the big financial mess: causes and implications for financial regulation ugo panizza

The BIG Financial Mess:Causes and Implications for Financial Regulation

Ugo Panizza

The Myth of Decoupling

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Outline

• Was it a surprise?• The role of financial innovation• 7+1 lessons for financial regulation

A Crisis Foretold

"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.

Fighting the last crisis?Bad idea if each crisis is different from the

previous 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 assets 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)

Outline

• Was it a surprise?• The role of financial innovation• 7+1 lessons for financial regulation• Topics for discussion

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

• (type of shoes cannot be packaged)

• But why would anybody buy crappy loans?• Enters the law of large number and the

magic of CDOs

CDO?• A CDO is a structured financial product which takes

risky financial instruments and supposedly transforms them in less risky instruments.

• Transformation of risk is achieved with a two-step procedure involving pooling and tranching.

• Pooling consists of assembling a large number of assets (for instance mortgages) into a debt instrument. – Pooling can achieve something in terms of risk

diversification • if the payoffs of underlying securities are negatively

correlated with each other – However, the expected payoff of the whole portfolio is the

same of the expected payoff of the underlying securities. – The credit rating of the new instrument would be similar to

the average credit rating of the underlying securities. • There is no credit enhancement with pooling.

CDO?• Tranching produces credit

enhancement. – With tranching, the original debt instrument

is divided into parts (tranches) which are prioritized in the way in which they absorb losses from the original portfolio

– CDOs are usually divided into 3 tranches • The bottom tranche (often referred to as "equity"

or even toxic waste) takes the first losses• The mezzanine tranche starts absorbing losses

after the bottom tranche is completely exhausted• The senior tranche starts taking losses only after

the mezzanine tranche is exhausted.

CDO?

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CDO?• With this mechanism, it is possible to start

with a pool of assets which is not investment grade and transform part of it into investment grade tranches of CDOs.

• The process does not necessary stop here. – By tranching the equity tranche of regular

CDOs, asset managers can generate CDO-squared which extract AAA assets from the toxic waste component of the original CDO.

– In 2007, about 60 per cent of structured products were AAA-rated while only about 1 per cent of corporate bonds received AAA rating

CDO?• Rating a CDO is more complex than the

rating a single name debt instruments – It requires the knowledge of both the average

probability of default of the various instruments included in CDO and the correlation between these probabilities of default.

• In other words, one needs to know the joint distribution of the payoffs of the various instruments included in the CDO

– Small mistakes (which are almost irrelevant in the rating of single name instruments) in estimating such distribution can lead to large rating errors

• (these rating errors are compounded in CDO-squared).

CDO?• More important:

– Investors and regulators did not understand that risk enhancement came at the price of transforming diversifiable risk into concentrated risk which is strongly correlated to overall economic performance.

• It is now clear that AAA ratings of CDO were based on assumptions that turned out to be wrong.

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)

…ooohhh yeah…

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

Outline

• Was it a surprise?• The role of financial innovation• 7+1 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 only if it

can produce contract under which agents can buy and sell insurance contracts covering all possible states of nature

• Often referred to as Arrow-Debreu contracts


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).

• 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

Source: Johnson (2009)

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”

There can be too much financeFigure 1: Financial Development and GDP Growth

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Pure Gambling

Figure 2.3OUTSTANDING CREDIT DEFAULT SWAPS, GROSS AND NET NOTIONAL AMOUNT

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Source: UNCTAD secretariat calculations, based on data from the Depository Trust and Clearing Corporation.

Who buys insurance against US default?


Efficiency• Key objective of regulatory reform:

– Do not stunt financial innovation but weed out financial instruments which increase risk but have no social return

• 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. – Through this maturity transformation

process, which provides small savers with the liquid instruments they prefer, the banking system can direct vast resources towards potentially productive investment projects.

3 Avoid Regulatory Arbitrage• In normal times, this system works well because only a

small fraction of savers ask for their cash back at any given moment of time.

• Thus, banks can satisfy any "reasonable" demand for cash withdrawals by holding small cash reserves.

• If a large number of savers were to approach their bank and ask for their money back (a thing they have the right to do because they hold demand deposits), the bank would soon exhaust its reserves and would have to recall its loans in order to pay back its depositors.

• But since loans are illiquid, the amount of money that the bank would be able to recover would be smaller than the face value of the loan, making the bank insolvent.

• Thus banks are subject to crises of confidence and self-fulfilling runs


• 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

can prevent self-fulfilling runs by guaranteeing that solvent banks always have enough liquidity to honour their deposits and protecting each depositor, up to a certain amount, even if the bank becomes insolvent

• 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


• 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


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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.

Asset backed securities issuers

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Figure 2.2THE SHADOW BANKING SYSTEM, 2007, Q2

Source: Shin (2009).

Each institution can be a source of systemic riskProviders of financial products should be supervised on the basis of the risk they produce

If an investment banks issues insurance contracts like CDS, it should be supervised like an insurance companyIf an insurance company is involved into maturity transformation, it should be regulated like bank


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


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


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").


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.


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.


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.


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– No data on cross-border exposure among banks and

derivative products– Need to develop a system for evaluating cross-

border systemic risk• Need 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 an

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


• Developing countries are often characterized by a non-competitive financial system in which banks make good profits by paying low interest on deposits and charging high interest rates on loans, which they only extend to super-safe borrowers

• Financial development is good – But it can also increase vulnerabilities because it

alters the incentives structure of the various players within the financial system (Rajan, 2005)

– Developing country regulators should develop their financial sectors gradually to avoid boom and bust cycles


• There is no one-size fits all financial regulatory system– We now realize that good financial

regulation is very difficult to implement. – Thus, there may be a trade off between

financial sophistication and stability• Countries with more ability to regulate and that

are better prepared to absorb shocks may want to adopt a more aggressive process of liberalization

• Other countries may want to be more cautious• The right approach is the one of Deng Xiaoping

+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)


• 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


• 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

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the big financial mess: causes and implications for financial regulation ugo panizza

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