The 2008 Financial Crisis - Causes and Effects

by Patrick on September 29, 2008

The 2008 financial crisis is affecting millions of Americans and is one

of the hottest topics in the Presidential campaigns. In the last few
months we have seen several major financial institutions be
absorbed by other financial institutions, receive government
bailouts, or outright crash.

So what caused the financial crisis of 2008? This is actually the

perfect storm which has been brewing for years now and finally
reached its breaking point. Let’s look at it step by step.

Market instability

The recent market instability was caused by many factors, chief

among them a dramatic change in the ability to create new lines of
credit, which dried up the flow of money and slowed new economic
growth and the buying and selling of assets. This hurt individuals,
businesses, and financial institutions hard, and many financial
institutions were left holding mortgage backed assets that had
dropped precipitously in value and weren’t bringing in the amount of
money needed to pay for the loans. This dried up their reserve cash
and restricted their credit and ability to make new loans.

There were other factors as well, including the cheap credit which
made it too easy for people to buy houses or make other
investments based on pure speculation. Cheap credit created more
money in the system and people wanted to spend that money.
Unfortunately, people wanted to buy the same thing, which
increased demand and caused inflation. Private equity firms
leveraged billions of dollars of debt to purchase companies and
created hundreds of billions of dollars in wealth by simply shuffling
paper, but not creating anything of value. In more recent months
speculation on oil prices and higher unemployment further
increased inflation.

How did it get so bad?

Greed. The American economy is built on credit. Credit is a great

tool when used wisely. For instance, credit can be used to start or
expand a business, which can create jobs. It can also be used to
purchase large ticket items such as houses or cars. Again, more jobs
are created and people’s needs are satisfied. But in the last decade,
credit went unchecked in our country, and it got out of control.

Mortgage brokers, acting only as middle men, determined who got

loans, then passed on the responsibility for those loans on to others
in the form of mortgage backed assets (after taking a fee for
themselves originating the loan). Exotic and risky mortgages
became commonplace and the brokers who approved these loans
absolved themselves of responsibility by packaging these bad
mortgages with other mortgages and reselling them as
“investments.”

Thousands of people took out loans larger than they could afford in
the hopes that they could either flip the house for profit or refinance
later at a lower rate and with more equity in their home - which they
would then leverage to purchase another “investment” house.

A lot of people got rich quickly and people wanted more. Before
long, all you needed to buy a house was a pulse and your word that
you could afford the mortgage. Brokers had no reason not to sell
you a home. They made a cut on the sale, then packaged the
mortgage with a group of other mortgages and erased all personal
responsibility of the loan. But many of these mortgage backed
assets were ticking time bombs. And they just went off.

The housing market declined

The housing slump set off a chain reaction in our economy.

Individuals and investors could no longer flip their homes for a quick
profit, adjustable rates mortgages adjusted skyward and mortgages
no longer became affordable for many homeowners, and thousands
of mortgages defaulted, leaving investors and financial institutions
holding the bag.

This caused massive losses in mortgage backed securities and many

banks and investment firms began bleeding money. This also caused
a glut of homes on the market which depressed housing prices and
slowed the growth of new home building, putting thousands of home
builders and laborers out of business. Depressed housing prices
caused further complications as it made many homes worth much
less than the mortgage value and some owners chose to simply
walk away instead of pay their mortgage.

The credit well dried up

These massive losses caused many banks to tighten their lending

requirements, but it was already too late for many of them… the
damage had already been done. Several banks and financial
institutions merged with other institutions or were simply bought
out. Others were lucky enough to receive a government bailout and
are still functioning. The worst of the lot or the unlucky ones
crashed.
The Economic Bailout is designed to increase the flow of credit

Many financial institutions that are saddled with risky mortgage

backed securities can no longer afford to extend new credit.
Unfortunately, making loans is how banks stay in business. If their
current loans are not bringing in a positive cash flow and they
cannot loan new money to individuals and businesses, that financial
institution is not long for this world - as we have recently seen with
the fall of Washington Mutual and other financial institutions.

The idea behind the economic bailout is to buy these risky mortgage
backed securities from financial institutions, giving these banks the
opportunity to lend more money to individuals and businesses,
hopefully spurring on the economy.

What? Credit got us into this mess! Why give more?!?

Ironic isn’t it? Yes, it is true that credit got us into this mess, but it is
also true that our economy is incredibly unstable right now, and
being that it is built on credit, it needs an influx of cash or it could
come crashing down. This is something no one wants to see as it
would ripple through our economy and into the world markets in a
matter of hours, potentially causing a worldwide meltdown.

As I previously mentioned, credit in and of itself is not a bad thing.

Credit promotes growth and jobs. Poor use of credit, however, can
be catastrophic, which is what we are on the verge of seeing now.
So long as the bailout comes with changes to lending regulations
and more oversight of the industry, along with other safeguards to
protect taxpayer dollars and prevent thieves from not only getting of
the hook, but profiting again, there is potential to stabilize the
market, which is what everyone wants. Whether or not it works is to
be seen, but as it has already been voted on and passed, we should
all hope it does.

Reforming financial regulation, supervision, and oversight: What to

do and who should do it

24 February 2009 Print Email

Comment Republish
This column sketches proposed reforms for regulation, supervision, and oversight of
international financial markets. At both the national and international levels, there will be
plenty of work to do for the IMF, the FSF, international standard-setting bodies, and national
regulators and supervisors.

In the midst of the most serious financial and economic crisis since the Great Depression, it is
clear that major regulatory failure (in the long run-up to the crisis) was one of the key
contributing factors. The two central questions are:
 • What to do, and
• Who should do it.

In what follows, I offer a summary of my recommendations.1

It is useful to group the proposed reforms under the seven headings that correspond to
problem areas highlighted by the current crisis: (i) reducing leverage and increasing liquidity,
(ii) counteracting the pro-cyclicality of bank capital regulation, (iii) pricking asset-price
bubbles, (iv) making financial failures less costly, (v) improving market incentives for prudent
behaviour, (vi) filling gaps in regulatory coverage, and (vii) early warning and monitoring.

Reducing leverage and increasing

liquidity
• Significantly increase (e.g., double) the international minimums for total and Tier 1
risk-weighted bank capital under the Basel regime. If bank capital were much higher
going into the crisis, banks would have had a bigger cushion for losses and there
would be less need for public money directed at bank recapitalisation.
• Introduce as part of the Basel regime a minimum (unweighted) leverage ratio for bank
capital. This would usefully restrain the increase in leverage during the upswing of the
business cycle and also provide some protection against errors in the weights used
for the risk-weighted capital measure.
• Consider introducing higher capital requirements for systemically-important financial
institutions (since failure of these institutions imposes higher costs on the rest of the
economy).
• Introduce a quantitative minimum liquidity requirement for banks and private-sector
liquidity pools to deal with inadequate holding and hoarding of liquidity, respectively. 2
More principles and stress tests for liquidity risk management, as proposed in the
latest report of the Basel Committee on Banking Supervision, will not do the job.
Think where we would be today if there were only principles for bank capital – not a
minimum quantitative ratio. Yes, central banks can offer large-scale liquidity
assistance to a broad range of market participants against a wide range of collateral,
but the larger, more frequent, and longer lasting is such assistance, the greater the
likelihood that the official lifeline will undermine incentives for market participants to
self-insure adequately against liquidity risks. Also, while central banks can inject
liquidity, hoarding of liquidity may prevent liquidity from going to those who need it
most. Private-sector liquidity pools, cum overdrafts, loss-sharing, and – as a condition
of membership – lending to other pool members that are short of liquidity, can deal
with the hoarding problem.
• Pressure the IMF to begin enforcing vigorously its guidelines on exchange rate
surveillance. This is directed at how global imbalances and prolonged currency
under-valuation in some emerging economies affects reserve accumulation, capital
flowing into the advanced countries, and ultimately, the level of long-term interest
rates. When these interest rates get too low, they encourage excessive borrowing
and leverage.

Counteracting pro-cyclicality in the

bank capital regime
• Introduce a range for minimal bank capital requirements where the lower part would
 apply during cyclical downturns and the upper part during upswings. This would
counteract the pro-cyclical tendency under the current regime for bank capital
requirements to increase during the downswing and fall during the upswing (with
knock-on effects on bank lending). There are various ways of making required bank
capital a function not only of the level of bank assets but also of the change in bank
assets (cum other cyclical and risk indicators).
• Ensure that decisions on changes in required bank capital (and provisioning) reflect
not only what is going on in individual financial institutions but also what is going on in
the macro-economy.3

Pricking asset-price bubbles before

they collapse
• Reject the doctrine that says that neither central banks nor regulatory authorities
should attempt to identify and to prick asset-price bubbles, and that once these
bubbles burst, the mess can be cleaned up at low cost simply by reducing interest
rates. The severity of the present crisis argues forcefully against this view.
• Central banks and regulatory authorities must coordinate much better on how they
are going to react to building asset-price bubbles – if one doesn’t act, the other must.
If, for example, central banks decide that they are very limited in how much they can
raise interest rates to deal with rapidly rising asset prices, then regulatory authorities
will need to increase their response (using whatever regulatory and supervisory tools
are at their disposal, including sterner warnings to lenders about rising concentration
risk).

Making financial failures less costly

• Require all countries to implement a prompt-corrective-action and orderly closure rule
for systemically important financial institutions – be they banks or non-banks (along
the lines of what we have banks in the US under the FDIC Improvement Act and
Competitive Equality Banking Act). Without prompt corrective action, regulators will
wait too long to impose needed corrective actions on faltering financial institutions.
Without an orderly closure rule, authorities will be confronted with two unappealing
options: (1) put the failing institution into the normal bankruptcy regime and accept
creditor stays and potential market lock-ups not helpful to restoring financial stability,
or (2) make a quick decision over the weekend to implement a large bail-out on terms
not necessarily favourable to taxpayers. What we need is a framework that combines
continuity of operations (e.g. a ‘bridge bank’), good moral hazard properties (wipe out
shareholders, change management, guarantee some liabilities at estimated recovery
cost, not par), gives some discretion to crisis managers for payment priorities, and
also provides crisis managers with “time to think.” Such a prompt-corrective-action
and orderly closure regime would have been helpful in the cases of Bear Stearns,
Lehman, Merrill-Lynch, and AIG, among others.
• Establish clearinghouses in the over-the-counter (OTC) derivatives markets.
According to the Bank for International Settlements, there were almost $600 trillion of
OTC derivative contracts outstanding as of the end of2007. The problem with so
much trading taking place is that the OTC market doesn’t offer the same level of
systemic protection as organised exchanges (or more generally, where there is a
central clearing party). What we need is a well-capitalised central-clearing party that
acts as a counterparty on all trades, initial and maintenance margins that are strictly
enforced, each participant’s net position to be known in real time and recorded
electronically, and price information to be transmitted accurately and rapidly to all
traders. Yes, you can’t get the same level of customisation on an organised exchange
 as you get in the OTC market, but the higher level of systemic risk (in OTC markets)
is too high a price to pay for it. Establishing a central clearing party in the credit
default swap market is a good start – but only a start. If it takes too long to establish
these clearinghouses, consideration should be given to using the bank capital regime
and/or the bankruptcy regime to create incentives for shifting more trading to the
organised exchanges.
• Temporarily suspend the use of credit ratings and banks’ internal assessments as risk
weights in the Basel II bank capital regime in favour of weights chosen by bank
supervisors. Although officials seem loathe to make yet another significant change in
the international bank capital regime given the long and arduous approval process for
Basel II, the promised benefits of using credit ratings and banks’ internal models as
risk weights have been undermined by the dreadful performance of such ratings and
models during the run-up to this crisis.
• Toughen IMF surveillance of currency mismatches. Currency mismatches have been
at the heart of all the major emerging-market financial crises of the past dozen years.
Unfortunately, we are once again seeing their systemic adverse impact – this time
among the economies of Eastern Europe. Although the IMF has argued that it has for
some time been given increased attention to such balance-sheet effects, it is clear
that more needs to be done to reduce those mismatches, so that large exchange rate
depreciations do not have such devastating effects on borrowers’ net worth.4

Improving market incentives for

more prudent behaviour
• Offer financial firms an incentive in the form of a lower capital charge to implement
sensible deferred compensation plans. If you pay top managers bonuses based on
annual profits but you don’t claw back the losses when tail risk materialises, you
create strong incentives for taking on such tail risk. The antidote is to have a deferred
compensation plan where you get only part of your bonus upfront and the rest only
when superior performance is confirmed over a period of years.
• Require originators/packagers of securitised instruments (including securitised home
mortgages) to take an equity slice in products that they sell/distribute to others. Such
an equity stake will give such originators and packagers “more to lose” if they don’t
perform adequate due diligence on the creditworthiness and transparency of the
borrowers and instruments. A polar example of such an arrangement is the covered
bonds instrument that has proved so popular in Europe.
• Improve the disclosure and documentation for complex structured products – and
restrict their sale to “sophisticated investors,” as recommended recently by the
Counterparty Risk Management Group III (2008). This will reduce the chance that
investors in these products will be unaware of what they are buying.
• Reduce conflict of interest in the major credit rating agencies by restricting the ratings
agencies to their ratings business – their consulting activities should be split into
separate firms. Firewalls within the same firm will not work. In this connection, we
should follow the example of what was done in the auditing/accounting industry after
the Enron (and similar) scandals.

Filling gaps in financial regulation

coverage
• There should be serious oversight and supervision of all systemically important
financial institutions, where “systemically important” is a function of size, degree of
inter-connectedness in financial markets, and leverage. Who gets regulated should
 not depend on whether the institution is classified as a commercial bank, an
investment bank, an insurance company, or a hedge fund.
• All systemically important financial institutions that operate globally should have a
well-functioning college of supervisors. The existing degree of cooperation between
home and host-country supervisors is not adequate for overseeing the operations of
global financial firms.
• Whatever their institutional frameworks, all national supervisory systems should have
one institution that has the mandate for maintaining overall financial market stability,
with the requisite authority to investigate sources of systemic risk and to identify and
recommend appropriate corrective actions.
• Any remaining regulatory capital bias in favour of off-balance-sheet entities should be
eliminated. The current crisis has demonstrated vividly what happens when there is
not a genuine transfer of risk (including reputational risk) from parents to off-balance-
sheet vehicles and when this risk has to be transferred back to the parent (after a
failure) at sizeable cost.
• The membership of the Financial Stability Forum (FSF) should be expanded to
include the larger emerging economies. The increasing weight of these economies in
the global financial marketplace argues persuasively for including them in the FSF. To
keep the size of the group manageable for an effective discussion, some other
participants will need to accept a reduction in the size of their representation.
• Improve further the collaboration between the IMF and the FSF – so that they
together can get a better fix on systemic risk. Each of these institutions has a distinct
comparative advantage that will be useful in identifying systemic risk – if they
collaborate effectively, we increase the likelihood of building an effective early
warning system.

Early warning and monitoring

• The focus of an early warning system should be on the monitoring of systemic risk.
• Both top-down (starting at the county level) and bottom-up (starting at the level of the
individual large financial institution or market segment) approaches to monitoring and
measuring systemic risk are useful.
• Analysing “contagion” must be an integral part of any systemic risk exercise.
• When sources of systemic risk are identified, there should be a “graduated’ response
(from the strictly confidential at one end to publication at the other) in communicating
that risk to the relevant parties.
• New regulatory and supervisory measures will be of little use unless compliance with
those measures is regularly assessed and unless there are pressures of one kind or
another placed on those countries/institutions that are out of compliance.

Who should do what?

If the framework for regulation, supervision, and oversight is to be strengthened – at both the
national and international levels – there will be plenty of work to do for the IMF, the FSF,
international standard-setting bodies, and national regulators and supervisors. Below, I sketch
out some thoughts on their assignments. I believe that the case for establishing a new super
international regulator is weak – both because there is not the political will to cede the
requisite authority to such a new institution and because – if reformed properly – the network
of existing institutions can do the job.

The IMF
 • Once a new international regulatory and supervisory template is agreed upon, the
Fund should expand its FSAP (Financial Sector Assessment Program) and ROSC
(Review of Standards and Codes) exercises so that it can evaluate countries’
compliance with the new template. Such exercises should be mandatory for all Fund
member countries, and the results should be published.
• The Fund’s membership should agree that FSAPs will be done for systemically
important countries at least once every 12-18 months. For other member countries,
FSAPs would be done once every 2-3 years.
• The Fund should strengthen its early warning capabilities – particularly its focus on
monitoring systemic risk-- by performing a regular quarterly exercise that ranks
countries’ vulnerability to currency, banking, and debt crises. The Fund should also
present regularly the kind of global credit loss analysis and projections that has
appeared in the last few Global Financial Stability Reports.
• Along with the FSF, the Fund should be informed before the fact when member
countries are planning to introduce crisis management measures related to the
financial sector (e.g, government guarantees on bank liabilities, capital injections, etc)
that could have important spillover effects on other countries’ crisis management
plans.
• As suggested earlier, the Fund needs to raise its game on exchange rate surveillance
and on identification and publication of currency mismatches.

The FSF
• The FSF should make recommendations to the standard-setting bodies whenever a
clear majority of its members conclude that there is a significant hole in the existing
regulatory structure and/or when a recent regulatory change is viewed as insufficient
to deal with the problem addressed by that regulation.
• The standard-setting bodies should submit to the FSF for review new proposed
regulatory measures so that the FSF can offer a view on whether the macroeconomic
impact of those proposed regulations would be pro-cyclical or not.5
• The FSF should intensify its work on monitoring systemic risk – covering both
microeconomic and macroeconomic factors.
• Folowing a proposal made in Brunnermeier et al (2009), the Managing Director of the
IMF and the head of the FSF should be given the authority to offer a joint public early
warning on systemic risk when they feel that circumstances are serious enough to
warrant such a statement.

The international standard-setting

bodies (BCBS, IOSCO, etc)
• The standard-setting bodies should translate the broader principles on reform of
financial regulation, supervision, and oversight agreed by the G20, the FSF, and the
IMF into more specific operational guidelines that can be incorporated into national
regulatory and supervisory frameworks (including the relevant legislation). In so
doing, these bodies should be mindful that an earlier excessive reliance on self-
regulation and on principles so broad as to provide little constraint on imprudent
behaviour has not been helpful.

National regulators and supervisors

 • They should examine the lessons of the crisis to determine which demonstrated
shortcomings in their national financial systems are country-specific in nature and are
therefore less amenable to international standards and codes of conduct; they should
then act accordingly to remedy such shortcomings (so long as such actions do not
jeopardise the recovery from the crisis). For example, in the US, there is a compelling
case for reforming housing finance – ranging from putting more resources into
education about mortgage financing, to designing a simple template for home
mortgages, to establishing a federal regulator for the home mortgage industry, to
putting Fannie and Freddie into receivership (on the way, inter alia, to breaking them
up into smaller units and privatising them). Similarly, the crisis has raised serious
questions about the desirability of retaining 50 state regulators for the insurance
industry instead of a national one and about the adequacy of existing regulations
covering prudent behaviour by money-market funds. As suggested in the US
Treasury (2008) “blueprint,” there is likewise a strong case for streamlining the US
regulatory structure along functional lines. And over the longer term, there is a serious
question as to whether the “too big to fail” problem can really be solved other than by
restrictions on the size and activities of financial institutions themselves – as
suggested in a recent Group of Thirty (2009) report on financial regulatory reform.
Other G20 countries have their own country-specific regulatory shortcomings to deal
with.
• Once a new international template for regulation, supervision, and oversight is
agreed, national regulators will have the primary responsibility for seeing to it that the
new template is reflected in domestic legislation and that a monitoring framework is
established to ensure that financial institutions under their oversight are complying
with the new international regulations.

http://www.voxeu.org/index.php?q=node/3076
An overview of the proposals to fix the financial system
15 February 2009 Print Email
Comment Republish
Proposals for financial regulatory reform are everywhere. This column presents an
opinionated synthesis of the key issues and proposals with the aim of focusing and
stimulating the debate.

The global crisis has scared the public, captivated policy makers, and fascinated the
academic community. A consensus has emerged that the financial system is broken and must
be fixed. This column puts forth an opinionated overview of the various reports and proposals
for new financial regulations in an attempt to stimulate and focus discussion.

I do not describe the crisis itself since much has already been written about it. Brunnermeier
(2008) and Hellwig (2008) provide excellent analysis of the early part of the crisis, the Policy
Recommendations from NYU Stern (2009) has a complete coverage, and Blanchard (2008)
offers a clear and concise macroeconomic perspective.

Three key reports

I will mostly focus on three reports:

· The “Geneva Report” (Brunnermeier, Crocket, Goodhart, Persaud, and Shin;

· The “G30 Report” by the Group of Thirty, chaired by Paul Volcker; and

· The “NYU-Stern Report” by a group of professors from NYU’s Stern School of which I
am one.

These three reports cover most, if not all, areas of financial regulation. I also discuss the
capital insurance proposals of Kashyap, Rajan and Stein (2008), and the proposals of
Zingales (2008, 2009).

SECTION 1: The failures of current

regulations
There is much agreement regarding the shortcomings of current regulations. Let me focus on
five specific areas.

Systemic risk. All reports agree that the financial regulatory frameworks around the world
pay too little attention to “systemic risk”. For instance, Acharya, Pedersen, Philippon and
Richardson (2009) argue that “Current financial regulations seek to limit each institution’s risk
seen in isolation; they are not sufficiently focused on systemic risk. As a result, while
individual risks are properly dealt with in normal times, the system itself remains, or is induced
to be, fragile and vulnerable to large macroeconomic shocks.” Or, as the Geneva Report puts
it: “regulation implicitly assumes that we can make the system as a whole safe by simply
trying to make sure that individual banks are safe. … a fallacy of composition.”

Pro-cyclical risk taking. All reports agree that current financial regulations tend to
encourage pro-cyclical risking taking which increases the likelihood of financial crises, and
their severity when they occur. Under current regulations, prolonged periods of low volatility
reduce statistical measures of risk and thus encourage excessive risk taking. In bad times,
the pendulum swings back producing excessive risk aversion.

Large Complex Financial Institutions (LCFIs). All reports agree that current regulations
do not deal adequately with LCFIs, defining LCFIs as “financial intermediaries engaged in
some combination of commercial banking, investment banking, asset management and
insurance, whose failure poses a systemic risk or `externality’ to the financial system as a
whole.” (Saunders, Smith and Walter 2009). All reports also insist on the danger induced by
implicit Too-Big-To-Fail guarantees.

Capital requirements. All of the reports struggle with a paradox of financial regulation;
capital held to meet minimum requirements cannot be used as a buffer against unexpected
losses. As such, fixed capital requirements can only ensure that losses do not immediately
make banks insolvent. They might give regulators enough time to intervene, but they are
ineffective against systemic risk. The real buffer can only come from equity in excess of the
requirements.

Liquidity and maturity mismatch. The traditional view of systemic risk focuses on
sequences of bank failures, for example a domino-like spread of counterparty failures.
Today’s financial system, where many banks finance their investments in credit markets,
faces a different type of systemic risk. As the Geneva Report points out, “a key avenue
through which systemic risk flows today is via funding liquidity combined with adverse asset
price movements due to low market liquidity.” Acharya and Schnabl (2009) also explain why
regulators should take liquidity into consideration when assessing capital adequacy ratios,
and Hellwig (2008) insists on the maturity mismatch in vehicles that relied on short term
market financing to fund long term assets (real estate assets in particular).

SECTION 2: Propositions for

regulatory reforms
The various reports agree broadly on the principles that new regulations should follow – they
should be based on rules rather than discretion, and they should address well-identified
externalities (see Hart and Zingales, 2008). When it comes to concrete proposals, however,
there are fewer practical ideas, and less agreement.

My goal here is not to be exhaustive, focusing rather on the issues that I view as most
essential, and on the proposals that are sufficiently spelled out to be evaluated.

Systemic risk. The first step towards regulating systemic risk is to measure it. But how
should we do that? In particular, how do we define how much a particular firm contributes to
systemic risk? How can we improve Value at Risk (VaR) measures?

There is some good news on the VaR front. There are currently two proposals to incorporate
systemic risk into the standard measures. The Geneva report argues for CoVaR, based on
the work of Adrian and Brunnermeier (2008), where CoVaR is the VaR of financial institutions
conditional on other institutions being in distress. The NYU-Stern report proposes a systemic
capital requirement based on the individual firm’s contribution to aggregate tail risk. These two
measures have much in common, and are specifically tailored to deal with systemic as
opposed to individual risks.

My view is that a combination of systemic and liquidity risk measures proposed by the NYU-
Stern and Geneva Reports can considerably improve risk management practices inside
financial firms, and, just as importantly, create the basis for a constructive dialogue between
these firms and their regulator. At this stage, we need more empirical work to show that the
proposed measures can indeed be used to identify institutions that pose systemic risk before
a crisis hits.

As far as institutions are concerned, all reports also agree that Central Banks should be
explicitly in charge of what the NYU-Stern Report calls “systemic regulations” and the Geneva
Report calls “macro-prudential regulation”.

LCFIs, Moral Hazard and the Scope of Regulation. A key problem in improving LCFI
regulation is that we do not have a good definition of LCFIs. The Geneva report argues that
the best measures are leverage, maturity mismatch, and asset growth. These measures are
certainly useful, but it is difficult to argue that they differentiate systemic from individual risks:
a firm with high leverage and maturity mismatch would already be classified as individually
risky. Saunders, Smith and Walter (2009) argue that LCFIs should be identified based on
measures of size in combination with measures of complexity or interconnectedness. The
difficulty is that we do not have readily available measures of complexity and
interconnectedness.

LCFIs are particularly problematic because they are too-big-to-fail. This is in part because we
do not have the procedures to deal with their failures. Altman and Philippon (2009) “advocate
the creation of specific Bankruptcy procedures to deal with LCFIs.” Zingales (2008, 2009)
argues that we need a “new piece of legislation introducing a new form of bankruptcy for
banks, where derivative contracts are kept in place and the long-term debt is swapped into
equity.” The G30 report argues that “legislation should establish a process for managing the
resolution of failed non depository financial intuitions comparable to the process for depository
institutions.” Thus, there is broad agreement on what is needed, but, as far as I am aware,
there are few concrete proposals about how to deal with the mind-boggling complexity of the
issue. Chapter 11 was deemed too risky for the standard (if large-scale) bankruptcy of
General Motors. How far are we, then, from a procedure that we could use to deal with the
failure of financial Godzillas such as AIG or Citigroup?

Hedge funds and similar. The reports do not present a consensus on the critical issue of
what to do with the largely unregulated sector of hedge funds and private equity. Should we
impose systemic regulations to a “group of institutions” if they are interconnected and can
collectively pose systemic risks even though they appear individually small? My view is that
we should, but I would not know how to start.

Capital requirements and cyclical risk taking. The reports suggest that capital adequacy
requirements should incorporate liquidity risk, and that they should be tightened in good times
– when systemic risk is building up but has not yet been realized – and should be loosened in
bad times when banks need a breathing space to weather the crisis.

I see mostly good news on the liquidity front. The G30 Report proposes “norms for
maintaining a sizeable diversified mix of long term funding and an available cushion of highly
liquid unencumbered assets.” The NYU-Stern report argues that, in order to limit regulatory
arbitrage, “regulation should not be narrowly focused on a single ratio of bank balance-sheet,”
and should take into account “liquidity to assets ratio” (measured only through stress-time
liquidity). The Geneva report has a well-articulated proposal for regulating liquidity and
maturity mismatch (their Chapter 5 is a must-read in my opinion).

Unfortunately, I have not seen as much progress on the issue of cyclical risk taking. As
Blanchard (2008) explains, “pro-cyclical capital ratios, in which capital ratios increase either in
response to activity or to some index of systemic risk, sound like an attractive automatic
stabilizer. […] The challenge is clearly in the details of the design, the choice of an index, the
degree of pro-cyclicality.” The Geneva report argues that “macro-prudential regulation should
be countercyclical and lean against bubbles,” but does not propose an index against which
the cycle should be measured.

The Group of Thirty report is even vaguer, since it simply advocates tighter benchmarks when
“markets are exuberant and tendencies for underestimating risk are great.” This hardly
sounds like the starting point of a useful regulatory debate. The NYU-Stern report argues that
stress tests for systemic risk capital can be used to construct a-cyclical risk measures. This is
a more precise and practical idea, but it is not clear that this will be enough to create pro-
cyclical regulations.

I very much doubt that we can agree on a set of objective measures of ‘excessive’ credit
expansion (let alone bubbles). I think that the best we can expect is a powerful regulator
running systemic stress tests based partly on historical data and partly on subjective forward
looking scenarios. The critical issue in my view does not lay in the construction of an
appropriate cyclical index, but rather in making sure that the regulator is powerful enough to
enforce tighter prudential regulations based in part on subjective and debatable
interpretations of economic data. The financial industry will not like it, and it has a strong track
record of capturing its regulators, so this will not be easy.

Recapitalization during crises. This is probably the most controversial and most
interesting topic. In times of crisis, asset values decline, and banks tend to curtail lending and
liquidate assets in order to control their leverage. These actions increase systemic risk. It
would be more efficient to recapitalize the banks automatically at the first sign of crisis.

An interesting idea is to create recapitalization requirements, in addition to capital

requirements. One way to do so is to force levered financial institutions to issue securities that
provide automatic recapitalization if the firm’s value decreases. Wall (1989) proposed
subordinated debentures with an embedded put option. Doherty and Harrington (1997) and
Flannery (2005) proposed reverse convertible debentures. These securities limit financial
distress costs ex-post without distorting bank managers’ ex-ante incentives.

In a thought-provoking paper, Kashyap, Rajan and Stein (2008) argue that the idea of
automatic recapitalization can be applied to systemic risk. They propose a capital insurance
scheme based on systemic risk. Each bank would buy capital insurance policies that would
pay off when the overall banking sector is in bad shape. The insurer would be a pension fund
or a sovereign wealth fund that would essentially provide fully funded `banking-industry
catastrophe insurance’. Kashyap, Rajan and Stein explain that “a bank with $500 billion in
risk-weighted assets could be given the following option by regulators: it could either accept a
capital requirement that is 2% higher, meaning that the bank would have to raise $10 billion in
new equity. Or it could acquire an insurance policy that pays off $10 billion upon the
occurrence of a systemic event.”

The issue with this proposal is that it does not provide a link between a firm’s own contribution
to aggregate losses and the insurance it must get. The policy pays off $10 billion regardless
of the health of the bank at that point. The financial institution still has the incentive to lever
up, take concentrated bets, and build illiquid positions which may improve the risk/return
profile of the firm but nevertheless increase the systemic risk in the system. The crisis has
shown that this is a first order concern. Another limitation of this sort of proposal is that if the
crisis is large enough, no amount of private money will ever be enough, and the Fed is always
going to be the lender of last resort. The mere existence of a LOLR creates moral hazard
unless LOLR services are properly priced ex-ante.

The NYU-Stern report proposes solutions to these problems (Acharya, Pedersen, Philippon
and Richardson 2009). One is to make the size of the required insurance policy proportional
to the estimated systemic risk capital charge defined above in the section on systemic risk.
Another is to specify that the insurance must cover the short fall from a pre-specified target:
the bank would have to buy an insurance contract such that its equity is at least $50 billion
upon the occurrence of a systemic event. If the bank had only $30 billion, the policy would
pay off $20 billion, but if the bank had $55 billion, the policy would pay nothing. The bank
would have an incentive to limit its systemic exposure in order to decrease its insurance
premium.

The Geneva Report is sceptical: “We doubt whether additional private insurance can then
help much on occasions when market and funding liquidity vanishes; the examples of the
mono-lines and of AIG confirm our doubts.” The NYU-Stern Report argues that the scheme
could be implemented with a mixture of private capital (if only for price discovery) and public
capital.

Another important caveat is that capital insurance dominates capital requirements only to the
extent that it is expensive to keep equity on banks’ balance. This is indeed the core motivation
of Kashyap, Rajan and Stein (2008). But one can take the opposite view, in which case higher
equity ratios would be a much simpler solution. Hellwig (2008) puts it eloquently: “At this
point, the institutions concerned will protest that equity capital is expensive. I have yet to see
a convincing argument showing that this protest is referring to social costs, rather than just
the private costs to the bank manager of having to go to outside financiers and having to
explain to them what he is doing and why his activities should merit their entrusting him with
their money.”

My view is that having some insurance and, perhaps more importantly, some price discovery
for the costs of systemic risk would be invaluable. It is therefore worth implementing such a
system even if its scale is somewhat limited. I would also argue that an imperfect system is
still preferable to ad-hoc LOLR interventions that create incentives for reckless risk taking ex-
ante, and leave large liabilities for tax-payers ex-post.
SECTION 3: Conclusion
Let me offer two concluding thoughts.

1. Regarding financial regulations, the devil is in the details – and the successive failures
of TARP versions 1.0, 2.0, etc. prove this point more than ever. We have enough agreement
on the broad principles of financial regulations, and we need to get down to specifics. I would
therefore consider any future report that does not include tables, figures, numbers, equations,
and specific proposals to be useless rhetoric.

2. We need to be ready to take a tough stand on future regulations for institutions that are
too-big-to-fail.

This issue reminds me of the paradox of free trade. The benefits of free trade are widespread
and difficult to grasp, while its costs are concentrated and easily publicized. Public support for
free trade is therefore structurally weak. Moral hazard created by implicit guarantees is also
widespread and difficult to grasp. It shows up in spreads lowered by a few basis points here
and there, in slight distortions of comparative advantages, and in overall weaker governance.
But the costs of LCFI failures are large and concentrated. It is therefore tempting for
regulators to focus too much on bailouts, and too little on incentives. But this is clearly the
wrong policy for the long run. Incentives and accountability must be improved, even if it
means fighting a regulatory battle with the industry.

Sir Winston Churchill famously remarked that “Britain and France had to choose between war
and dishonour. They chose dishonour. They will have war.” If in the hope of ending the crisis
quickly, we choose to bail out the banks without making their managers, shareholders and
creditors accountable, then we choose dishonour, and we will have more devastating crises.

Note: I thank Richard Baldwin and Viral Acharya for their comments on an early draft. All
errors are mine.
3.3 Implications for the financial sector
Adverse macroeconomic developments such as oil price and interest rate hikes, apart from
the direct
impact of reducing demand, may put further pressure on the debt service and loan repayment
abilities
of corporate and household sectors in the longer term. The financial strength and risk
management
capability of the financial sector are therefore important in ensuring that the sector will be able
to
withstand potential difficulties.
However, this is helped by the fact that credit risks related to asset quality of the whole
banking
system, in particular concentration risk, have declined following enhanced credit
diversification into
different economic sectors in addition to the low, and still declining, expected probability of
default of
bank customers (Figure 10).
Having begun to move away from collateral-based lending to a risked-based approach,
commercial
banks have improved credit analysis and risk management. There is increasing use of credit
scoring
and credit rating, application of value-at-risk, sensitivity and gap analyses, and fair accounting
value