The Financial Crisis: Lessons for Developing and Emerging

Market Countries

Ugo Panizza

Outline

• Was it a surprise?• The role of financial innovation• 7 lessons for financial regulation

The roots of the crisis

"I think this economy is down because we built too many houses"

What really went wrong: Weak regulatory regimeJ. Stiglitz said: this is the not surprising

consequence of appointing as regulators people who don't believe in regulation.

A Crisis Foretold

• If each crisis is different from the previous one we risk of fighting the last crisis

• But are they different?

Was it a surprise?

• Certainly some new elements– Originate and distribute model– Financial derivatives– Shadow banking system

• But the basic mechanism is always the same (described by Kindleberger and Minsky)

Was it a surprise?

• A positive shock leads to high growth, low volatility, and low risk aversion

• This leads to an increase in leverage which further boosts asset prices and leads to even more risk taking

• People start thinking that asset prices can only go up

• People who say that the situation cannot continue forever are made fun of and marginalized– The standard answer is "This time is different"

• If they are in the financial sector they lose their jobs– “The trend is your friend”

Was it a surprise?

• Of course things are never different– Each time the instrument is different

(Tulips, Inexistent countries, Railways, Internet stocks, Houses)

– Nobody knows what will come next (for sure not subprime mortgages)

– But the mechanism will be the same

Was it a surprise?

• Research by Claudio Borio of the BIS shows that two or three variables (credit growth, stock prices growth and housing prices growth) can predict financial crises 2-4 years in advance with considerable precision– (not the exact time of course)

• A few people (Robert Shiller, Nouriel Roubini) and institutions (UN, BIS) were screaming, but nobody listened to them

Was it a surprise?

• Policymakers did not do anything because the operated under the assumption that markets know best– I made a mistake in presuming that the self-

interest of organizations, specifically banks and others, were such is that they were best capable of protecting their own shareholders and their equity in the firms. It shocked me. I still do not fuIly understand why it happened…

• They also thought that cleaning up the mess was easy and cheap

Was it a surprise?

• Academic economists where seduced by policymakers– …we were in sync with policymakers… lured

by ideological notions derived from Ayn Rand novels rather than economic theory. And we let their... rhetoric set the agenda for our thinking and … for our policy advice. Acemoglu (2008)

• Incentives also matter, both in business schools and econ departments (Eichengreen, 2008)

Was it a surprise?

• So, it should not have been a surprise– Ideology– Incentives

Outline

• Was it a surprise?• The role of financial innovation• 7 lessons for financial regulation

The role of financial innovation in the subprime

mess• How did NINJAs get all these loans?

– In the old system, bankers carefully evaluated loan applicants and used a lot of soft information

– With securitization, bankers can sell the loans and care less and less about creditworthiness, soft information became irrelevant

• (This is both good and bad: less racial bias but also less information)

• But why would anybody buy bad loans?• Some people thought that financial innovation

could do the trick (especially the 'pooling' and 'tranching' of CDOs)

• However, even these sophisticated instruments were only sustained by excessive optimism

Crazy assumptions• FPA: “What are the key drivers of your rating model?”• Fitch: "FICO scores and home price appreciation of low single

digit or mid single digit…"• FPA: “What if home price appreciation was flat for an

extended period of time?”• Fitch: "Our model would start to break down."• FPA: “What if home price appreciation were to decline 1% to

2% for an extended period of time?”• Fitch: "The models would break down completely."• FPA: “With 2% depreciation, how far up the rating’s scale

would it harm?”• Fitch: "It might go as high as the AA or AAA tranches."

Conference call between First Pacific Advisor (FPA) and Fitch Rating (Coval, Jurek and Stafford, 2008)

Crazy assumptions

But at least the banks were safe…

• Not really because they went back in the game with lightly regulates SIV– (more on regulatory arbitrage later)

Who was right?• “There is growing recognition that the dispersion of

credit risk by banks to a broader and more diverse group of investors … has helped make the banking and overall financial system more resilient … commercial banks may be less vulnerable today to credit or economic shocks”

IMF Global Financial Stability Report, Spring 2006,

• “Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know.”

BIS 77th Annual Report, June 2007

The lighter side of the story

• PG13 • It contains strong language

Outline

• Was it a surprise?• The role of financial innovation• 7 lessons for financial regulation

1 Focus on the Right Definition of Financial

Efficiency• Information arbitrage efficiency

– In a market that is efficient according to this definition, prices reflect all available information and, without insider information, it is impossible to earn return that constantly beat the market.

• In technical parlance, in an informational efficient market the best asset pricing model is a random walk.

• Fundamental valuation efficiency– The price of a financial asset is completely determined by the

present value of the future stream of payments generated by that asset.

• Full insurance efficiency – According to this definition, a market is efficient if agents can

buy and sell insurance contracts covering all possible states of nature

• Often referred to as Arrow-Debreu contracts

1 Focus on the Right Definition of Financial

Efficiency• Transactional efficiency

– It refers to the market's ability to process a large number of transactions at a low cost.

• Functional efficiency – It relates to the value added of the

financial industry from society's point of view (it could thus also be called social efficiency).

1 Focus on the Right Definition of Financial

Efficiency• Functional efficiency essentially boils

down to two things: consumption smoothing and economic growth.

• From the point of view of a regulator, social efficiency should be the only relevant definition of efficiency

• Several financial products can yield large private returns but have no social return

Large Private Returns, But Where Are the Social

Returns?• In 1983, the US financial sector generated 5 per

cent of the nation's GDP and accounted for 7.5 per cent of total corporate profits.

• In 2006, the US financial sector generated 8 percent of GDP and accounted for 40 per cent of total corporate profits.

• In the meantime, the US financial sector had to be bailed out 3 times in three decades– Tobin (1984) “There must be something wrong with an

incentive structure which leads the brightest and most talented graduates to engage in financial activities remote from the production of goods and services”

– Rodrik (2008) “What are some of the ways in which financial innovation has made our lives measurably and unambiguously better”

1 Focus on the Right Definition of Financial

Efficiency• Key objective of regulatory reform:

– Do not stunt financial innovation but weed out financial instruments which increase risk but have no social return• Litan (2009)

• Avoid regulatory cycles– Learn from near misses

2 Market-Based Regulation Does Not Always Work

• There are flaws with the assumption that markets know best and regulators should not try to second guess them– Regulation is necessary because markets sometimes

do not work.

• How can one avoid market failures by using the same evaluation instruments used by market participants?– Market-based risk indicators (such as high-yield

spreads or implicit volatility) tend to be low at the peak of the credit cycle, exactly when risk is high

3 Avoid Regulatory Arbitrage

• Deposit-taking banks are special because the main source of their success --the provision of liquidity-- is also their main weakness. – The stereotypical bank collects demand

deposit and grants illiquid loans – This maturity transformation process allows

to direct vast resources towards potentially productive investment projects

– However, this is also a source of fragility• Banks are subject to crises of confidence and

self-fulfilling runs (DD)

3 Avoid Regulatory Arbitrage

• Given the importance of the banking system, few policymakers are willing to tolerate the possibility of a self-fulfilling run

• Especially because there is a simple method to prevent such runs. – A lender of last resort with a deposit insurance

scheme

• Like all insurance schemes, deposit insurance and the presence of a lender of last resort may lead the insured bank to take too much risk

3 Avoid Regulatory Arbitrage

• This is the classic moral hazard problem, which is also the main justification for regulating banks.

• Normally, banks take more risk by reducing capital ratios and thus increasing leverage.

• As a consequence, modern prudential regulation revolves around the risk-adjusted capital requirements established in the Basel I and Basel II Accords

3 Avoid Regulatory Arbitrage

But regulation needs to be comprehensive!

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1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Leve

rage

Banks Financial services Life insurance

Figure 2.1LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR

Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream.Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average.

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• Bank regulation tends to be micro-prudential

and concentrates on the behaviour of individual banks.

• This assumes that policies aimed at guaranteeing the soundness of individual banks can also guarantee the soundness of the whole banking system

• This is a fallacy of composition because actions that are good and prudent for individual institutions may have negative systemic implications– Problems with mark-to-market accounting– Problems with ratings

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• Consider the case of a bank that suffers large

losses on some of its loans– The prudent choice for this bank is to reduce its lending

activities and cut its assets to a level which is in line with its smaller capital base.

– If the bank in question is large, the bank’s attempt to rebuild its capital base will translate into a massive drainage of liquidity from the system.

– Such drainage of liquidity will be amplified by the fact that banks lend to each other in the interbank market.

– Less lending by some banks will translate into less funding to other banks

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough– As a consequence, a bank's attempt to do what is

prudent from its own point of view (i.e., to maintain an adequate capital ratio) may end up causing problems to other banks and have negative systemic implications • (this is the "interconnection" or "credit crunch"

externality). – In fact, banks with problems may even have an

incentive to make the crisis systemic, because a large crisis will increase the probability of a bailout • (this is the "bailout externality").

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• Another channel through which the current regulatory system may

have negative systemic implication relates to "mark-to-market"– Consider again the example of a large bank that realizes losses

and needs to reduce its risk exposure. – This bank will sell some of its assets and may thus depress the

price of these assets. – This will lead to "mark-to-market" losses for banks that hold the

same type of assets. – If these losses are large enough to make capital requirements

binding, banks will need to reduce their exposure and amplify the deleveraging process

• (this is the "fire sale" externality).

– The opposite process happens in boom periods and it is one of the main sources of leverage cycles.

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• By thinking in this way, one realizes that some

of the assumptions at the basis of the Basel Accords do not make much sense.

• The risk weighted capital ratios of the Basel Accords impose high capital charges on high-risk assets and low capital charges on low-risk assets.

• From a systemic point of view this is

problematic for at least two reasons.

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• First, it is likely that during good times some

assets will be deemed to be less risky than what they actually are and during bad times the same assets might be considered more risky than what they actually are.

• This amplifies the leverage cycle because it leads to a required capital ratio which is too

low in good times and too high in bad times.

44 Guaranteeing the Safety Guaranteeing the Safety of Individual Banks Is Not of Individual Banks Is Not

EnoughEnough• Second, relatively safe assets may be those with the

highest systemic risk. – If there is continuous of debt securities, going from super-safe

assets (e.g., AAA German bunds) to high-risk junk bonds, and there is a sudden downgrade in ratings linked to a systemic crisis, which assets are more likely to be downgraded?

– Not the super safe (because of flight to quality) and not the very high risk (because they cannot be downgraded by much).

• The assets that are most likely to be downgraded are those on the safe side of the spectrum, but not super-safe (AAA-rated tranches of CDOs come to mind).

• But these are exactly the assets that had low regulatory capital during the boom period and, because of the downgrade, will need a much higher regulatory capital in the crisis period.

44 Guaranteeing the Safety of Guaranteeing the Safety of Individual Banks Is Not EnoughIndividual Banks Is Not Enough

• Macroprudential regulation needs to complement microprudential regulation– It can work like a system of automatic

stabilizers which is also good for political economy reasons

55 International Cooperation

• Data sharing– We don not have sufficient data on cross-border

exposure among banks and derivative products– We need to develop a system for evaluating cross-

border systemic risk• It is necessary to agree on regulatory

responsibility for banks and other financial institutions with an international presence

• Avoid races to the bottom• But no common regulatory system

– Increase the participation of developing countries in standard-setting bodies and agencies in charge of guaranteeing international financial stability

6 Adjust Incentives in The Financial Industry

• Pay structure– Seeking alpha– How do you measure alpha?– You can't year over year, people have

incentives to hide risk taking and claim it's alpha

• Credit rating agencies– How do you create incentives for truthful

rating in a world where the rated pay the raters?

7 Lessons for Developing Countries

• Protect yourself– Avoid appreciations– Accumulate reserves

• But they are never enough

– Avoid currency and maturity mismatches– Remember that it may be true that a fully

open capital account can deliver the goods with a well-regulated financial system• But who has a well-regulated financial system?

+1 The role of state-owned banks

• Two views– The scarcity of capital was such that no banking system

could conceivably succeed in attracting funds. . .Supply of capital for the needs of industrialization required the compulsory machinery of the government

• Gerschenkron (1962)

– Whatever its original objectives, state ownership tends to stunt financial sector development, thereby contributing to slower growth

• The World Bank (2001)

+1 The role of state-owned banks

• What do the data say?– The World Bank is right

• La Porta, Lopez de Silanes, and Shleifer (2002)– It is impossible to say about growth and financial

development• Levy Yeyati, Micco, and Panizza (2006); Rodrik (2004)

– But public banks can help stabilizing the economy during periods of crisis…

• Micco and Panizza (2006)– ..and increase the efficiency of the banking system in low

income countries• Detragiache, Tressel, and Gupta (2008)

• Gerschenkron might be right, after all

+1 The role of state-owned banks

• Governance is key– Some countries have excellent state-owned banks– Some countries have bad state-owned banks– Some have both types

• A clear objective function is also necessary to avoid Sisyphus's syndrome

• But remember, in bad times all banks are state-owned

The Financial Crisis: Lessons for Developing and Emerging

Market Countries

Ugo Panizza