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Financial Year with Finyear


Peter Praet, Executive Director, National Bank of Belgium

Peter Praet
Peter Praet
What lead us to the financial crisis?
In fact, no one really thought that the financial system could collapse. Everyone believed that sufficient safeguards were in place. The financial system is the economy's plumbing. Over the past few years, this essential and complex system of finance has been critically damaged. Evidence of serious trouble emerged when banks became less willing to lend to each other, because they were no longer sure how to value the assets held and promises made – both their own and those of potential borrowers. For a time, central bank lending was able to fill the gap. However from August 2007 the stress in the financial system increased in waves. By March 2008, Bear Stearns had to be rescued. Six months later, on September 15, Lehman Brothers went bankrupt because neither the US Government nor the Fed would offer guarantees regarding its balance sheet to Bank of America and Barclays Bank who were at that time interested in acquiring the investment bank. The financial system is based on trust and in the wake of the Lehman failure, trust was lost. The modern financial system is immensely complex – possibly too complex for one person alone to really understand it. Interconnections create systemic risks that are extremely difficult to figure out. A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires identifying and treating the causes of the disease. We can divide the causes of this crisis into two broad categories: macroeconomic and microeconomic.

What were the macroeconomic failures of the crisis?
Before tackling this matter one should not forget that microeconomic and macroeconomic
causes are related.

The macroeconomic causes fall into two groups: on one side, imbalances in international claims; on the other, difficulties created by long periods of low interest rates.

Global imbalances are due to the persistent and large current account deficits and surpluses resulting in capital inflows from capital-poor emerging markets countries to capital-rich economies especially the USA. It is difficult to figure out what to do about the dependency that developed between the export- led growth in much of the emerging world and the leverage-led growth in a large part of the Industrial world.

However those imbalances just measure the net flow of goods and services and the matching of private capital plus changes in official reserve holdings. Apart from the net flows, the total stock of claims is important as well.

The second set of macroeconomic causes of the crisis stemmed from the protracted periods of low interest rates in the first half of the decade. The proximate causes of low interest rates was the combination of policy choices in both the industrial and emerging world together with the capital flows from emerging market countries seeking low-risk investment. A fear of deflation in those years led policy-makers to keep short -term real rates unusually low.

Low interest rates had a variety of important effects. On the more predictable side, by making borrowing cheap they led to a credit boom in a number of industrial economies. For instance, credit in the USA and the UK rose annually by 7 % and 10 % respectively, between 2003 and mid-2007. This cheap credit formed the basis for the increase in home purchases as well as for the dramatic rise in household revolving debt like credit cards. The second -more predictable- effect of low interest rates was to increase the discounted value of the revenue streams arising from assets, driving up the asset prices.

Among the less expected effects were the incentives they created in the asset management business. When interest rates are low, it is very difficult for these firms to generate high rates of return. The institutions responded by taking more risk in the hope of generating the returns needed to remain profitable! By increasing risk (but in this case hiding it), they could meet clients' demands and expectations. So, low interest rates increase risk taking.

All these elements together, – the housing boom, the boom in debt -financed consumer expenditure and the search for yield, – contributed to distort the macro-economic structure of a number of countries. Those distortions fooled investors, consumers and policy makers, making them think that the trend growth was higher then it really was. Bubbles tend to be concentrated in sectors where productivity growth is being perceived to have risen. In the 1990s, the sector of predilection was high technology ; in this decade, it was finance.

What were the microeconomic causes?
The causes are numerous: distorted incentives for consumers, financial sector employees (bonuses), rating agencies; flaws in techniques used to measure, price and manage risk and in the corporate governance structures used to monitor it; and failings in the regulatory system.

Very few people have access to the balance sheets of the banks or to the firms’ finances in which they invest through the purchase of equity or debt securities. The investors were all too willing to assume that their investments were safe; moreover they believed in the trusted manager, an equity analyst, a credit rating agency or a government official.

The drive to increase returns led to an explosion in debt financing because leverage yields higher returns to their owners. This created an unstable financial system. Compensation schemes encouraged managers to take more risk. Indeed asset managers in a given class were rewarded for performance exceeding benchmarks; compensation based on a large part on the volume of business encouraged managers and traders to accumulate huge amounts of risk. Added to that were the skewed incentives of the rating agencies. The fact that they are compensated by the issuers distorted in these boom times their analysis. This was further exacerbated by the complexity of the financial instruments and its pace of development. This made the rating agencies increase in sophistication but also in being more profitable. The differences in methodology used by the rating agencies in rating
ABS provided incentives for the originators to structure their ABS in ways that would allow them to “shop
around“ for the best available combination of rating across both rating agencies and the liability structure of those instruments. Due to the complexity of the instruments, reliance on ratings increased even among the most sophisticated investors. The issue of unrealistic high rating, like in the case of ABS contributed to the building up of systemic risk.

The innovation of pooling together large numbers of what were objectively low-quality loans and then creating a mix of high quality and low quality securities backed by the pool, allowed debt market access to an entirely new class of borrowers. The major flaw was however that the originators retained little of the default the risk, and so the boom developed, the quality of the loans progressively worsened to end in the sub-prime disaster.

The reliance on historical performance, price and management risks was another pitfall. It led, like in the case of the 1980s junk bonds, to misleading estimates of correlation among various classes of risk. When asset prices that previously moved independently (providing diversification) or in opposite directions (providing hedging) start to move together, what used to reduce risk increases it. When bad times came, correlations became large and positive. What was finally risk reduction became risk concentration.

Governance problems regarding risk management practices, where managers could not understand the complexity of the financial instrument devised by physicists and sophisticated mathematicians.

Beside the lack of in-house risk management, financial institutions found it relatively easy to move activities outside the regulatory perimeter. This created the “Shadow Banking system“ which resulted from the enlarged financial sector comprising both traditional banks, bank intermediaries, asset managers like hedge funds, investment banks and investment conduits like SIVs. Most of it in off-balance sheets and in offshore tax haven entities.

Wasn’t there also some major regulatory failure?
Regulatory arbitrage also contribute to the crisis: the failure of the Basel international rules to impose sufficiently high capital requirements on securitized mortgage obligations held in bank's trading books. It was there that the vast quantities of these toxic products were being accumulated. Because these securities could be held with minimal capital backing, this gave banks the possibility to build gigantic positions in their portfolios. When these holdings turned out to be unsalable except at a huge loss, the disaster was exposed. This regulatory issue does not however go any way towards exonerating banks that took advantage of it believing that this was a fantastic investment.

Were there warnings?
In fact, very few! The former Chairman of the FED professed in his October 2008 testimony to Congress that he watched with “shocked disbelief“ his “whole intellectual edifice collapse in the summer of 2007”. Official models missed the crisis not because the conditions were so unusual, but also of a strong belief in the efficient market paradigm. In a 2007 interview, Eugene Fama, the father of the efficient-market theory, declared: ”the word bubble drives me nuts and came to explain why we can’t trust the housing market; it's typically the biggest investment the consumers are going to make in their lives, so they look around very carefully and compare prices“. Indeed, home buyers generally do carefully compare prices but this doesn’t say anything whether the overvalued housing prices are justified. Yet there have been doom forecasters. Professor Robert Schiller did identify the bubble via his “Case-Shiller index” and warned of its painful consequences. Also Bill White, at the time chief economist of the BIS, repeatedly warned about the risks related to rapidly growing consumer debt. The majority view however trusted market discipline.

Michel-François Clerin
Michel-François Clerin
How do you see the new financial system ?
The dramatic developments forced monetary, fiscal and regulatory authorities to expand their fight. The health of the financial system and of the real economy in most of the Industrial world depends on it. Central bankers cut policy rates to record lows and then moved to ease monetary conditions even further by using their balance sheets in unconventional ways. Meanwhile, fiscal authorities worked to implement unprecedented stimulus programs while, together with regulators and supervisors, they provided resources to correct financial institutions' balance sheets. The result has been a mixture of urgent treatment designed to stem the decline combined with an emerging agenda for comprehensive reforms to set the foundations for sustainable growth. A healthy financial system is essential in the long run for the economy to return to a normal path. Until the intermediation system is working again, the large scale fiscal stimulus being presently deployed risk to create a massive build-up of public debt like in Japan in the 1990s.

What is the framework for addressing the systemic risk ?
There are three essentials elements:

1. instruments: loans, bonds, equities and derivatives;
2. markets: OTC and organized exchanges;
3. institutions: banks, securities dealers, insurance companies and pension funds.

Two externalities are central to systemic risk :
• first, the joint failure of institutions resulting from their common exposure to similar risks at a single point in time: the shocks may include both credit and liquidity shocks and their interaction, while the linkage arises from the complex web of daily transactions;

• the second externality is known as procyclicality, which means that over time the dynamics of the financial system and of the real economy reinforce each other, increasing the amplitude of booms and busts and undermining both the financial sector and the real economy.

What are the steps in order to enhance safety ?
I. Improvement of the safety of financial instruments: it is necessary to solve the evaluation of opaque, complex and the sheer quantity of some instruments like securitized sub-prime mortgages.
II. Reduction of the systemic risk posed by such instruments in their capacity to be exacerbated by financial innovation, with the result that, during a boom, flourishing financial innovation will tend to create hidden, under-priced risks.
III. Balancing innovation and safety in financial instruments requires providing a scope for progress while limiting the capacity of any new instrument to weaken the system as a whole.

How can the regulators improve the safety of financial markets?
The crisis has shown that markets can fail to self-correct, putting the entire financial system at risk with the principal systemic hazard being liquidity. This crisis demonstrated again the lessons of the 1998 experience with LTCM: 1. the ability to buy and sell risk is surely efficiency -enhancing, but when one institution holds a sufficiently large position, like Lehman Brothers did, it creates common exposure that puts the system at risk and 2. when transactions occur bilaterally, as they do in OTC markets, the failure of one individual or institution can, through linkages across firms and markets, generate joint failures.

One way to address some of the systemic risks created by OTC financial markets is to replace bilateral arrangements with central counter parties (CCP's). The CCP addresses that risk by requiring each participant to hold a margin account in which the balance is determined by the value of the participant's outstanding contracts. In this way the CCP can both reduce risks of common exposure and dampen volatility.

Further more CCP's are in a position to mitigate the pro-cyclicality that arises from the tendency of individual counter parties to demand increased margin during times of financial stress.

What is the macroeconomic framework to improve the safety of financial institutions ?
The current crisis has shown how common exposures create the potential for a broad cross section of institutions to fail simultaneously. It has been proven that the total risk is not only the sum of the risks arising inside individual institutions but also can be inflected according to the degree of correlation among the institution's balance sheets.

Some proposals to mitigate the risks arising from common exposure focus on implementing a systemic capital charge (SCC). The ieda is to create a distribution of capital in the system that better reflects the systemic risk posed by individual failures. However implementing such a scheme requires a measure of systemic risk and an understanding of the marginal contribution of each institution to the total. A conclusion of one study is that large banks contribute more than proportionally to systemic risks, as do banks that are more exposed to system-wide shocks.

Does it mean reducing the size of individual financial institutions ?
This is the position, among many others, of Lord Turner of the FSA in the UK.This could result in taxing size to create a level playing field from a system wide perspective. Institutions which are considered too big to fail pose a significant challenge in this context.

How do regulators plan to reduce pro-cyclicality ?
Policy makers have shown clear desire to create new policy instruments to ensure that financial institutions adjust their capital and, for example, loan provisioning and liquidity standards to counter cyclically. Such a countercyclical capital charge (CCC) would require institutions to build up defensive buffers in good time that could be drawn down in bad times. An obstacle to calculating a CCC is knowing when buffers have to be built (increasing the CCC) to make lending more costly in boom, and when they can be reduced to promote lending during a bust. Moreover capital buffers may need to vary with the nature of individual institutions’ business; in addition because cycles differ across countries, a CCC might need to be adjusted separately for each geographical portfolio held by an institution operating across national boundaries.

What about the average level of capital that needs to be held in the global system ?
Answering this question involves to ascertain the long-term equilibrium level of capital. To simplify, the higher the level of capital that financial institutions are required to hold, the lower the risk borne by the public. But higher capital levels raise the costs of doing business and thus raise the price of loans.

Do you think that the profitability of investment banks will be substantially reduced ?
A recent JP Morgan study predicts that the global regulatory crackdown is likely to cut long term profitability of US and European Investment banks by a third. This report gives a deeply pessimistic view of the impact of regulation changes that include tougher capital rules for trading and a push to trade derivatives on exchanges and no more on OTC's.

The report calculates that investment banks’ return on equity will fall from 15 % to just 11 % in 2011. The report forecasts that banks will be unwilling to operate at reduced profitability levels and will respond with massive restructuring, including further headcount reductions in some areas and swinging cuts in compensation across the board.

By contrast, banks that focus on traditional lending are expected to be less affected by much of the regulatory clampdown. These findings are likely to be well received by politicians and regulators who have been fighting hard for policy changes to reign in investment banks and to encourage ordinary lending. The abatement of financial tensions has led some financial institutions to imagine they can return to the same mode of actions prevalent before the crisis. The leaders of the UK, France and Germany wrote a letter outlining their goals for the G20 summit. The letter focuses mainly on proposals that have a strong support in the US and does not include the higher overall capital requirements discussed by the G20 ministers of Finance in London early this month.

What about the consolidation of financial institutions’ balance sheets ?
This is definitively a very serious matter. The crisis has clearly exposed the risk caused by the “Shadow Banking System“. The first order of business improving the management of capital is to bring all the entities like SIV's and the like within the regulatory perimeter to ensure that appropriate capital is held against all financial institutions obligations.

What are the macroeconomic policies needed to enhance financial stability ?
First of all, the crisis has confirmed that the monetary and fiscal policy framework that delivered the so-called "great moderation" cannot be relied upon to guarantee financial stability. Fiscal and monetary policy help shortcircuit the re-enforcing feedback between the real economy and the financial system. Fiscal policy through stabilizers and countercyclical discretionary stimuli's sustains income and employment, – though more in Europe than in Japan and the USA, – lowering the probability that borrowers will default. Monetary policy lower policy rates and thus improve the state of financial institutions balance sheets by increasing the spread between the cost of borrowing and the lending rates; in other words, by reducing cyclical fluctuations in the real economy, counter cyclical fiscal and monetary policies reduce the pro-cyclicality of financial institutions' capital.

Don't you think that monetary policy must be bolder in responding to booms in both credit and asset prices ?
I agree, and this is also an opinion largely shared by the central banking community. But it will not be easier in the future to identify bubbles and calibrate policies to neutralize them. However the financial crisis has shown that it is ultimately too costly for central bankers to focus too narrowly on inflation over short term horizons with a view towards cleaning the mess caused by bursting bubbles and collapsing credit after the fact. The issue presently is how monetary policy makers should expand their frameworks to make room for property prices, equity prices and amounts of debt outstanding.

What will be the final outcome of the Pittsburgh Summit ?
I believe everybody has understood that finance grew too big for its boots, even if it is impossible to put a figure on the scale of its overexpansion. Government’s bail-outs have also prevented the industry from shrinking as much as it might have.

There is an army of technicians brooding over these complex issues. The Basel committee of banking regulators has launched new proposals on both capital and liquidity. The various accounting bodies have also recognized fundamental weakness in the present standards. The sheer complexity on these
reforms means that they will take months, even years, to be fully redesigned.

But the direction of the new regulatory framework has been agreed at Pittsburgh.

Entretien réalisé par Michel-François Clérin, partenaire-expert CFO-news

Michel-François Clerin
524 Av. Louise
B-1050 Brussels - Belgium

Lundi 19 Octobre 2009

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