic assets problem
emerged many banks did not have the
strength to survive.
Balance Sheet Breakdown
Capital
Shares – collapse in market
value
Reserves – depleted by the
need to cover losses
Deposits
Retail –declining as savings
ratios fall drastically
Interbank – rising rapidly to fill
the gap and allow expansion
Assets
Market instruments – losses
huge and difficult to calculate
Mortgage loans – affected by
the fall in the property market
Corporate loans – losses
growing as recession fears hit
eg sectors like builders; car
makers
Personal loans – threatened
as recession looms
The Big Bank Breakdown in figures
 Rapid lending growth -since 2002 UK bank lending
has grown by 50%
 Capital weakness -since 2002 banks’ leverage ratio
has fallen from 1:30 to 1:40
 Growing losses – losses worldwide are put at 3 trillion
$ of which UK banks some 500 bn$. Some assets
have lost 50% of their value.The true losses in credit
derivatives and asset backed securities cannot be
measured
 Reliance on interbank market has trebled between
2001 and 2007
The Big Bank Breakdown in Figures
 In October 2008 7 trillion $ was the amount
put up by governments from some 20
countries to guarantee banks wholesale
liabilities, to buy poor quality assets and to
inject capital into banks at risk of failing.
Crisis management
 Monetary support by the Fed the Bank of England
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and the ECB
Deposit protection schemes for individuals
Deposit guarantees for interbank deposits
Asset purchase and guarantees
Capital injections by other banks and by governments
Comprehensive government support for assets,
capital and deposits
Rescue procedures being streamlined systematised
and internationalised
Some signs of recovery in financial
markets
 Banks are making profits again; have raised
capital; are reducing reliance on the interbank
market; and are cutting back on assets
 Supervisors have become proactive in this
process
 Interbank market has reopened
 Financial markets have rebounded
 Confidence is returning but remains fragile
Major risks remain
 Rebalancing balance sheets means that the banks
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cannot grant so much credit as in the boom years
Credit may not be sufficient to sustain the economic
recovery
Renewed economic problems could rebound on the
banks
All of the losses have not yet been realised so banks
are still vulnerable
Bank income in future will not be so high as in the
past which will impact on capital building and growth
Reform of bank regulation
 Financial Stability Board created
 Emphasis on financial stability and the
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macroprudential
Capital levels/quality/measurement methods/capital
buffers/countercyclicality/stress tests
Liquidity with emphasis on stocks of liquidity
Measures to strengthen the securitisation markets
Crisis management more coordinated and systematic
Reform of bank regulation
 Will take time
 National interests will intervene
 Gradualism will be needed so that banks can
rebalance their balance sheets
 Management memories are short
 Closing the stable door after the horse has
bolted
 Fighting the last war
Reform of bank regulation
 Some very important lessons have been
learned
 1 The importance of the macroprudential
 2 The need for real international cooperation
 3 More coordinated and systematic crisis
management
 4 Sophistication should not blind us to some
basic common sense rules
 THE ECONOMIC CRISIS
Economic freefall
 The crisis broke after a decade of low
inflation and steady growth
 Financial problems in 2007 meant that there
were signs of recession by September 2008
 After the collapse of Lehmans the world
economy went into freefall
 7.5 % decline in real GDP in Q4 2008
 Collapse in global trade
 Fears of repeat of the Great Depression
 Fears of DEFLATION !!!!
Rescuing the world economy
 Financial rescues were the first priority to
prevent a total collapse of the banking system
 Monetary policy -low interest rates and many
innovative solutions by central banks to ease
credit conditions and reassure markets
 Fiscal stimulus packages amounting to 2% of
GDP in 2009 and 1.5 % in 2010
 IMF finance for emerging markets. IMF
facilities strengthened and streamlined
Signs of recovery
 Global economy appears to be expanding again
 Modest growth in advanced economies; Asia further
ahead on road to recovery; emerging markets in
Europe and CIS lagging behind
 World trade is beginning to pick up
 Strong rallies in some financial markets and capital
flowing again
 But the pace of recovery is slow and growth rates are
unlikely to return to their pre-crisis levels for many
years to come
Challenges remain
 Economic and financial recoveries are fragile and are
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dangerously interlinked
The financial crisis will take a long time to resolve
and during that time credit to the world economy will
be restrained
More fiscal stimulus may be needed but public
finances are overstretched
The timing of the withdrawal of monetary and fiscal
support will be crucial
Emerging markets in Europe will take a long time to
recover
Economic reform
 Monetary policy will be more focused on growth and
stability
 Fiscal policy-recognition of the role of the public
sector in a market economy and a drive for greater
efficiency in public finances
 International architecture strengthened
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G20 at the centre with more recognition for China
IMF strengthened
 Symetrical adjustment of payments imbalances
 Linkages between bank regulation, monetary and
fiscal policy in maintaining stability
 SOME QUESTIONS ANSWERED
What should the crisis be called
 The crisis of the 1930’s has acquired a
historical name: the Stock Market Crash and
the Great Depression
 The crash of 2009 has not yet acquired a
name. Should it be related to:
 The credit crunch/toxic assets/market
meltdown
 My preference is the Big Bank Breakdown
Why did no-one blow the whistle
 They did but not loud enough
 Many warnings from IMF, regulators, central
banks and economists
 But the warnings were just one among many;
too scattered and unspecific
 They also missed the aggregate implications
of individual risks
 There was a lack of follow through
Why did bank regulation fail
 Long period of regulatory permissiveness
 Failure fully to understand and capture the risks of
the new products and new vehicles
 Focus on individual institutions rather than on the
build up of risks in the system as a whole – ie on the
micro prudential rather than the macroprudential risks
 Overreliance on bank management and systems to
manage the risks
 Reluctance to intervene and damage apparently
successful commercial business
Why was Lehman Bros allowed to fail
 No market solution could be found
 Moral hazard should be tested
 The markets had had a long time to adapt to
the idea that Lehmans might fail.
 Underestimation of the consequences
 Concern at the growing cost to the public
sector
 Undoubtedly this was the biggest mistake in
crisis management in the financial history of
the last century
What are toxic assets?
 Credit derivatives market started in 1990’s
 Respectable instrument which allowed banks to
unbundle their risks
 Loans converted into marketable instruments and
credit risk could be distributed round the market
 Became a means of growing balance sheets and
avoiding regulatory controls on risk
 “Search for yield” and “originate to distribute” caused
banks to accept poorer quality credit risks
What are toxic assets?
 It transpired that the instrument had many
unforeseen weaknesses which rapidly came
to light when market conditions were less
benign
 Infection by subprime loans ;poor liquidity;
questionable valuations; inadequate market
systems; losses difficult to estimate
Credit derivatives market
 Single name credit default swaps
 Portfolio default swaps
 CDO’s
 Synthetic CDO’s
Single name credit default swaps
CDO’s
Synthetic CDO’s
Portfolio default swaps
Who was to blame for the crisis
 The Chinese!
 The banks : bank management ; or the whizz
kids in the investment houses
 Regulators
 Monetary authorities/governments
 The IMF
 Consumers
 The United States
The balance sheet of blame
Low inflation, high global
liquidity, low interest rates
Governments, IMF
Monetary authorities
Easy credit
Banks, Monetary authorities
Customers
Banks grow too much, too
sophisticated, too risky
Banks
Regulators
Risks in markets not
identified and acted upon
Banks
Regulators
Monetary authorities
Initial rescue response
inadequate
Governments, Monetary authorities
Is 2008 worse than 1929?
 An economic boom in the US in the second half of
the twenties began to stall in 1929
 The US stock market which had been booming and
had risen to unrealistic values crashed
 Bank failures followed and a deep recession began
which lasted for some 10 years known as the Great
Depression
 Production levels did not recover until 1941;more
than 8 mn unemployed in the US throughout the
1930’s; in 1933 25% out of work; thousands of banks
failed; rescue not started until the New Deal of 1932
and regulatory reform ( Glass Steagall Act and
Deposit Protection ); international reform only in 1944
( IMF)
How big is the crisis
 One trillion is 1000 billion
 World GDP is 70 trillion – US 15, Europe 15 , China
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8, Russia 2, Ukraine 0.3
Size of the credit derivatives market 40 trillion
Losses of the banks 4-5 trillion $
Financial rescues 7 trillion $ ( 10% of world GDP)
Economic rescues 3.5 trillion $ ( 5% of world GDP)
Total rescues probably at least 20% of world GDP.
Is 2008 worse than 1929?
 Monetary easing; credit boom ; financial bubble
 New financial products not well understood; new
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structures and institutions based on complex
pyramids
Assumption that values will keep rising; divorce
between market and underlying values; difficulty of
obtaining realistic valuations
Technical factors – the ticker and failures in the credit
derivatives market
Small number of individuals responsible for the Crash
Authorities worried about the bubble but unwilling to
act to “stop the party”
Is 2008 worse than 1929?
 One major difference is the scale and rapidity of the
policy response
 Inaction in 1929 led to the Great Depression;
competitive devaluations; trade wars; and caused the
Second World War
 Governments today are determined to act rapidly,
internationally and on the scale necessary. The
speed of action is AMAZING.
 In the 1930’s it took until 1944 to get action on the
international financial system. This time round work
has already started on reform
Why was international cooperation so
successful in coping with the crisis?
 There was a driver who recognised the need
and took on a leadership role
 There was a route map – the lessons of the
past from the Great Depression made it clear
what the consequences would be of failure to
manage the crisis successfully
 There were vehicles – the IMF, the G20, the
Financial Stability Forum. These have all
been strengthened enormously in the process
and cooperation between them has been
enhanced.
Is the crisis over?
 Will last for at least two years and growth levels will
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not be the same as in the past
Recovery will take longer in some countries
Economic crises last longer when accompanied by
financial crisis
Unemployment and asset prices will take a long time
to recover
Biggest risk is the close links between the two crisesthe financial and the economic
Public sector finances could not bear another round
of major stimulus
 CONSEQUENCES OF THE CRISIS
Management of the international
economy will change fundamentally
 Regulation – less liberal; more proactive; macro
prudential; market oriented; international; and
countercyclical. Could stifle innovation.
 Monetary policy- unconventional; uncertain; and
growth oriented. Could cause inflation.
 Fiscal – expansive and supportive. Risk of pressure
on public finances, currency impacts and state
capitalism. Greater public sector efficiency.
 International system – recognition of the role of China
and other emerging countries; more real cooperation;
efforts at greater intervention and symmetry but risks
that it will remain a talking shop.
Costs of the crisis
 World economic growth will not return to pre-crisis
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levels for many years
Emerging countries in Europe will be worst affected
Financial rescues will take a decade to unwind but
could yield a profit
Economic rescues will take many years to repay- in
Iceland each citizen owes 1.6 mn $
Banking system will recover only slowly and will
become more risk averse at least for a decade
The perpetrators are not doing too badly
Conclusions
 The crisis came when economic managers
thought they had found Nirvana
 Economic management will change for the
better but will never be perfect
 The next crisis will be different !!!!!
 We cannot live in a constant state of crisis
management
 Rapid response is the ultimate answer and
we are better equipped for that now than we
were before the crisis.
 UKRAINE AND THE CRISIS
Causes of Ukraine’s problems
 Ukraine’s economy has grown rapidly since
2000
 By mid 2008 the economy was overheating
 Problems exacerbated by the banking
breakdown
 Terms of trade deteriorated ( steel and gas)
 Capital inflows dried up
 Political system did not inspire confidence
 Banking system was under severe stress
Problems in the banking sector
 Formidable growth since 2004
 Large banking sector risks- weak ratios and
large foreign exchange exposures
 Recession will lead to an increase in bad
loans
 Capital position of the banks is seriously
threatened
 HRV 80 bn required to restore capital ratios (
8% of GDP)
The policy response in Ukraine
 Exceptional loan from IMF in November 2009
 Restore financial stability – liquidity support; bank
resolution framework; recapitalisation of banks;
deposit guarantees.
 Economic measures – flexible exchange rate; base
money targets; incomes policy ;prudent fiscal policy;
energy pricing
 Should stabilise the economy and restore growth in
two and a half years time ( by mid 2011)
 IF THERE ARE NO OTHER SHOCKS
Progress to date
 The IMF review in July 2009 indicated:
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Financial situation has eased
But the economic situation has deteriorated more than
expected: GDP forecast to collapse by 14% in 2009
Policy implementation is broadly in line with the
programme
 The fiscal deficit has had to be increased to more than
8% of GDP ( from 4%)
 Resolving the banking crisis has progressed but there
is more to do
Concerns about the fragile political consensus and the
upcoming Presidential elections