Journal of Regulation & Risk - North Asia, Volume II, Edition I, Spring 2010

J ournal of Regulation & Risk
North Asia
Volume II, Issue I, Spring 2010
Articles & Papers

Fed monetary and regulatory policy: lessons from the crisis
Janet L. Yellen
The post-crisis fix: regulatory or monetary policy remedies?
Stephen S. Roach
Risk orientation in regulation and supervision
Patrick Raaflaub & Gabe Shawn Varges
Regulation, supervisory lessons from Japan since the 1990s
Kazuo Ueda
Enhancing cross-border regulation after the 2008 crash
Richard Neiman
What we thought we knew and what we didn’t know
Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro
The ‘business of bribery’ sparks anti-corruption drive
Gavin Sudhakar
Public or private accounting and the Sarbanes-Oxley Act
Alex J. Pollock
‘Innumerate bankers, systemic idiocy & accounting standards’
Lord Adair Turner
Lessons for the forex market from the global financial crisis
Michael Melvin & Mark P. Taylor
Exports and financial shocks: new evidence from Japan
Mary Amiti & David Weinstein
A case of mistaken identity: the illusion of ‘too big to fail’
Avinash Persaud
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Editor Emeritus
Dr John Pattison
Editor
Ian Watson
Chief Sub-Editor
Fiona Plani
Commissioning Editor
Christopher Rogers
Editorial Standards Board
Dr Giovani Barone-Adesi, Dr Colin Lawrence, Luo Ping, Dr Patrick McConnell,
Dr Michael Ong, Dr John Pattison, William Ryback, Dr Kariya Takeaki, Simon Topping,
Dr Peter Treadway, Lawrence Uhlick and Dr Lawrence White.
Contributors
Dr Susan Ariel Aaronson, Mary Amiti , Olivier Blanchard, Prof Charles Calomiris,
Giovanni Dell’Ariccia, Prof Simon Johnson, James Kwak, Paolo Mauro, Michael Melvin,
Richard Neiman, Avinash Persaud, Alex J. Pollock, Patrick Raaflaub, Stephen S. Roach,
Gavin Sudhakar, Janet Tavakoli, Mark P. Taylor, Edwin M. Truman, Lord Adair Turner,
Prof. Kazuo Ueda, Gabe Shawn Varges, David Weinstein, Dr Janet Yellen.
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Email: christopher.rogers@irrna.org
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JRRNA is published quarterly and registered as a Hong Kong journal. It is
distributed free of charge to governance, risk and compliance professionals in
China, Hong Kong, Japan, Korea and Taiwan.
© Copyright 2010 Institute of Regulation and Risk, North Asia

Material in this publication may not be reproduced in any form or in any way
without the express permission of the Editor.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.
Journal of Regulation & Risk North Asia 1

The Institute of Regulation & Risk North Asia
is proud to present:
An Evening Dialogue with
Mr. Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago
5:15 PM – 10:00 PM
Tuesday, 30 March 2010
Grand Ballroom, Conrad Hotel, Pacific Place
5:15 PM Registration opens

6:15 PM Welcoming Remarks
Ms. Au King-chi, Permanent Secretary for Financial Services and the
Treasury Bureau, Hong Kong SAR
6:30 PM Some perspectives on regulatory reform
Charles L. Evans
6:45 PM Regulating risk, a UK perspective
Andrew Haldane, Executive Director, Financial Stability
Bank of England
7:00 PM What happens after an end of quantitative easing: A Japanese Perspective?
Prof. Kazuo Ueda, Former member of the Policy Board
Bank of Japan
7:15 PM Break
7:30 PM Panel Discussion and Audience Q&A
Moderator:
Robert Pringle, Chairman Central Banking Publications
Panelists:
Charles L. Evans
Andrew Haldane
Prof. Kazou Ueda
Stephen Roach, Chairman, Asia Morgan Stanley
8:45 PM Evening Meal & Beverages
10:00 PM End of Evening Dialogue
Volume II, Issue I – Spring 2010
INSTITUTE OF REGULATION & RISK

NORTH ASIA
Contents
Foreword – Dr John Pattison 5
Acknowledgments 7
Q&A – Dr Janet Yellen 9
Book overview – James Kwak & Simon Johnson 19
Opinion – Janet Tavakoli 23
Opinion – Susan Ariel Aaronson 27
Debate – Prof Charles Calomiris 31
Debate – Edwin M. Truman 47

Articles
Fed monetary and regulatory policy: lessons from the crisis 55
Janet L.Yellen
The post-crisis fix: regulatory or monetary policy remedies? 61
Stephen S. Roach
Risk orientation in regulation and supervision 75
Patrick Raaflaub and Gabe Shawn Varges
Regulation, supervisory lessons from Japan since the 1990s 87
Kazuo Ueda
Enhancing cross-border regulation after the 2008 crash 99
Richard Neiman
What we thought we knew and what we didn’t know 107
The ‘business of bribery’ sparks anti-corruption drive 113
Gavin Sudhakar
Public or private accounting and the Sarbanes-Oxley Act 123
Alex J. Pollock
‘Innumerate bankers, systemic idiocy & accounting standards’ 129
Lord Adair Turner
Lessons for the forex market from the global financial crisis 141
Michael Melvin and Mark P. Taylor
Exports and financial shocks: new evidence from Japan 147
Mary Amiti and David Weinstein
A case of mistaken identity: the illusion of ‘too big to fail’ 153
Avinash Persaud

Dr. James Bullard
President and Chief Executive Officer
Federal Reserve Bank of St. Louis
5:30 PM – 10:00 PM
Monday, June 14, 2010
The Willard Room, InterContinental Hotel, Tokyo Bay, Japan
5:15 PM Registration opens

6:15 PM Welcoming Remarks & Opening Address
Mr. Takatoshi Kato, Deputy Managing Director
International Monetary Fund
6:30 PM Monetary policy and medium term inflationary risks: What should central
banking monetary policy focus on: Inflation or deflation?
Dr. James Bullard (Confirmed)
6:45 PM Monetary policy and the medium-term outlook for price stability
Mr. Jurgen Stark, Member of the Executive Board
European Central Bank
7:00 PM From insider to outsider: Coping with a financial meltdown —
the good, the bad and the ugly
Sir John Gieve, former Deputy Governor,
Bank of England
7:15 PM Break
Moderator:
Robert Pringle, Chairman
Central Banking Publications
Panelists:
Dr. James Bullard
Mr. Jurgen Stark
Sir John Gieve
Mr. Takatoshi Kato
Foreword
T he papers in this edition of the Journal are from some of

the leading practitioners of monetary policy, regulation and
supervision as well as those from academia and the financial sec-
tor. They highlight a number of critical themes that will guide, or
haunt, the financial world in coming years.
This edition demonstrates that the agenda for policy makers
is both diverse and full. While work at the national level as well
as the various Basel Committees, the Financial Stability Forum,
the International Organization of Securities Commissions and
many others progresses, the issues are complex, analytically diffi-
cult and often without the historical data and experience on which
to repose confidence. This is well known. By default it places a heavy load on assessment
of the challenges, balancing conflicts and making difficult judgments. This cannot satisfy all
national interest groups let alone conflicts between countries, nor should it. But progress is
being made. This may be halting at times as we will need to learn from experience in previ-
ously uncharted areas.
A second theme is that within this financial house there are many rooms. The finan-
cial crisis exposed issues in virtually every corner. However the financial world is networked.
Some issues are separable, many are not. Thus making individual steps correctly is sensible.
However the cumulative effects may not be. This is true of monetary policy as well as regula-
tory issues. Once again we will need to rely upon judgment.
A third theme is that we are in a world of dramatic change for all participants, be they
supervisors, central bankers, securities regulators or financial market players. If achieving
financial reform and improved operating procedures for central banks are difficult, it will be
equally challenging for those trying to operate in a new and uncertain world.
Finally, what is often an unstated theme is that operational risks will rise for all parties
as the financial world attempts to adapt to a more demanding and critical environment.
Supervisors have long commented that financial innovation is often followed by a predict-
able round of losses as firms adapt to new businesses with an inadequate understanding
and poorly designed controls. The risks this time are different, and hopefully declining but it
remains true that institutions will need to adapt, from Boards of Directors through every layer
of their organisations to a new world with higher standards and lower tolerances for errors.
Dr John Pattison
Editor Emeritus
Institute of Regulation & Risk – North Asia

Mr. Jurgen Stark,
Member of the Executive Board
European Central Bank
5:45 PM – 10:00 PM
Tuesday, June 15, 2010
Grand Ballroom, Conrad Hotel, Pacific Place
5:15 PM Registration
6:00 PM Welcoming Remarks
Arthur Yuen, Deputy Chief Executive Office,
Hong Kong Monetary Authority (Invited)
6:15 PM What should central banking monetary policy focus on: Inflation or
deflation?
Dr. James Bullard, President & CEO, Federal Reserve Bank of St. Louis
6:30 PM Monetary policy and the medium-term outlook for price stability
Mr. Jurgen Stark, Member of the Executive Board, European Central Bank
6:45 PM From insider to outsider: Coping with a financial meltdown —
the good, the bad and the ugly
Sir John Gieve, former Deputy Governor,
Bank of England
7:00 PM Break
Moderator:
Robert Pringle, Chairman
Central Banking Publications
Panelists:
Dr. James Bullard
Mr. Jurgen Stark
Sir John Gieve
Mr. Takatoshi Kato, Deputy Managing Director
International Monetary Fund
Acknowledgments
THE Secretariat of the Institute of Regulation and Risk – North Asia could not
have published this edition of the Journal without a great deal of assistance
and advice from professional associations, international monetary and finan-
cial bodies, regulatory institutions, consultants, vendors and, indeed, from the
industry itself.
A full list of those who kindly assisted would be impossible, but the Secretariat
would like to thank: the Federal Reserve Bank of Boston; the Federal Reserve
Bank of Chicago; the Federal Reserve Bank of New York; the Federal Reserve
Bank of San Francisco; the State of New York Banking Department; the Ameri-
can Enterprise Institute; The Peterson Institute, for International Economics;
the Swiss Financial Market Supervisory Authority (FINMA); the International
Monetary Fund; the Securities and Exchange Commission; the UK’s Financial
Services Authority; the University of Warwick, Loughborough University; Co-
lumbia University Graduate School of Business; George Washington University,
the Baseline Scenario; FinReg21; Voxeu; World Scientific; Barclays Global Inves-
tor; Morgan Stanley Asia; Blackrock; Sapling Solutions; Intelligence Capital and
Tavakoli Structured Finance for their kind permission to reproduce material and
articles from their respective publications and websites – much of which was
revised for the purposes of this Journal.
Detailed comments and advice on the text and scope of contents from Prof Wil-
liam Black, Robert Pringle, Dr Michael Ong, Dr Heong Wee Chong and Prof
Charles Calomiris were invaluable; we are also grateful to Ian Watson and Fiona
Plani of Edit24.com for their due diligence in setting out, editing and correcting
the text.
Special consideration must also be given to Dr. John Pattison once more for
taking time out from a hectic schedule to review all contributions within this
Journal and engage actively with all those who submitted papers and articles.

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Q&A
Joblessness, price stability

and quantitative easing
San Francicso Fed head, Dr Janet Yellen,
and guests tackle awkward questions from
some of Hong Kong’s leading bankers.
ON the evening of November 17, 2009, over and the worst downside risks to the US
some 400 guests assembled in Hong Kong economy have subsided substantially. We’re
to engage with Dr Janet Yellen, Sir John all breathing a sigh of relief and I think we
Gieve, Norman Chan and Jochen Sanio. have a growing economy.
Below is a transcript of the proceedings. There are many things to fret about in
terms of downside risk because some of the
Robert Pringle: We are honoured to be growth that we have seen during the last
joined by Mr Norman Chan, Chief Executive quarter, and probably through to the end of
of the HKMA. It is a pleasure that he’s cho- the year, rely on fiscal policy, a diminution of
sen to participate at this event – one of his inventory liquidation, and some government
first public engagements. programmes, like stimulus for auto pur-
I would like to start this Q&A session by chases that are temporary. So one can won-
inviting Dr Janet Yellen to say a few words der what will happen when some of these
about the macroeconomic situation and temporary impulses fade. Can the economy
outlook in the United States and the state of keep going on its own?
monetary policy of the Fed. To have a mem-
ber of the FOMC here in Hong Kong, I think Savings rate growth
we should give her the opportunity, if she I’m reasonably sanguine that the economy
would be so kind, to say a few words about can and will continue to grow into next year.
this first and then we can go into the ques- We’ve seen some strength in consumer
tion and answer session. Thank you. spending, maybe more than I would have
anticipated, given all the negative things that
Dr Janet Yellen: Thank you very much for have happened to households. And while I
that . . . I’ll try to be brief and we can take think that the savings rate is going forward,
follow-up questions if you have some. Let American consumers will end up saving
me just summarise by saying that while more and so consumer spending growth
it’s not yet official, the recession is probably will be more sluggish than we saw in the

years leading up to the crisis. However, I’m conclusion that the FOMC has drawn from
reasonably optimistic that consumer spend- this is that while there are no promises about
ing will return to growth and the housing what our policy will be, it depends on the
market is beginning to recover. On the other state of the economy. We use language that
hand, when I think how robust this recovery says we can anticipate the economic condi-
is likely to be, I’m not alone among forecast- tions: low rates of resource utilisation, sub-
ers in anticipating a recovery that is going to dued inflation trends and stable inflation
be slow. I think this is consistent with what expectations are likely to warrant exception-
we’ve seen in almost every country around ally low levels of the Federal Fund rate for the
the globe that’s experienced a financial crisis. next extended period. I certainly share that
view, but I also want to emphasise that we all
Stubborn jobless scenario understand very well that we cannot have an
It takes a long time for financial markets and accommodative policy for too long and that
institutions to heal, and that means a period once these conditions no longer prevail, it is
of subdued growth. For example, in a new a core responsibility of the Federal Reserve to
study out this morning, 41 professional fore- preserve price stability.
casters said that by the end of 2010 unem- And we are making sure right now that
ployment will still be above 10 per cent in the we have the tools, and not just one tool but
United States and so I think employment many tools, which Chairman Bernanke
growth particularly will be very weak. On has described as a ‘belt and suspenders’
the inflation side, over the past year infla- approach. We don’t want to rely on just one
tion has actually been negative, and the core tool. We want to make sure that we have
inflation that we focus on has been around more than enough tools to tighten mon-
1¼ per cent. etary policy when the appropriate time
To just tell you what this survey of pro- comes. And though right now inflation is
fessional forecasters thought in the poll, they running a little bit below levels consistent
anticipated core inflation would be running with price stability, we don’t want inflation
at the same rate – 1¼ per cent in 2010 and to pick up. We regard it as a core responsibil-
1½ per cent in 2011 – and when they were ity that every FOMC member is committed
asked to go through to 2013, their expecta- to removing the accommodations we’ve put
tion was that inflation would run at a very in place in a timely fashion, so that inflation
low rate. In fact, it was a down revision to doesn’t pick up.
just 1.8 per cent; so professional forecasters
do not expect high levels of inflation at least Price stability pledge
in the next five years. My own view is that I would like to give you just my own personal
inflation is going to be quite subdued for a assurance that this is the Federal Reserve’s
number of years and that reflects a great deal intention. I know a lot of people are con-
of slack in the economy and subdued infla- cerned with fiscal policy in the United States
tion expectations. and long-run budget deficits. And globally
So with respect to monetary policy, the there is a connection between loose fiscal
10 Journal of Regulation & Risk North Asia

policy and inflation, but you don’t see that by US$1.2 trillion, the other central banks by
correlation in advanced countries with inde- another $800 billion, representing altogether
pendent central banks, and we regard it as around $2 trillion of quantitative easing
our job [to keep a tight rein on inflation]. Of injected into the financial system. Of course,
course, it is important to have a responsible those measures were introduced with good
fiscal policy, but regardless of what fiscal reason, but the issue for all of us is the timing
policy turns out to be in the United States, of the exit.
it’s the Federal Reserve’s job to ensure price There are other challenges about fiscal
stability and we take that as our core respon- stimulus, whether you should exit, whether
sibility and our pledge to achieve that. it’s sustainable in the medium term . . . but on
the monetary side, I think that this is clearly
Robert Pringle: Thank you very much a challenge for Asian economies. Because,
indeed, Janet. Now I suggest that in this ques- with this very significant inflow of funds – it
tion and answer session we start with some doesn’t matter in Hong Kong where we have
questions on the broad macro-economic no independent industry policy instruments
outlook and the panel’s view of the monetary – our hands are tied. Even in Singapore
policy aspect of this evening’s discourse. We or Malaysia, where they have, in theory, a
will then move on to ask questions about possible US dollar interest rate, they’re in a
regulators, future banking regulations and dilemma, because if they raise interest rates,
so forth. If you can divide the questions into they attract even more hot money coming in,
those two parts, I think it could be very help- betting on an appreciation of their currency
ful to the panellists. And so without further against the US dollar, high interest rates and
ado, may I ask for the first question. better economic prospects in the asset mar-
kets. So the problem with Asia, at least in
Norman Chan: Yes, thank you. I just want Hong Kong’s context, is the risk of an asset
to comment on the point that Janet just bubble forming in Hong Kong.
mentioned about maintaining price stability
in the US. Clearly this is the core mandate ’A lot of money’
of the Fed, but I think you need to actually Now we understand that to maintain low
consider the threat to financial stability in interest rates is necessary within a certain
this part of the world, of which we are more period of time, but the question that one
familiar, whether it’s inflation compared to really has to ask is to what extent is quantita-
asset bubble. I just want to share a point of tive easing necessary? If it is necessary, is the
observation that in Asia economies, Hong amount right, is the dosage right, because $2
Kong included, we have seen a very massive trillion is a lot of money. In the banking sys-
inflow of funds. This is explainable by the tem it is high-powered money, it’s M zero,
very low global interest rates and is coupled so what does that mean in terms of help-
to this huge amount of quantitative easing. ing US economies and US households to
I did take a look at the numbers this morn- repair their balance sheets, and how long
ing and the Fed’s balance sheet expanded do you allow them to do this? Looking at

it in another way, savers, depositors, all over you face and the forces you are acting on in
the world are getting close to zero. In Hong terms of asset prices here. The reason that
Kong, I’m glad to say, I get 0.01 per cent on we engaged in quantitative easing – actu-
my deposits. Elsewhere, it is very low. The ally we don’t use the term ‘quantitative eas-
banks are now able to lend, even [for] mort- ing’, we prefer to call it‘credit easing’– is that
gages, at two or 2.25 per cent, a historic low. we focused our attention particularly on
So housing has become very affordable and the market for mortgage-backed securities.
therefore a lot of families would like to think We thought that the spreads on mortgage-
about maybe going into the housing market backed securities over long-term treasuries
to buy a property. Indeed, housing has never reflected breakdowns in financial markets
been so affordable. in terms of causing risk spreads that were
unduly high. We didn’t think that merely
Quantitative easing policy expanding our balance sheet would have
So going back to this question of the poten- very much effect, so we were trying to sub-
tial risk of an asset bubble forming, if this is to stitute our own asset purchases in cases
continue for a long period of time, it is a big where we thought market functioning had
challenge for us. And therefore the question diminished.
that I address to Janet, is: To what extent is I think when we tighten monetary policy
this quantitative easing necessary and how – which we can do, for example, by raising
do you assess the kind of dosage that is both the rate of interest that we pay on reserves
necessary and needed in terms of helping to – whether we contract our balance sheet or
achieve your original goals? not, the impact on other countries, on Asia,
on capital flows, will be identical. I did say in
Dr Yellen: Well let me comment briefly and my prepared remarks that I think one of the
I’m sure the other members of the panel will things that monetary policy-makers should
want to comment as well. I would say that learn from this crisis is that we need to, at a
even if we had not used a quantitative eas- minimum, monitor developments in asset
ing policy and had merely added enough markets, much more carefully than we did
reserves to the banking system to bring the going into this crisis. I am well aware of the
Federal Funds rate down to zero, I believe concerns you have here and that many Asian
that the impact of our monetary policy on economies have, about the capital inflows.
Asia and on other countries, and on poten-
tially provoking asset bubbles, would be the Credit spread narrows
same. To my way of thinking – and you may I also agree that low interest rates in the
have a different view – but the fact that we US are triggering capital outflows, but Asia
have purchased assets and expanded our is recovering more quickly than the United
balance sheet beyond the minimum level States, and it is logical that you would see
necessary to push the Federal Funds rate more impact on your asset prices. We’re
and short-term interest rates to zero, hasn’t closely monitoring US asset prices, and I
added significantly to the very real pressures don’t want to say that I’ve got a wonderful

model that can tell us exactly what is a fair perhaps the market will respond, to print-
value for the stock market or any other asset ing money in the West and the changing of
price, but the kinds of rough indicators that exchange rates. And of course that is nor-
we do have for valuations suggest to me that mally what would happen.
the US stock market is not massively over- But this isn’t happening, because that’s a
valued. And when I look at credit spreads, part of your policy obviously here in Hong
they have narrowed dramatically and that is Kong; it’s also a policy of many countries
what we’re trying to accomplish. around here and I think that the bigger pic-
But do I see credit spreads resulting in a ture is . . . yes, it is possible that credit creation
narrowing so great that it suggests bubble- in the US will show up in asset price infla-
like conditions in US debt markets? No I tion at the other end of the world rather than
don’t see that. I see levels that are typical or in the US. That means that we’ve got to co-
slightly higher than one would normally see ordinate internationally and, at the moment,
in a deep recession. But I do think that you we’ve got each country essentially pursuing
need to be aware of this, we all need to be its own strategy in the light of what’s hap-
aware, and in addition to monetary policy, pening in its own economy.
we need to be prepared to deploy regulatory I’m afraid one lesson we should have
tools to address these imbalances. learnt over the past few years is that we
should be co-ordinating more, albeit at a
Robert Pringle: Thank you so much for that time when it might be a bit uncomfortable
very full reply, Janet . . . John? for everyone.
Sir John Gieve: Just three points in response Robert Pringle: Thank you very much.
to Norman and Janet. Firstly, we’ve thrown Jochen, do you have anything to add on this
everything at it because we thought there point?
was a real risk that we were going into not
just a recession but a depression. And it’s not Jochen Sanio: I’d feel quite comfortable if
been an operation, certainly in the UK, where you don’t press me on monetary matters,
we’ve known how much is enough. We just which to me sometimes as a supervisor
did everything we could in order to stop a looks like a random walk, and that’s some-
downward spiral and obviously stopping thing that is difficult to cope with. I think
this downward spiral is pretty important to one thing that is sure for us is that the law
Asia too, because you need our consumers. of unintended consequence applies eternally
My own view is that we’re coming to the and, as John just pointed out, in these mat-
end of adding to any quantitative easing.You ters I think it’s still the old principle of eve-
will see that there’s been a deceleration in rybody on their own and then you have to
the US and the UK. I don’t know quite when look for the side-effects. You could ask me
it will come to an end, but I think that we’re the question, which is among my half-dozen
coming to an end of that phase. The other unanswerable questions. How can we react
point is that one way of responding, and to this? I’m not an expert in the Hong Kong

market, but what I’ve been told here, within degree can a capitalist system effectively
the past two days, to me as a laymen in this function in a zero interest rate environment?
environment, it looks as if an asset bubble
might be forming, to put it very mildly. Robert Pringle: Who would like to take that
So what then is the supervisor’s answer one on?
to this? Of course it seems to be easy – you
have to do everything to suppress this – but Norman Chan: The answer is difficult.To me
how do you do so? In my country, in a very it is very difficult. Let’s say inflation is moder-
liberal market economy, as a supervisor I ate and subdued – let’s say one per cent or
have no right to substitute the business deci- 1.5 per cent – it’s a very respectable rate. But if
sions of banks, although if you think they are interest rates are zero then you have negative
totally wrong and might end up in a catas- real interest rates and therefore savers, who
trophe, then it’s very easy to say that we must are by nature very prudent people and don’t
watch very carefully. want to take risks for many reasons such
We must play the old, very ancient as liquidity, retirement, school fees for their
soccer strategy of always keeping close to children… They save up and deposit with
the one who wants to strike, which is not a banks via their short-term instruments and
very modern way of playing, but in the end they take very little risk.
we have to admit that our possibilities are
rather limited. And then we must again do Switch to risk
a cleanup operation. And that’s my night- But with zero interest rates, you’re actually
mare . . . we’re always doing the cleanup punishing them and therefore they are sort
operation! of tempted or compelled to go into riskier
assets. It could be stocks, it could be futures, it
Robert Pringle: Thank you very much. Let’s could be property. And therefore the theory
have one or two questions from the floor goes that if you keep interest rates low, or
now. Thank you. zero for a long period of time, people would
actually go out and switch their savings into
Stuart Winchester, RCM: It’s not clear to riskier assets and therefore you may have a
me how a capitalist system can function bubble.
effectively with a zero interest rate policy, so So the question I have for Janet is: Maybe
I have an open question to the panel mem- you have an asset, because yours is the big-
bers. How can a capitalist system effectively gest economy in the world, so it’s crucial.
work? We can look at Japan and see what a It’s a question of not whether we have asset
disaster Japan has become economically. But bubbles in Asia, it’s a question of the asset
you go to Japan and obviously things are fine; price level in the United States, sustained by
but Japan is just not competitive anymore, very low-level interest rates. I would feel a lot
which has broad implications for everyone. happier – and you talk about no exuberance
And so I’m just wondering, again addressing within this and that may well be right – but
my question to the panel members: To what I would feel a lot more comfortable at the

current price levels (if) interest rates were at rates that would further and further dis-
two per cent or three per cent for depositors. courage spending and cause the amount of
I don’t have a rigorous model to justify this slack in the economy to grow ever larger. We
kind of belief, but my gut feeling is that if you would then fall into the black hole of defla-
sustain a certain price level in the asset mar- tion. So why do we bring short rates to zero
ket and a close-to-zero deposit rate and two when long rates are by no means at zero lev-
per cent lending rate, then I become very els? Because it is possible that an economy
sceptical. – in a condition such as ours, still suffering as
it is from the housing bubble collapse and a
Dr Yellen: OK. Let me try to explain what it weak financial system – has an equilibrium
is that has motivated us to reduce our inter- real interest rate that is actually negative;
est rate to zero. It’s exactly the same motiva- and for our economy to recover, at least for
tion that Japan had when it became the first a time, this is a very abnormal situation. One
country since the Great Depression to find would never expect in a capitalist economy
itself in this situation. Japan had such an to have negative real interest rates for a pro-
enormous shortage of demand for the goods tracted time. But could an economy, in order
and services its economy was capable of pro- to recover, require negative real interest rates
ducing that it had huge amounts of unuti- for a while? Yes, and were we not to lower
lised resources. That’s what we now have it to zero, we would risk falling into a defla-
in the United States. We don’t have enough tionary spiral.
buyers lining up to buy the goods and serv-
ices our economy is capable of producing. Robert Pringle: Any more questions from
the floor?
Deflation danger
So if all the workers were to be employed Luca Silipo, chief economist, Asia-
producing goods and services, and if facto- Pacific, Natixis: I have a question that
ries were running at normal capacity, utilisa- basically is built upon the former theme of
tion rates, as opposed to roughly the lowest capital movement and international capital
capacity utilisation we’ve seen in the entire movement and I think it is central. What Dr
post-war period, would result in an enor- Yellen said about quantitative easing and
mous slack in real interest, and in our real the fact that even if we adjust assets to bring
economy. If we had not brought interest the Federal Fund target to around zero we
rates to exceptionally low levels, then infla- would have had asset inflation here. This
tion arguably might fall and continue to fall would have been particularly interesting and
with such slack that we would have had the question is a little bit provocative. But
deflation like Japan… an intensifying defla- if this is the case, isn’t there then too much
tion that would be in contrast to the current capital flowing internationally and isn’t there
negative real short rate of say1¼-1½ per cent. the need to restrain a little bit of this capital,
If we went into deflation we would end up because even if the fundamental power of
with ever-increasing positive real interest domestic monetary policy can induce asset

bubbles on the other side of the world, then alternative model, and so we’re not going to
maybe there is too much. see a return to general capital controls. There
And then it’s not only the fault of the will be lots of changes in banking and the
United States. I see these countries in Asia path on which we have been progressing for
– I’ve been living here for a year-and-a-half the past 20 years or so – which has resulted
now – still terrorised by external debt and I in a much more liberal product in terms of
think there is less and less need for such ter- capital financial markets internationally – is
ror. It’s also the fault of these countries which leading to greater concentration in financial
do not sufficiently diversify assets at the dis- justice and a greater concentration in terms
posal of international investors. An interna- of manufacturing, resulting in big blows
tional investor which wants to invest usually and interdependencies which are going to
has one choice and that is the stock market. continue.
So this, of course, leads to horrible allocation
of savings in this country. So shouldn’t there Few takers for bonds
be some kind of global control over raising That’s another reason why we need rather
capital? And the second question: Should better international co-operation in dealing
those countries in Asia try to minimise bad with it. On your other point, of whether it
allocations of savings by issuing or by giving would be good if Asian countries should offer
more opportunities to investors to invest in more bonds as well as equities, well, actually
something that they can control more, such I think it’s been the policy of many Asian
as external debt? Thank you. countries to try to promote a bond market.
It’s not that they’ve been reluctant, but they
Robert Pringle: Thank you for your ques- haven’t found many takers, partly because
tion. Many Asian countries have begun to so many sovereigns have had huge reserves
put controls on various currencies and, in and haven’t had to raise money and, on the
the West too, there’s a feeling of needing to whole, neither have companies. Companies
ask the question of whether we are going to have been able to raise equity so I think the
go back to a kind of earlier stage in banking problem, as I see it, is as much demand as it
where you have more credit controls and so is fear on the part of the authorities.
forth. This kind of discussion is starting again
all over the world. So would anybody on the Robert Pringle: Thank you very much.
panel like to respond to this question? No We’ve only got time for just two more ques-
great enthusiasm? John’s going to have a go! tions, I’m afraid.
Sir John Gieve: Picking up on Robert’s point Eugene Yip, Morgan Stanley: I have a ques-
about whether or not we’re going to see a tion for Norman Chan. It is my understand-
return to financial protectionism and capital ing that interest rates are trending towards
constraints. The most striking thing about the level of growth in the economy, yet
this crisis – which is very different from the because of the US dollar/Hong Kong dollar
1930s crisis – is that I don’t think there is any peg, you cannot raise rates in Hong Kong

to match the level of growth. Clearly Hong try to prevent this. For example the HKMA
Kong’s economy is more tied to China than introduced not long ago a tightening of
the US. So if the US dollar/Hong Kong dol- underwriting standards for the high rent
lar peg is fuelling the asset bubble in Hong of the property market in Hong Kong. We
Kong, how do you justify use of the peg in lowered the loan-to-valuation rate for the
the current environment? top end from 70 per cent to 60 per cent. We
have also asked banks to be more diligent
Norman Chan: I think one has to be very and vigilant in underwriting mortgage loans.
careful. The peg has served Hong Kong very Those measures are having some effect; it
well since 1983. Financial stability is some- seems to be working and we continue to
thing like your personal health. You don’t monitor the situation very closely. There will
really appreciate it until you’ve lost it and be instruments other than monetary policy
therefore I would go back to the question tools to help us mitigate the risk of another
about whether the peg has reached its time bubble forming.
of life, whether it’s time to change and move So I think, to answer your question, that
on. Actually, I disagree with the idea. You it is highly justified for us to continue to
therefore, from any economist’s point of view, maintain the linkage system.
have to look at empirical evidence. Have we
fared very badly in terms of inflationary per- Robert Pringle: Thank you. One final ques-
formance or so-called asset increases? I have tion please.
just done a very recent check.
Philip Goeth, Deloitte: Thank you for
Sharp rise in rents this highly interesting evening. My ques-
The Hong Kong equity market – if you look tion is: If you look at the trading desks,
at Morgan Stanley Asia, ex Japan and Hong there is an old saying that some of us may
Kong, compared with the Hang Seng Index, know. I think it comes from the Las Vegas
it has tracked very closely in the past 12 to poker tables really … If you’re in trouble,
18 months. So our stock market is no more double. And my question is, Sir John said
exuberant within its Asian peers, despite something very extraordinary – he said that
this very massive inflow of funds. Our we’ve thrown everything at it. So my ques-
book prices, yes, we have seen a very sharp tion to the Federal Reserve really is what if
increase in high rent – but so has Singapore, this doesn’t work? What is your Plan B for
so has Korea, so has Malaysia to varying this leverage?
degrees.
So one cannot draw the conclusion that Dr Yellen: Well, you know, I think we have
because our currency is pegged to the US thrown everything we can at it. In the dark-
dollar, that this is fuelling any asset bubble. est days of the crisis, just a little bit more than
Therefore I think there’s a potential risk of an a year ago, I think the Federal Reserve was
asset bubble being formed at the moment, very inventive in terms of devising a whole
and of course we have other measures to range of tools that would restore liquidity to

markets and stabilise the financial system, down the unemployment rate more rapidly
and we’ve been very effective in this. than I anticipate it is going to be declining in
Part of the reason that markets have the United States, if I knew how to do that,
recovered and the US economy is recover- if the Fed could do it, I would certainly be
ing is because of the extraordinary array of inclined to consider further policy. But I really
policies that, not just the Fed, but also gov- think that we’ve used the tools that we have,
ernments – and not just in the United States and so we don’t really have, in that sense, a
but around the world – have thrown at Plan B. I think that what we’ve put in place
the problem to avoid a repeat of the Great is going to work and I’m very hopeful that
Depression. I do believe that we’ve used we’re not going to need a Plan B.
the tools that we have at our disposal. We
are beginning to pull back on some of the Sir John Gieve: There wasn’t a Plan B, so
liquidity facilities and to phase them out.You it’s lucky that Plan A worked! But that was a
might think of that as the initial phases of an reaction to a loss of confidence in the finan-
exit strategy. cial markets particularly, which was certainly
the first time in my lifetime, and I think that
Timely phase-out we’ve stopped a spiral into depression and
Indeed, many of the facilities we put in we’ve restored some confidence in financial
place were designed to be phased out and markets.
to become less attractive for market partici- The real problem, though, is in a short-
pants to use, as markets began to heal. And term set of measures and the fact that there
as markets are beginning to heal, the usage remain some big structural problems in our
of these facilities is declining, so we will economies, which again will take time, in
phase them out over time as they become fact years to work through. And the restora-
unnecessary. We have announced what the tion of household balance sheets and bank
overall size of our so-called quantitative or balance sheets is going to take years. But in
credit easing programmes will be – that we all honesty, I don’t know that there was any-
will complete $1.25 trillion worth of pur- thing else to do a year ago when it was done,
chases of mortgage-backed securities at our so it was lucky it worked!
agency, as well as debt purchases.
We have no current plans to push those Robert Pringle: Any other comments?
programmes further, so you might think of Well, it forces me then to wrap up these
that as we’re continuing to make those pur- proceedings. I would like on behalf of us all
chases up to pre-announced limits. We’re not here at this gathering to thank the members
going to push them further. I do believe we’ll of the panel, especially Dr Janet Yellen, for
be successful in restoring economic growth giving such very full answers to our ques-
and in gradually getting the US economy tions, and the other members, Sir John
moving again. Gieve, Jochen Sanio, Norman Chan. Thank
If I could think of policies that would you for the honour of coming and participat-
be effective to put in place that would bring ing with us today. •

Book overview
13 Bankers: Wall Street’s coup

d’état and next financial crisis
James Kwak & Simon Johnson present a
brief summation of their highly acclaimed
critical study of Wall Street and DC.
What caused the French Revolution? of 2008-2009 has subsided; people no longer
People have been arguing that ques- fear the imminent collapse of the global
tion for centuries. Since 1789, believers financial system as a whole.
in the march of freedom and progress Although the world economy still
have seen the Revolution as a victory of faces serious threats, we have moved from
the principles of Enlightenment over the responding to the financial crisis to arguing
superstition of the “ancien régime”. about it. And this is not merely an academic
discussion; each explanation of the crisis
Yet one precipitating cause of the revolts of implies different policy lessons, and so the
1789 was high grain prices caused by the continuing debate over the crisis is inher-
poor harvests of the preceding year. Alexis ently political.
de Tocqueville saw the Revolution as a col-
lision between the rising aspirations of the Apportioning blame
middle class and the rigidity of the existing Several early books about the crisis focused
political structure. Karl Marx saw the over- on the key figures involved and the actions
throw of the aristocracy by the bourgeoisie, they took in the heady days of 2008; these
an ineluctable historical process driven by narratives reflect the view that the decisions
changes in the mode of production. The of key people are sufficient to explain what
debate continues to this day, with each gen- happened. However, many other explana-
eration giving its own answer to the questions have been advanced. Some people
tion and interpretation of issues. blame the financial crisis on ‘global imbal-
Major historical events are almost always ances’ (code for China); on this theory,
over-determined. They are caused and Chinese over-saving forced the United
shaped by multiple forces, many of which States to accept a flood of cheap money,
may be necessary for the event, but none of which necessarily created a bubble.
which is alone sufficient. The recent financial The implication is that we need to pres-
crisis is no exception. Today, the acute panic sure China to let its currency appreciate. A

few blame excessive government interfer- officials, and Congress. This does not imply
ence in markets, arguing that the housing that we need less government, it implies
bubble was caused by government-sub- that we need government to step up to its
sidised home ownership; they would like responsibility to protect the public interest.
to see a smaller government role in the
economy. Question of questions
Much has been made of Wall Street’s But the question remains: why did the gov-
recent innovations, which created the secu- ernment fail us? The answer, we argue, is
rities and derivatives that were at the heart that the federal government came to see its
of the crisis; this explanation implies a need interests as being aligned with those of the
for greater government regulation. Some financial sector. The financial sector, or the
have noted that human beings have a pro- megabanks at its pinnacle, became a new
pensity for speculative bubbles and therefore American oligarchy – in accordance with
perhaps there is nothing we can do to avoid Aristotle’s view – a ruling economic elite.
them. In the United States over the past two
In 13 Bankers, myself and Simon decades, the titans of Wall Street did not
Johnson focus instead on politics. We think themselves call the shots in Washington, but
that much of the recent financial innova- they had something that was, in many ways,
tion has been destructive; that lenders used even better – they convinced Washington
exotic mortgage products to take advan- policymakers that what was good for Wall
tage of homebuyers; that Wall Street bank- Street was good for America.
ers took advantage of their customers; that They did this in part through lavish
flawed compensation structures led banks campaign contributions, but even more so
to take on too much risk and, in short, that through the revolving door, in which Wall
the US financial system became a dysfunc- Street veterans stepped into important
tional, bloated, exploitative cancer on the government positions, and former regula-
American economy. We are no friends of tors and officials became successful bank-
Wall Street. ers. Finally, American culture (unwittingly)
created a cult of the smart, hard-working,
Greed like gravity rich investment banker, beginning with
Yet we believe that in the analysis of causes Liar’s Poker, the first Wall Street movie, and
and solutions, it is not enough to simply Barbarians at the Gate.
blame Wall Street. Greed is like gravity: it is By the first decade of this century, invest-
always present, and you need account for it ment banking was the career of choice for
in your calculations. In the United States, the many top graduates of America’s leading
entity responsible for protecting the public schools, and up and down the East Coast it
interest is the government. was nearly universally accepted that finance
Failure to prevent the financial crisis – or was not only good for financiers, but for
the many problems that led up to it – was a society as a whole. This was the secret of
failure of regulatory agencies, administration Wall Street’s success; the banks disarmed

the government not through corruption, longer argues that monopolies are good for
but through persuasion. Seduced by high society or for the economy.
finance, policymakers and regulators gave The solution to a concentrated financial
free rein to the creative imaginations of the oligarchy is to take the same trust-busting
bankers, setting the stage for both the bub- approach to the large banks that currently
ble of the 2000s and the crash, the conse- dominate our financial system. There has
quences of which we are still living through. been much talk of the problem that certain
So what is the solution? banks are ‘‘too big to fail’’. We believe they
If the cause of the crisis is essentially should be broken up until they are no longer
political, then the solution must also be a too big to fail.
political one. This will require shifting the conventional
wisdom away from the idea that finance is
A return to anti-trust regulation always good and that bigger is always better.
A century ago, President Theodore Roosevelt This will take political leadership. Whether
launched the ‘trust-busting’ campaign that President Obama will rise to this challenge
eventually brought down Standard Oil, the remains an open question. •
most dominant monopoly in the country
at that time. In the process, he changed the Editor’s note
conventional wisdom about economic con- Information on purchasing 13 Bankers is at:
centration, to the point where no one any www.13bankers.com
www.edit24.com
Asia, Australia, Africa
writers, editors, press &

public relations practitioners
AT YOUR SERVICE AROUND THE CLOCK
Hong Kong: +852 9144 5549 Australia: +61 (41) 271 8715 South Africa: +27 (82) 449 6333
email: ian@edit24.com email: fiona@edit24.com email: remo@edit24.com

Opinion
Wall Street and Congress hope

you’re gullible: disappoint them
Tavakoli Structured Finance’s CEO Janet
Tavakoli vents her spleen as bankers get
bonuses and the US gets the Great Recession.
IF a driver, high on crack cocaine, crashed they borrowed many multiples more than
his speeding rental car into your house they could afford. Wall Street pumped the
and killed your spouse, you would be Fed’s cheap money through financial ‘meth
outraged if law enforcers took bribes and labs’ and deceptive financial vehicles ran
gave the driver a pass on a blood test. If over securities laws at top speed.
a judge merely fined the killer and then More than 20 per cent of mortgage loans
ordered you to pay the fine, you would – including what were originally considered
appeal, wondering what had happened to be sound loans – are underwater, meaning
to justice. If the government then handed that the borrower owes more than the home
the same driver the keys to a bigger rental is worth. Official unemployment numbers
car and presented you with the bill, you hover at around 10 per cent. If you include
would certainly protest. underemployment, this figure escalates to a
whopping 18 per cent.
How is it, then, that you have remained
largely silent in the face of the same sort of Destitute group
behaviour by Wall Street and Washington? In depressed areas where the nation’s poor-
Bonus-seeking bankers careered off the est reside (chiefly from minority groups);
right path and ran Ponzi schemes that nearly people have been hurt the most. In these
ruined our economy. Bureaucrats and elected areas, unemployment has soared past 30 per
officials bailed them out without demanding cent. For this largely destitute group, unem-
consequences. And bankers are revving up ployment combined with underemploy-
their engines again. ment exceeds 50 per cent.
Taxpayers are asked to believe that over- As US soldiers fought wars in Iraq and
borrowing by US consumers created a global Afghanistan, Wall Street flattened Main
financial crisis; this myth aids and abets Wall Street. Our foreign wars drag on, while the
Street. The economy was nearly destroyed US continues to battle a crippling recession
because banks borrowed massively, and back home.

Fraud by borrowers, fraud on borrowers and car. Paul Volcker suggested reforms, and
speculation by people who thought home special interest groups lobbied successfully
prices would rise forever have all contributed to make the same reforms essentially mean-
to tarnish the mortgage lending industry. ingless. His proposal to limit ‘proprietary’
Yet this pales compared to the epidemic of trading – a small step in the right direction
predatory lending. – has been thwarted by banks claiming that
Predatory snipers committed financial they engage in high risk trades on behalf of
murder as deliberately as British soldiers customers.
sold blankets contaminated by smallpox to Washington seems to have already for-
Native Americans. Honest homeowners gotten that AIG came close to bankruptcy
were systematically targeted and actively and nearly took the entire financial system
misled into bad mortgage products. Loans down with it – because of Wall Street’s ‘cus-
were presented as gifts, but these Trojan tomer’ trades. Both AIG insiders and Wall
horse loans hid destructive risk. ‘Disclosures’ Street grew rich on bonuses based on a
were seen as acts of malice. myth and taxpayers funded AIG’s US$180
When Wall Street packaged these loans billion bailout.
and sold deceptive‘investments’’, documents
did not specifically disclose that the associ- Bonus billions ‘myth’
ated credit ratings were misleading. If you Wall Street now makes most of its ‘profits’
know or should know that a car’s gas tank from high-risk trading, and rewards risk
will blow up, you cannot use a misleading with huge bonuses. It has unfettered access
third-party consumer report as an excuse. to more of US taxpayers’ money than that of
Yet bonus-seeking bankers used this sort the combined history of the United States.
of excuse to get through a few more highly- Traditional banking suffers; it cannot gen-
paid bonus cycles before it all fell apart. Only erate enough revenue to ‘justify’ massive
the elite crowd of insiders prospered.* bonuses. Bankers get billions in bonuses
based on a myth and US taxpayers face a
Global Ponzi scheme deeper recession and yet more risk.
This was the most massive Ponzi scheme in Congress has protected Wall Street
the history of the global capital markets. US and passed on the costs to hard-working
taxpayers became unwilling unsophisticated taxpayers. ‘Too-big-to-fail’ financial institu-
investors as we bailed out the financial sys- tions are those that are too big to exist and
tem. We must hold Wall Street accountable it is past time to break them up. They cur-
for this fraud. rently enjoy around $13 trillion of taxpayer-
Banks that contributed to our economic funded support, including tens of billions
distress are now heralded as geniuses inso- of Federal Deposit Insurance Corporation
far as risk management is concerned… that (FDIC) debt guarantees aimed at each of
is, after taxpayers saved them from ruin. Wall the too-big-to-fail banks and more than $2
Street has so far escaped prosecution, and trillion in nearly zero-cost funding from the
Congress gave it a faster and more powerful Fed. President Obama has yet to condemn

Wall Street’s massive fraud, and Congress’ to financial institutions and institutional
bailout methods have simply rewarded Wall investors. Ms Tavakoli has more than 20
Street’s malicious mischief. The House just years’ experience in senior investment bank-
passed a bigger bailout bill that will give the ing positions, trading, structuring and mar-
so- called too-big-to-fail Wall Street banks keting structured financial products. She is a
access to $4 trillion dollars the next time former adjunct associate professor of deriva-
they trigger a crash in the economy. tives at the University of Chicago’s Graduate
Congress must start again from scratch, School of Business.
and give us real reform. Washington needs A prolific author and media pundit, Ms
to get back in the driver’s seat, and voters Tavakoli wrote: Credit Derivatives & Synthetic
need to make Congress steer straight this Structures (1998, 2001); Collateralised Debt
time by calling and writing to representatives Obligations and Structured Finance (2003);
and senators. • Structured Finance & Collateralised Debt
Obligations (John Wiley & Sons, September
Editor’s note 2008). Her book on the causes of the global
Janet Tavakoli is the founder and President financial meltdown and how to fix it is titled:
of Tavakoli Structured Finance, a Chicago- Dear Mr Buffett: What an Investor Learns
based firm that provides consulting services 1,269 Miles from Wall Street (Wiley, 2009).

North Asia J ournal
of regu
lation &
north a risk
sia
Articles & Volume I,

Issue
Papers III, Autumn
Reprints Available
Winter 2009
-2010
Issues in reso
lving syst
emically imp
Resecuritisat ortant fina
ion in bank ncial insti
ing: major tutions
A framewo challenges Dr Eric S. Rosen
rk for fund ahead gren
ing liquidity
Housing, in times of
monetary financial crisi Dr Fang Du
and fiscal s
Derivativ polic ies: from bad
es: from disa to worst Dr Ulrich Binds
ster to re-re eil
Black swa gulation
ns, market Stephan Schoe
crises and ss,
Measuring risk: the hum Professor Lynn
& managin an perspect A. Stout
g risk for ive
Red star span innovativ
e financia Joseph Rizzi
gled bann l instrume
er: root caus nts
The ‘family’ es of the fina Dr Stuart M.
risk: a caus ncial crisi Turnbull
e for conc s Andreas Kern
Global fina ern among & Christian
ncial chan Asian inve Fahrholz
ge impacts stors
The scrambl complian
e is on to tack ce and risk David Smith
le bribery
Who exac and corrupti
tly is subj on David Dekker
ect to the
Financial Foreign Corr Penelope Tham
markets rem upt Practices & Gerald Li
uneration Act?
Of ‘Black reform: one
Swans’, stres step forw Tham Yuet-M
s tests & ard ing
optimised Umesh Kuma
Contact
Challenging risk managem r & Kevin Marr
the value ent
of enterpri
Rocky road se risk man
ahead for agement David Samu
els
global acco
The Asian untancy conv Tim Pagett
regulator ergence & Ranjit Jaswa
l
y Rubik’s
Cube
Christopher Rogers
Dr Philip Goeth
Alan Ewins
and Angus
Ross
General Secretary
christopher.rogers@irrna.org

Opinion
A failure of credibility
undermines future of the WTO
George Washington University academic
Susan Ariel Aaronson calls on the global
trade body to bare its teeth to China.
IS the WTO doomed? This column argues market, and the world’s leading provider of
that the World Trade Organisation’s cred- manufactured goods. China’s regulatory and
ibility is waning and that to get it back it trade practices can move global markets.
needs to rein in China’s erratic govern- There is no doubt China’s growth has led
ance. Beijing’s failure to enforce trade to global growth. Chinese demand for raw
laws threatens the concept of mutual goods and materials have created jobs. The
benefit that underpins the WTO. China World Bank notes that the efficiency and
is broken, and a broken China could scale of China’s manufacturing has pushed
break the WTO. down the price of many manufactured
products relative to other goods and services
The year 2010 could be a daunting one for (Commission on Growth 2009). Investors,
the WTO. Many observers believe it is con- consumers, and taxpayers have benefited
demned to irrelevance if it does not find from these developments.
common ground among its 153 member
states on the Doha Round – now in its 10th Inadequate governance
year. Many of these same countries bypass But China’s competitive advantage is to some
the WTO as they seek to expand trade. As degree based on its inadequate governance;
an example, WTO members completed its failure to enforce its own laws in a trans-
some 25 new preferential trade agreements parent, even-handed manner. As part of its
in 2009, bringing the total of such bilateral or accession to the WTO, however, China was
regional agreements to 186. required to enforce the rule of law through-
But the WTO’s most difficult challenge out all of its territories. China’s political econ-
may be to discipline trade relations among omy has two key attributes: authoritarian
China and other WTO member states. China governance and inadequate governance. At
today is now the world’s third-largest trading the national level, the Communist Party sets
nation, the world’s largest recipient of invest- the rules, yet it is sometimes willing to ignore
ment, the world’s fastest growing consumer its international commitments in order to

maintain power. In addition, the Communist in China 2009 and US China Business
Party owns and operates or is tied to private Council 2009).
enterprises in key sectors such as transport, WTO members deliberated a long time
energy and banking. Some have described before they let China join the WTO. And they
the government as both a market competi- used the accession to hold China on a tight
tor and referee. leash. The 2001 Protocol on the Accession of
China’s inadequate governance at the the People’s Republic of China (WTO 2001)
provincial level also reflects many factors explicitly calls on China to:
including corruption, a lack of uniformity “apply and administer in a uniform,
among rules, and arbitrary abuse of power. impartial and reasonable manner all its laws,
Local officials often have financial stakes in regulations and other measures of the central
the same companies they are supposed to government as well as local regulations, rules
regulate. and other measures … pertaining to or affect-
ing trade … China shall establish a mechanism
Missing: the rule of law under which individuals and enterprises can
These officials sometimes ignore or circum- bring to the attention of the national authorities
vent governmental mandates from Beijing. cases of non-uniform application.”
Finally, China has a culture of non-compli- It also calls on China to ensure that:
ance, where bad actors set the norm, where “those laws, regulations and other meas-
laws and regulations are often ignored or ures pertaining to and affecting trade shall be
unevenly enforced, and where many citizens enforced.”
and market actors don’t know or can’t obtain The rule of law was a key element of
their rights under the law. China’s accession agreement because trade
Inadequate Chinese governance is a policy-makers understood that how China
trade problem because of the country’s was governed could distort trade.
dominance in global markets. Its failure to
enforce the rule of law threatens the concept Key trade issues
of mutual benefit that underpins the trade In recent years, China has become infa-
regime. China is broken, and a broken China mous for its failure to enforce its own laws,
could break the WTO. whether those laws related to intellectual
On one hand, China’s leaders have tried property, product or food safety, human
very hard to comply with its WTO obliga- rights, or employment.
tions. China has changed many of its laws In both its 2006 and 2008 Trade Policy
and met most of its market access commit- Review at the WTO, member states lauded
ments. On the other hand, it has yet to meet Chinese trade diplomats for their export
many of the obligations delineated in its pro- prowess but also complained that China was
tocol of accession. European and American not transparent, accountable, or sufficiently
business groups investing in China believe even-handed (WTO 2006, 2008). Nor could
that the country is becoming more interven- they trust Chinese statistics or assertions on
tionist and protectionist (European Business enforcement related to key trade issues such

as product and food safety or intellectual standards. But a multilateral approach would
property protection. Meanwhile, Chinese bring the issue to global attention and could
leaders argued that they are a developing move China to do a better job of educating
country and thus deserve patience as they managers, policy-makers, and workers on
learn to govern effectively. the importance of the rule of law.
China’s membership in the WTO has no
What can the WTO do? doubt provided benefits for the people of the
WTO members have the ability to encour- world. But China is exporting its inadequate
age China to address its inadequate govern- governance. At the WTO, member states
ance. They could begin by using the trade can work collectively to encourage China to
policy process more effectively to discuss the change its behaviour. And in so doing, they
rule of law and how it distorts trade. And may bolster the WTO. •
they could threaten a trade dispute on some
aspect of inadequate governance. Under Editor’s note
GATT Article XXIII, any country in the WTO The publishers would like to thank VoxEU
is entitled to a “right of redress” for changes – www.voxeu.org – and Associate Professor
in domestic policy that systematically erode Susan Ariel Aaronson for kindly allowing
market access commitments even if no the Journal to reproduce this article in its
explicit GATT rule has been violated. entirety.
Such a“non-violation”complaint entitles
the aggrieved party either to compensa- References
tion in the form of other tariff concessions Commission on Growth (2009), “The Growth
to “rebalance” market access commitments Report: Strategies for Sustained Growth and Inclu-
or the complaining partner may withdraw sive Development,” 93-94.
equivalent concessions of its own. European Business in China (2009), “Position Paper
Legal scholar Joost Pauwelyn, says: “In 2009-2010,” Executive Summary; USTR, National
non-violation cases a WTO panel could, Trade Estimates Report.
indeed, be called upon to refer to non- Pauwelyn, Joost (2003), Conflict of Norms in Public
WTO rules . . . in its assessment of whether International Law: How WTO Law Relates to Other
certain governmental measures, though Rules of International Law, New York: Cambridge
not in violation of WTO rules, have affected University Press, 456.
the ‘legitimate expectations’ that could have US China Business Council (2009), “US Companies
been derived from a trade concession” China Outlook,” Member Priorities Survey Results
(Pauwelyn 2003). 9-13.
WTO (2001),“Accession of the People’s Republic of
Hard to prove China, Decision of 10 November 2001,” November.
A trade dispute may not succeed because WTO (2006),Trade Policy Review China, Minutes of
it would be hard to prove that market the meeting,April 19 and 21.
access was undermined by China’s failure WTO (2008),Trade Policy Review China, Minutes of
to enforce its own laws and international Meeting, May 21 and 23.

Debate
Origins of the subprime crisis

and regulatory imperatives
Columbia’s Prof Charles Calomiris blames
lax Fed policies and government initiatives
for the 2008 financial implosion.
FINANCIAL crises not only impose rise to a raft of changes in bank regulations,
short-term economic costs, they also most of which were subsequently discred-
create enormous regulatory risks. The ited by economists and economic histori-
financial crisis that has been gripping the ans as counterproductive and destabilising
global economy for the past two years is (Calomiris 2000). Since the 1980s, the US
already inspiring voluminous proposals has been removing many of the regulatory
for regulatory reform coming from all missteps that arose out of the financial col-
quarters. Previous financial crises – most lapse of the Great Depression, by allowing
obviously the Great Depression – have banks to pay market interest rates on depos-
usually brought in their wake significant its, operate across state lines, and offer a
financial regulatory changes. wide range of financial services and products
to their customers (which has diversified
Some crises breed sensible reforms. For banks’ sources of income and improved the
example, in the United Kingdom, policy efficiency of bank services to clients).
reforms in the 1850s and 1860s that changed
the rules governing Bank of England assist- Permanent policies
ance to distressed banks (effectively ending It is worth remembering how long it took for
the bailout of banks during crises) had enor- unwise regulatory actions taken in the wake
mous consequences for incentives toward of the Depression to be reversed. Indeed,
risk-taking, which stabilised the financial some regulatory policies introduced during
system dramatically; Britain had experienced the Depression – most obviously, deposit
severe banking panics in 1825, 1836, 1847, insurance – will likely never be reversed,
1857, and 1866, but (with the exception of despite the fact that financial economists
the upheaval in 1914 as the world prepared and economic historians regard the adverse
for World War I) none for more than a cen- incentive consequences of deposit insurance
tury afterward (Calomiris 2009a). (and other safety net policies) as the pri-
The Great Depression, in contrast, gave mary source of the unprecedented financial

instability that has arisen worldwide over the of assets were smaller and came later in the
past 30 years (Barth, Caprio and Levine 2006, cycle (because they reflect the endogenous
Demirguc-Kunt, Kane, and Laeven 2009). economic consequences of the shocks that
A major lesson of the regulatory response originated in subprime, as for example, the
to the Great Depression (and many other losses in credit card lending).
post-crisis policy reactions), therefore, is that In other words, this was not just a world-
unwise policy reactions to crises can have wide asset price bubble, or a US asset price
very long lives and very large social costs. bubble; it was first and foremost (although
not exclusively) a US subprime credit-driven
Bad thinking, ulterior motives housing bubble. That particularity requires
Unwise reactions to crises have two sources: an explanation.
bad thinking about the sources of crises, Furthermore, everyone was not equally
and ulterior (politically captured) motives of exposed to subprime losses (or to losses more
“reformers” (which, to some extent, thrive generally), and any attempt to come to grips
because of a lack of general understanding with the causes of the subprime crisis that
of the true causes of crises). It is important, does not explain this cross-sectional varia-
therefore, in the interest of shaping desirable tion is incomplete. JP Morgan Chase, Bank
reform, to get our story straight about what of America, Deutsche Bank, Goldman Sachs,
happened to cause the recent crisis. Morgan Stanley, Barclays, and Credit Suisse
In my discussion, I will focus on the had relatively small exposures to subprime;
United States for the simple reason that the indeed some of these institutions benefited
US was the place where the earliest, larg- in some ways from the crisis, either because
est and most persistent shocks originated, they were able to buy competitors at low cost
namely the problems in the intermediation (e.g. JP Morgan’s acquisition of Bear Stearns),
of subprime mortgage risk. That is not to say or because their competitors disappeared.
that the US was unique in its high-risk, high-
leverage binge from 2002 to 2007; many Utter disaster
other countries (including, for example, the In contrast, for the financial firms with large
UK, Iceland, Spain, Ireland and Hungary) subprime exposures – Fannie Mae, Freddie
have also suffered from their over-exposure Mac, Bear Stearns, Lehman Brothers, AIG,
to risk during that period. However, I would Merrill Lynch, Citibank, and UBS – the cri-
argue that without the US’s uniquely large sis was an utter disaster that forced them
subprime shock, the global financial cri- either [1] to be placed in bankruptcy or
sis and its severe macroeconomic conse- conservatorship (Fannie Mae, Freddie Mac,
quences for the world would have been mild and Lehman Brothers), [2] to be acquired by
and short. private firms (Bear Stearns, Merrill Lynch), or
Why the focus on subprime shocks? [3] to receive heavy assistance from govern-
After all, US and global banks ultimately face ments to survive as independent firms (AIG,
losses on virtually all kinds of loans. While Citibank, and UBS).
that is true, the losses on other categories The stories about the origins of the subprime

shock that are being told are not all the same, just a wide-ranging financial crisis. The his-
and some popular stories do not withstand tory of banking crises – that is, financial col-
scrutiny. For example, some critics point to lapses in which banks are severely exposed
allegedly obvious incentive problems inher- to loss – provides helpful guidance of where
ent in the “originate and distribute model” to look for explanations. Macroeconomic
that led to the failure of securitisation as an factors, including monetary policy laxity, are
intermediation strategy technology. generally associated with financial booms
and busts, but they don’t explain banking
Credit card alternative crises; when one looks specifically at banking
The problem, we are told, is that securitisa- crises, these macroeconomic circumstances
tion permits sponsors to have too little skin in are not sufficient conditions to produce a
the game. But two facts belie that view. First, banking crisis. Banking crises typically result
sponsors actually retained large amounts of from severe microeconomic distortions, often
the subprime debts that they issued (and relating to government subsidisation of risk
have the losses to show for it). Second, secu- (Calomiris 2009a).
ritisation, per se, did not fail. Credit card secu- In summary, when coming to grips with
ritisation, an alternative product to subprime the origins of the current global financial
mortgage backed securities (MBS) for con- crisis, one should: [1] place this banking cri-
sumer-finance based securitised debts, has sis in the broader context of the history of
operated reasonably well for three decades. banking crises, which suggests an emphasis
It maintained fairly normal deal flow until on microeconomic distortions in incentives
September 2008, when all financial trans- toward risk; [2] explain the particular origins
actions shrank dramatically, and in recent of subprime related risk-taking in the US
months it has recovered along with other and its timing; [3] explain why some, but not
financial flows. all, large financial firms had taken on large
Others point to rating agencies as the subprime risks; and [4] explain the break-
culprits for the crisis. But here again, there down in the ratings process for subprime
was not uniformity in behaviour. For over related securitised debts, but not other debts.
a decade, research has noted that ratings of
securitised debts tend to be inflated relative Predictable error, or bad luck?
to corporate debts, so there is evidence of The default risk on subprime mortgages
a general inflation of ratings for securitised was substantially underestimated in the
products. But during the financial crisis, the market during the subprime boom of 2003-
severe errors in rating methodology that 2007 (Calomiris 2009b). One starting point
produced grossly overstated ratings were for explaining the origins of the subprime
specific to subprime-related securities. crisis is to ask whether the large losses and
When searching for explanations for huge underestimation of risk that occurred
these and other facts about the origins of the in the pricing of subprime-related securities
US subprime crisis, something else should was the result of identifiable and predictable
be kept in mind.This was a banking crisis, not errors or, alternatively, just bad luck. Recent

academic studies describe in detail the would have been no subprime debt crisis.
faulty assumptions that underlay the mas- And yet, those assumptions were obviously
sive securitisation of subprime mortgages unreasonable on an ex ante, not just ex post,
and related collateralised debt obligations basis during the subprime boom, as they
(CDOs).1 It can be difficult to establish the ex contradicted both logic and experience.
ante unreasonableness of any assumptions. What was the basis for assuming that
Nevertheless, in the case of subprime securi- house prices would never fall? Subprime
tisations, it is not so difficult. was a relatively new product which grew
from humble beginnings in the early 1990s
Facts ignored and remained small even as recently as 2003,
Some facts known to everyone in advance of after which it took off, roughly tripling in
the subprime collapse were simply put aside 2004 and peaking in 2006 and early 2007.
in the modelling of risk. In retrospect, the Subprime risk models based their stress
two most important errors of subprime risk tests, including their house price stress tests,
modelling were: on a short period of “lookback.” For some
[1] the assumption that house prices would variables in the models (say, interest rates)
not fall (an especially important assump- that may have been a reasonable practice,
tion, given that subprime MBS was given the short track record of the product,
much more sensitive to house price but it was not reasonable to base projections
assumptions than normal MBS, as dis- of the possible paths of housing prices on a
cussed further later), and 10-year retrospective history of house price
[2] the assumption that ignoring“soft”infor- change.
mation and allowing lending through
“no-docs” or “low-docs” mortgages Reasonable assumption
based entirely on Fair Isaac Corporation Doing so meant that modellers relied on
(FICO) credit scores would not result in the experience of housing prices as demon-
significant adverse selection in the pool strated during the 2001 recession to gauge
of no-docs and low-docs mortgages. the potential downside for the housing mar-
In other words, the models wrongly ket – this was the only recession in their lim-
assumed that a mortgage with a 600 FICO ited sample. It was also a unique recession
score and with proper documentation of from the standpoint of the housing cycle
employment was roughly as good as a – the only recession in US history in which
mortgage with a 600 FICO score with no housing price growth was sharply positive.
documentation. Other prior recessions show a very dif-
According to recent research by Rajan, ferent pattern. Would it not have been more
Seru and Vig (2008) each of those two mod- reasonable to assume in 2003-2007 that the
elling errors was of roughly equal impor- next recession might see a flattening or a
tance in production of the massive shortfalls decline in housing prices, which was the rule
of performance in subprime mortgage port- rather than the exception?
folios. Without those assumptions there Indeed, some risk managers were

Figure 1. Real Federal Funds Rate
Figure 2. Federal Funds Rate and Inflation Targets
worried that the US was overdue for a based on a false extrapolation of the past into
housing price decline, partly because of the the future:“We are less likely to get the house
extremely positive performance of the 1990s price appreciation we’ve had in the past l0
and early 2000s. David Andrukonis, a risk years to bail this programme out if there’s a
manager at Freddie Mac, recognised in his hole in it.”2
April 5, 2004 letter to a superior that the reli- By “this programme” he was refer-
ance of underwriters on house price appre- ring to the proposed entry of Freddie Mac
ciation to “bail out” subprime lenders was into no-docs lending on a large scale. The

assumption that no-docs mortgages would of those three events are generally known
have the same risk as well-documented to the borrowers long before their conse-
mortgages with similar FICO scores defied quences show up in the FICO score; only
economic logic and the experience of the by doing proper due diligence can a lender
mortgage market with no-docs products in detect these problems before they show up
the 1980s, and Mr Andrukonis weighed in to in the FICO score. Banks that do not perform
discourage his superiors from entering this such due diligence will predictably“adversely
product area in 2004. select”lower quality borrowers.
Even more remarkably, subprime and
No-docs, low-docs mortgages Alt-A originations for late 2006 and early 2007
He reminded them that “in 1990 we called continued at peak levels despite mounting
this product ‘dangerous’ and eliminated it evidence beginning in mid-2006 that hous-
from the marketplace.”No one listened. The ing prices were flattening (which had predict-
growth in subprime originations from 2004 to ably disastrous consequences for subprime
2007 was meteoric, and was accompanied by portfolios), and evidence of unprecedented
a significant deterioration in borrower quality performance problems beginning to occur
due to the growth in no-docs and low-docs in existing portfolios, which were discussed
mortgages. The heavy weight of no-docs openly by the ratings agencies.
mortgages in subprime portfolios after 2004
largely reflected the decisions of Fannie Mae Flight from subprime
and Freddie Mac (the 800-pound gorillas Josef Ackerman, the CEO of Deutsche Bank,
in the mortgage market) to enter massively in a speech given at the European Central
into purchases of no-docs subprime MBS in Bank in December 2008, said that Deutsche
mid-2004, over the strong objections of their Bank fled the subprime market in mid-2006
risk managers who pointed to large adverse- in reaction to these obvious signals of poten-
selection consequences from doing so, and tial problems. Professor Gary Gorton of Yale,
those objections were specifically based on in his oral comments at the August 2008
the experience they had with no-docs mort- Kansas City Federal Reserve Bank’s Jackson
gages in the 1980s. Hole Conference described the continuing
Not only did lenders know better from high-volume of originations in 2006 and
their own experience, but using simple eco- 2007 by Merrill, UBS, and Citibank in light of
nomic theory, the consequences of no-docs the obvious problems brewing in the hous-
lending were predictable. If a mortgage ing market as“shocking.”
lender hangs out a shingle saying that he As Gorton (2008) emphasises, the core
will ask no questions but the FICO score, assumption on which subprime lending had
then he will attract (“adversely select”) peo- been based was the permanent apprecia-
ple who know that their FICO scores are tion of home prices. By the middle of 2006,
about to deteriorate. The three primary rea- that assumption was being disproved, and
sons for consumer defaults are the loss of a no one – least of all the rating agencies –
job, a severe health problem, and divorce. All seemed to care.

The rating agencies did notice the prob- instrumental in producing the crisis: First, lax
lem; they just did not react to it. According to Fed monetary policy, especially from 2002
Fitch’s (2006) extremely negative discussion through 2005, promoted easy credit and
of subprime prospects in December 2006, kept interest rates very low for a protracted
the environment became increasingly nega- period. As I have already noted, the history
tive after the first quarter of 2006, as reflected of banking crises teaches us that, while mon-
in the fact that “the number of sub-prime etary policy laxity by itself is not a sufficient
downgrades in the period between July and condition for generating a banking crisis, it is
October 2006 was the greatest of any four- frequently a contributor to aggravating bad
month period in Fitch’s history for that sec- decision making by empowering bad deci-
tor”(up to that point). sion makers with easy credit (Bordo 2009,
Fitch correctly predicted that “the sensi- Calomiris 2009b).
tivity of sub-prime performance to the rate
of HPA [home price appreciation] and the Sharp deviation
large number of borrowers facing scheduled As Figure 1 shows, the history of post-war
payment increases in 2007 should continue monetary policy has seen only two episodes
to put negative pressure on the sector. Fitch in which the real Fed funds rate remained
expects delinquencies to rise by at least an negative for several consecutive years; those
additional 50 per cent from current levels periods are the high-inflation episode of
throughout the next year and for the general 1975-1978 (which was reversed by the
ratings environment to be negative, as the anti-inflation rate hikes of 1979-1982) and
number of downgrades is expected to out- the accommodative policy environment of
number the number of upgrades.” 2002-2005.
As Figure 2 shows, the Federal Reserve
Feverish pace deviated sharply from its “Taylor Rule”
Nevertheless, in the midst of all this negative approach to setting interest rates during the
news, the originations continued at a fever- 2002-2005 period; Fed funds rates remained
ish pace, and not until the middle of 2007 substantially and persistently below the lev-
did these serious problems become reflected els that would have been consistent with the
in any significant (albeit still inadequate) Taylor Rule.
changes in modelling assumptions by the Not only were short-term real rates held
ratings agencies. at persistent historic lows, but because of
The predictable risk-taking mistakes of peculiarities in the bond market related to
financial managers were not the result of global imbalances and Asian demands for
random mass insanity; rather, they reflected medium- and long-term US Treasuries, the
a policy environment that strongly encour- Treasury yield curve was virtually flat during
aged financial managers to underestimate the 2002-2005 period, implying extremely
risk in the subprime mortgage market. Risk low interest rates across the yield curve.
taking was driven by government policies. Accommodative monetary policy and a flat
Four categories of government error were yield curve meant that credit was excessively

available to support expansion in the hous- and the actions of members of Congress that
ing market at abnormally low interest rates, encouraged reckless lending by the GSEs in
which encouraged overpricing of houses. the name of affordable housing were arguably
the most damaging of microeconomic policy
Political pressures actions leading up to the crisis.
Second, numerous government policies spe- In order for Fannie Mae and Freddie Mac
cifically promoted or subsidised subprime to maintain their implicit (now explicit) gov-
mortgage-related risk taking by financial ernment guarantees on their debts, which
institutions (Calomiris 2009b, 2009c). Those contributed substantially to their profit-
policies included: (a) political pressures from ability (with good cause), they believed that
Congress on the government-sponsored they had to cater to the political agendas of
enterprises (GSEs), Fannie Mae and Freddie their supporters in Congress. In the context
Mac, to promote “affordable housing” by of recent times, that meant making a huge
investing in high-risk subprime mortgages; amount of risky subprime loans (Wallison
(b) lending subsidies via the Federal Home and Calomiris 2009).
Loan Bank System to its member institutions Fannie Mae and Freddie Mac ended up
that promoted high mortgage leverage and holding US$1.6 trillion in exposures to these
risk; (c) FHA Home Loans (FHA) subsidisa- toxic mortgages, which constitutes half of
tion of high mortgage leverage (nearly zero the total non-FHA outstanding amount
down payments) and high borrower default of toxic mortgages (Pinto 2008). Calomiris
risk; (d) government and GSE mortgage (2008) argues that it is likely that absent the
foreclosure mitigation protocols that were involvement of Fannie Mae and Freddie Mac
developed in the late 1990s and early 2000s in aggressive subprime buying beginning in
to reduce the costs to borrowers of failing 2004, the total magnitude of toxic mortgages
to meet debt service requirements on mort- originated would have been less than half
gages, which encouraged risky mortgage its actual amount, since Fannie and Freddie
borrowing by forcing originators to rene- crowded in market participation more than
gotiate delinquencies rather than foreclose they crowded it out.
(these new protocols were associated with a
substantial reduction from the mid-1990s to Prudential regulatory failure
the early 2000s in the probability of foreclos- Their entry into no-docs mortgages in an
ure occurring conditional on 90-day delin- aggressive way in 2004 was associated with
quency) and, almost unbelievably, (e) 2006 a tripling of subprime originations in that
legislation that prohibited so called “notch- year. In mid-2006, when housing price
ing,” which encouraged rating agencies to weakness led others like Goldman Sachs
relax their standards for measuring risk in and Deutsche Bank to pull back, Fannie
subprime securitisations. All of these govern- and Freddie continued to make markets in
ment policies contributed to encouraging the subprime securities which produced a dis-
underestimation of subprime risk, but the astrous prolongment of peak-level deal flow
politicisation of Fannie Mae and Freddie Mac well into 2007.

Third, prudential regulation of commer- ratings are used for regulatory purposes, buy-
cial banks by the government has proven to side participants reward rating agencies for
be ineffective. That failure reflects (a) fun- underestimating risk, as that helps the buy-
damental problems in measuring bank risk side clients avoid regulation. Many observers
resulting from regulation’s ill-considered wrongly believe that the problem with rating
reliance on credit rating agencies assess- agency grade inflation of securitised debts is
ments and internal bank models to meas- that sellers of these debts (sponsors of secu-
ure risk, and (b) the too-big-to-fail problem ritisations) are the ones who pay for ratings;
(Stern and Feldman 2004), which makes it on the contrary, the problem is that the buy-
difficult to credibly enforce effective disci- ers of the debts want inflated ratings because
pline on large, complex financial institu- of the regulatory benefits they receive from
tions, such as Citibank, Bear Stearns, AIG, those inflated ratings.
and Lehman Brothers, even if regulators
detected that those institutions have suffered Buy-side client influence
large losses and that they have accumulated Rating agencies had no incentive to construct
imprudently large risks. realistic models or respond realistically to
The risk measurement problem has been bad news relating to subprime instruments
the primary failure of banking regulation, for a simple reason: their buy-side clients
and a subject of constant academic regula- did not want them to. Institutional investors
tory criticism for decades. Bank regulators managing the portfolios of pensions, mutu-
utilise various means to assess risk, depend- als, insurance companies and banks contin-
ing on the size of the bank. Under the sim- ued to buy subprime-related securitisation
plest version of regulatory measurement of debt instruments well into 2007.
bank risk, subprime mortgages have a low Even the banks that sponsored these
asset risk weight, of 50 per cent that of com- instruments (and presumably had the clear-
mercial loans, even though they are much est understanding of their toxic content)
riskier than most bank loans.The more com- continued to retain large amounts of the
plex measurement of subprime risk (applica- risk associated with the subprime MBS and
ble to larger US banks) relies on the opinions CDO securitisations they packaged, through
of ratings agencies or the internal assess- purchases of their own subprime-related
ments of banks and, unsurprisingly, neither debts and credit enhancements for sub-
of those assessments is independent of bank prime conduits.
management. Were the bankers who created these
securitisations and retained large exposures
Underestimating risk for their banks related to them, and other
Rating agencies, after all, are supposed to sophisticated institutional investors who
cater to buy-side market participants (i.e. bought subprime-related securities, aware of
banks, pensions, mutuals and insurance the flawed assumptions regarding housing
companies that maintained subprime- prices and no-docs mortgages that underlay
related asset exposures), but when their the financial engineering of subprime MBS

by ratings agencies? These assumptions in risky assets because of an incentive con-
were widely publicised as part of the proc- flict or “agency problem,” and rating agen-
ess of selling the securities. Did they object? cies, and the regulators that relied on their
Apparently not. ratings, were their willing (fee-receiving)
accomplices. If asset managers had informed
Someone else’s money their clients of the truth – that the supply of
Why did these bank investors create such good investments in risky assets has been
risks for themselves and other institutions, outstripped by the flood of financial sav-
and why did sophisticated institutional inves- ings, and that consequently, the risk-reward
tors buy these overpriced securities? The trade-off did not warrant further investment
obvious answer is that asset managers were in risky assets – then asset managers would
placing someone else’s money at risk, and have been required to return money to cli-
earning huge salaries, bonuses and manage- ents rather than invest in risky assets.
ment fees for their willingness to pretend that
these were reasonable investments. Low risk, low fees
Rating agencies gave legitimacy to this Presumably the money would then have
pretence and were paid to do so. Investors ended up in bank deposit accounts or other
may have reasoned that other competing low-risk (and low-fee generating) invest-
banks and asset managers were behav- ments. Returning the money to investors
ing similarly and that they would be able under these circumstances would have
to blame the collapse (when it inevitably made investors better off (given the poor
came) on a surprising shock. The script return to bearing risk), but it would have
would be clear and would give plausible made asset managers worse off, since man-
deniability to all involved.“Who knew? We agement fees earned grow in proportion to
all thought that the model gave the right the amount of funds invested in risky assets.
loss assumption! That was what the rating Managers faced strong incentives to benefit
agencies used.” themselves at their clients’expense.
Plausible deniability was a co-ordinating To what extent is it plausible to argue
device for allowing asset managers to par- against this view by pointing to the novelty
ticipate in the feeding frenzy at little risk of of securitisation products (subprime MBS,
losing customers (precisely because so many CDOs, etc), which may have made inves-
participated). Because asset managers could tors and rating agencies unable to gauge risk
point to market-based data and ratings at properly in advance of the crisis? As I have
the time as confirming the prudence of their already noted, data and logic available prior
actions on a forward looking basis, they were to the crisis showed that key assumptions
likely to bear little cost from investor losses. regarding the possible path of home prices
In short, the regulatory reliance on ratings and the adverse-selection consequences of
magnified a pre-existing agency problem on no-docs mortgages were unrealistic.
the buy side of the securitised debt market. Furthermore, the novelty of a securitisa-
Asset managers willingly invested too much tion product, in and of itself, should be an

indicator of a need to adjust estimates of the housing market. And there was dra-
risk upward. Experience suggests that rating matic new entry into subprime origination in
agencies have frequently underestimated 2004-2006 by fly-by-night originators; these
the risks of new products and only adapted new entrants offering new, riskier products
their behaviour after major credit or fraud to new customers seem to have been able
events occur, and this shows that their risk to raise funds under more or less the same
measures and controls for new products low loss assumptions as old originators who
tend to be inadequate. offered older, lower-risk products. The princi-
Experience prior to the subprime collapse ples learned over 20 years in the credit card
(in credit card securitisation, in delinquent securitisation business were thrown out
consumer account receivable securitisa- the window when rating subprime-related
tion, and in other areas) has shown that the securitisations.
learning curve related to underestimation of
risk can be steep. Decades of experience with Supply and demand
steep learning curves in new securitisation This account does not place the primary
products indicates yet another reason that blame for the mispricing of risk on securi-
properly incentivised institutional investors tisation sponsors (the sell side) or on rating
should have been cautious about the new, agencies. After all, sponsors were only sup-
fast growing markets in subprime mort- plying what asset managers of their own
gages and CDOs. institutions or outside buyers were demand-
Indeed, it is particularly revealing to con- ing. The rating agencies were also doing
trast the measurement of subprime risk with what the investors wanted – going through
the measurement of risk in the much older the mechanical process of engineering con-
credit card securitisation business. In credit duit debt structures, and rating them, based
card securitisation, even during the sub- on transparently rosy assumptions.
prime crisis, market participants paid close Rating agencies were not deceiving
attention to the identities of originators, to sophisticated institutional investors about
their performance in the past, to the compo- the risks of the products they were rating;
sition of portfolios, and to how compositions rather they were transparently understating
changed over time, and originators were risk and inflating the grading scale of their
rewarded with greater leverage tolerances debt ratings for securitised products so that
for “seasoned” receivables with good track institutional investors (who are constrained
records. by various regulations to invest in debts rated
In contrast, until the middle of 2007, the highly by Nationally Recognised Statistical
ratings of subprime portfolios (based largely Rating Organisations) would be able to
on the unrealistic expected loss assump- invest as they liked without being bound
tions) seem to have been extremely insensi- by the constraints of regulation or the best
tive to changes in borrower quality, product interests of their clients.3
type (which is correlated with unobservable Many observers wrongly attribute rat-
aspects of borrower quality), or the state of ing agencies’ behaviour to the fact that

sponsors, rather than investors, paid for awaiting further developments (i.e. either an
the ratings. But that fact was not relevant; improvement in the market environment or
sponsors and investors alike knew what a handout from Uncle Sam).
was going on, and if the investors had not In particular, Lehman Brothers did lit-
wanted the models to be misspecified and tle to raise capital or shore up its position.
the ratings to be inflated, then the ratings But when conditions deteriorated and the
agencies would not have built such faulty anticipated bailout failed to materialise for
models and would not have generated Lehman Brothers in September 2008 –
such inflated ratings. Ratings inflation and showing that there were limits to Treasury-
model misspecification of subprime-related Fed generosity – the other major investment
securitised debts was demand-driven, and banks immediately either became acquired
thus would have occurred if the buy side or transformed themselves into commercial
had paid for ratings. bank holding companies to increase their
access to government support.
‘Moral hazard’ problem Fourth, government regulations limit-
The too-big-to-fail problem relates to the ing who can buy stock in banks have made
lack of credibility of regulatory discipline for effective corporate governance within large
large, complex banks. For large, complex banks virtually impossible, which contrib-
banks, the prospect of failure is considered uted to the buy-side agency problems within
so potentially disruptive to the financial banks that took large subprime risks. Hedge
system that regulators have an incentive funds and private equity funds have tradi-
to avoid intervention. The incentives that tionally been barred from controlling bank
favour “forbearance” and/or explicit govern- holding companies.
ment assistance ex post can make it hard for Pension funds, mutual funds and insur-
regulators to ensure compliance ex ante. The ance companies are limited by regulations
too-big-to-fail problem magnifies the so- to only own small stakes in any public firm,
called “moral-hazard” problem of the gov- including banks. Given the importance of
ernment safety net; banks that expect to be the incentives that come from ownership
protected by deposit insurance, Fed lending, concentration in enforcing effective corpo-
and Treasury-Fed bailouts, and believe that rate governance, these regulations make the
they are beyond discipline, will tend to take managers of large banks virtually immune
on excessive risk, since taxpayers share the to effective challenges from sophisticated
costs of excessive risk on the downside. shareholders.
The moral hazard of the too-big-to-fail Lax corporate governance allowed bank
problem was clearly visible in the behaviour management to pursue investments that
of the large investment banks in 2008. After were in the long run unprofitable for stock-
Bear Stearns was rescued by a Treasury-Fed holders but were very profitable to manage-
bailout in March, Lehman Brothers, Merrill ment in the short run, given the short time
Lynch, Morgan-Stanley and Goldman horizons of managerial compensation sys-
Sachs sat on their hands for six months tems. When stockholder discipline is absent,

managers are able to set up the manage- failures of regulation, rather than deregula-
ment of risk within the firms they man- tion, as causes of the crisis.
age to benefit themselves at the expense of The severity of the crisis may seem para-
stockholders. An asset bubble (like the sub- doxical given the limited size of the subprime
prime bubble of 2003-2007) offers an ideal market. Roughly $3 trillion in non-FHA
opportunity; if senior managers establish subprime mortgages were outstanding at
compensation systems that reward subordi- the time of the crisis, and ultimate losses on
nates based on total assets managed or total those securities are likely to be roughly $600
revenues collected, without regard to risk billion.4 Why did this limited loss cause such
or future potential loss, then subordinates widespread havoc throughout global finan-
are incentivised to expand portfolios rapidly cial markets? The answer to that question
during the bubble without regard to risk. revolves around liquidity risk.
Senior managers then reward them-
selves for having overseen that “successful” Liquidity risk
expansion with large short-term bonuses, The shocks of financial loss are magnified
and ensure they cash out their stock options when the distribution of loss is hard to ascer-
quickly so that a large portion of their money tain. This“asymmetric-information”problem
is safely invested elsewhere by the time the produces a widespread scramble for liquid-
bubble bursts.This review of the four areas in ity throughout the financial system, which
which government policy contributed to the causes suppliers of credit to refuse to roll over
financial crisis makes no mention of deregu- debts, and causes interest rates on risky secu-
lation. During the 2008 election, many can- rities and loans to rise dramatically, reflecting
didates (including President Obama) often not only the fundamental credit risk in the
made vague claims that “deregulation” had system, but also the illiquidity of the mar-
caused the crisis. That claim made no sense; kets. This scramble magnifies losses and the
involvement by banks and investment risk of financial failure far beyond what they
banks in subprime mortgages and mortgage would have been if it were easy to identify
securitisation was in no way affected by the exactly who suffered from the fundamental
deregulation of the past two decades. exogenous shocks giving rise to the crisis.
As Gorton (2008) shows, the complexity
Cushioning effect of subprime-related securitisations contrib-
In fact, deregulation cushioned the financial uted greatly to the inability of the markets to
system’s adjustment to the subprime shock identify the distribution of loss in the system,
by making banks more diversified and by once the crisis began. That inability reflected
allowing troubled investment banks to stabi- the complex design of the distribution of
lise by becoming, or being acquired by, com- cash flows in the various securitisations, the
mercial banks (Calomiris 2009b). Since the multiple layers of securitisation, and the sen-
election, President Obama and other erst- sitivity of securitisation portfolios to uncer-
while critics of “deregulation” have changed tain changes in housing prices.
their emphasis, and now properly focus on The sensitivity of subprime mortgage

valuation to housing prices was particu- ownership rules relating to large banks – all
larly problematic because subprime securi- of which have been the subjects of substan-
ties payouts had been based on scenarios tial academic research prior to the recent
that only envisioned rising housing prices, financial crisis.
which made it especially difficult to project It is therefore no surprise that cred-
payouts in a declining housing price ible solutions to these problems have been
environment. identified by financial economists who
write about public policy, and those pro-
Liquidity vs. expected loss posals are reviewed elsewhere (Calomiris
Schwarz (2009) devises an innovative 2009b, 2009c, 2009d, 2009e). Successful
means of distinguishing between the reform must begin with the recognition that
exogenous effects of fundamental loss major flaws in policy and regulation have
expectations and the endogenous effects existed for decades and that these flaws
of the scramble for liquidity in explaining must be addressed if we hope to avoid a
the widening of credit spreads during the repeat of the recent crisis. •
crisis. Liquidity risk is captured by mar-
ket factors unrelated to default risk (e.g. References
spreads on sovereign bonds of different Barth, James R., Gerard Caprio, Jr., and Ross Levine (2006).
liquidity), and credit risk is captured by dif- Rethinking Bank RegulationTill Angels Govern, Cambridge: Cam-
ferences between banks in the rates they bridge University Press.
paid in the interbank market (abstracting Bordo, Michael D. (2009).“The Crisis of 2007:The Same Old
from changes in the average interest rate Story, Only the Players Have Changed,” Working Paper, Rut-
and, therefore, from the common effect of gers University.
liquidity risk). She finds that roughly two- Calomiris, Charles W. (2000). US Bank Deregulation in Histori-
thirds of the widening of credit spreads cal Perspective: Cambridge University Press.
was attributable to liquidity risk. Calomiris, Charles W. (2008). “Statement Before the Com-
mittee on Oversight and Government Reform, United
Conclusion States House of Representatives,” December 9, 2008.
Loose monetary policy and global imbal- Calomiris, Charles W. (2009a).“Banking Crises and the Rules
ances explain the timing of the subprime of the Game,” NBER Working Paper 15403, October.
crisis, but like other severe banking crises Calomiris, Charles W. (2009b). “The Subprime Turmoil:
historically, microeconomic government What’s Old,What’s New, and What’s Next,” Journal of Struc-
policies that distorted the risk-taking deci- tured Finance, Spring, 6-52.
sions of financial institutions were crucial Calomiris, Charles W. (2009c).“Financial Innovation, Regula-
necessary conditions for causing the crisis. tion, and Reform,” Cato Journal,Winter, 65-92.
The microeconomic policy errors enumer- Calomiris, Charles W. (2009d). “Prudential Bank Regulation:
ated above that caused the subprime cri- What’s Broke and How to Fix It,” in Reacting to the Spending
sis relate to the fundamental design of the Spree: Policy Changes We Can Afford, edited by Terry L.Ander-
financial system – housing finance policy, son and Richard Sousa, Stanford, CA: Hoover Institution
prudential regulatory policy, and corporate Press, 17-34.

Calomiris, Charles W. (2009e). “The Debasement of Wallison, Peter J., and Charles W. Calomiris (2009). “The
Ratings:What’s Wrong and How We Can Fix It,” Work- Last Trillion-Dollar Commitment: The Destruction of
ing Paper, Columbia Business School. Fannie Mae and Freddie Mac,” American Enterprise Insti-
Demirguc-Kunt, Asli, Edward Kane, & Luc Laeven, Editors tute, Journal of Structured Finance, Spring, 71-80.
(2009). Deposit Insurance Around the World, MIT Press.
Ellis, Luci (2008). “The Housing Meltdown:Why did it Hap- End notes
pen First(?)/Only(?) in the United States?” Working Paper, 1 Mason and Rosner (2007a, 2007b), International Mon-
Bank for International Settlements. etary Fund (2008), Ellis (2008), Keys, Mukherjee, Seru,
Fitch Ratings (2006).“2007 Global Structured Finance Out- and Vig (2009), Rajan, Seru, and Vig (2008), and Calo-
look: Economic Sector-By-Sector Analysis,” Dec. miris (2009b).
Gorton, Gary (2008). “The Panic of 2007,” in Maintaining 2 Calomiris (2008).
Stability in a Changing Financial System: Symposium Sponsored by 3 Calomiris (2009e) shows that ratings shopping – the
Kansas City Federal Reserve, 131-262. practice where originators of subprime-related securi-
International Monetary Fund (2008). Global Financial Stability tisations get a preview of rating agencies’ views before
Report, 2008 choosing which ones to permit to rate their debts –
Keys, Benjamin J., Tanmoy K. Mukherjee, Amit Seru, and produced a race to the bottom among agencies. It is
Vikrant Vig (2009). “Did Securitisation Lead to Lax Screen- important to recognise that in order for rating shop-
ing? Evidence from Subprime Loans,” Quarterly Journal of ping to result in a race to the bottom in ratings, that
Economics, forthcoming. race must be welcomed by the buy side of the market;
Mason, Joseph R., and Joshua Rosner (2007a). “How Resil- ratings shopping will not benefit the sell side without
ient Are Mortgage Backed Securities to Collateralised Debt the co-operation of the buy side. If institutional inves-
Obligation Market Disruptions,” Working Paper, Louisiana tors punish the absence of good rating agencies in an
State University. offering (by refusing to buy or by paying a lower price,
Mason, Joseph R., and Joshua Rosner (2007b). “Where Did when a reputable rating agency is excluded from rat-
the Risk Go? How Misapplied Bond Ratings Cause Mort- ing a securitisation), then would-be ratings shoppers
gage Backed Securities and Collateralised Debt Obliga- would have no incentive to exclude reputable rating
tion Market Disruptions,” Working Paper, Louisiana State agencies. Thus, the fact that ratings shopping tends to
University. exclude relatively reputable rating agencies and leads
Pinto, Edward J. (2008). “Statement Before the Commit- to low quality and inflated ratings implies that the buy
tee on Oversight and Government Reform, United States side favours a ratings shopping process that results in
House of Representatives,” December 9. low-quality, inflated ratings.
Rajan, Uday, Amit Seru, and Vikrant Vig (2008). “The Failure 4 Because of creative accounting practices by Fannie
of Models that Predict Failure: Distance, Incentives and Mae and Freddie Mac, which disguised the true size of
Defaults,” Working Paper, London Business School. their subprime mortgage exposure, it was not widely
Schwarz, Krista (2009). “Mind the Gap: Widening Risk known until roughly September 2008 that Fannie Mae
Spreads Explained By New Measures of Credit and Liquid- and Freddie Mac held half of the total subprime expo-
ity,” Working Paper,Wharton School. sure, or that the total amount of subprime exposure
Stern, Gary H., and Ron J. Feldman (2004). Too Big To Fail: was so high (Pinto 2008,Wallison and Calomiris 2009).
The Hazards of Bank Bailouts,Washington, D.C.: Brookings Thus, prior to mid-2008, the general perceptions of
Institution Press. total exposure and expected loss were even lower.

F O R E W O R D B Y P A U L V O L C K E R
SENSELESS
PANIC
H O W WA S H I N G T O N FA I L E D A M E R I C A
W I L L I A M M . I S A AC
with P H I L I P C . M E Y E R
Debate
Root causes of the subprime

crisis: What broke?
Peterson Institute’s Edwin M. Truman
argues that agreement is necessary if an-
other financial crisis is to be avoided.
IN the Fall of 2009, the Federal Reserve about what happened to cause the recent
Bank of Chicago, in conjunction with the crisis.” I agree and would add that doing so
World Bank, organised its 12th annual is equally important with respect to other
symposium – The International Financial lessons that should affect policies but might
Crisis: Have the Rules of Finance Changed? not necessarily rise to the level of reforms
A number of academics, central bankers, requiring Congressional action, for example
economists and government advisers monetary policy.
delivered a series of lectures and papers
focusing on the origins and consequences Multiple points of view
of the financial crisis and remedies to There is no paucity of potential candidates
mitigate against further occurrences. The who postulate the root causes of the crisis
previous paper, by Charles W. Calomiris, of 2007-09. The number is probably larger
gave one perspective on the origins of than the four or five presented in Calomiris’
the subprime crisis which the Peterson article, or the four or five largely implicit in
Institute for International Economics’ the Mussa chapter, and less than the 10 or
Edwin M. Truman fundamentally disa- 12 presented in the Baily-Elliott chapter.
greed with. Below is an edited transcript However, the intersection of these lists of
of Mr Truman’s discourse. causes is essentially a null set aside from a
common theme of the housing boom.
Mr Truman …It is is a pleasure to partici- These observations illustrate the reality
pate once again in an International Banking that even today, more than two years after
Conference at the Federal Reserve Bank of the crisis broke in August 2007, and essen-
Chicago. tially there is no agreement about the root
Charles Calomiris wrote in his article causes. This is unfortunate if we want to
(see previous paper in this journal): “It is learn the lessons and apply this learning to
important, therefore, in the interest of shap- policy reform; but it gives me free reign in my
ing desirable reform, to get our story straight commentary.

Conventionally, the identified causes of • Excessive reliance on credit rating
the global financial crisis that has affected agencies;
the world economy and financial system • US too-big-to-fail policies; and
for two-plus years fall across four broad • US government policies to limit stock
categories: ownership.
Failures of macroeconomic policies, Calomiris is less clear about the relevance
which have three sub-categories: monetary of the fourth item, but I assume he is hinting
and fiscal policies, global imbalances, and a at a limitation on outside influences relating
housing boom; to corporate governance.
Failures of financial-sector supervision
and regulatory policies and practices, which Too-big-to-fail policies
have innumerable sub-categories; Baily and Elliott agree on the first two of
Excesses of poorly understood financial Calomiris’items, but as far as I could tell they
engineering innovations, which have several do not agree on the third and fourth. They
sub-categories; and add, by my count, five items in this category:
Excesses, or imprudence, of large private (1) a general erosion of lending and regula-
financial institutions, in particular those with tory standards,
a global reach. (2) flaws in the originate-to-distribute
In the first category of macroeconomic model,
policies, Calomiris includes lax US monetary (3) lack of a US comprehensive supervisory
policy and global imbalances that flattened system,
the US yield curve. (4) mark-to-market accounting, and
(5) inadequate capital cushions.
To blame or not to blame Mussa explicitly focuses on the too-big-
Baily and Elliott, largely absolve Federal to-fail policies in his concern about moral
Reserve policies, but don’t absolve global hazard in the wake of the crisis and implic-
imbalances. Baily and Elliott, also include itly as a contributor to the crisis, but I suspect
government policies that encouraged a that his indictment is not fully consistent
boom in housing construction. Calomiris with Calomiris. He also, in passing, refers
is less explicit under the macroeconomic to financial excesses. However, he basically
heading. traces the causes of the financial crisis to the
Mussa does not absolve the Federal business cycle and to financial sector devel-
Reserve and other central banks, but his only opments over several decades that got ahead
mention of global imbalances is to note that of the regulators.
the US imbalance was declining in advance
of the crisis. He mentions housing as well. Three specifics
In the second category (supervision and In the third category (financial engineer-
regulation), Calomiris includes four items: ing), Calomiris includes the liquidity risk and
• US government policies to promote sub- complexity associated with new instruments
prime risk taking; that contributed towards uncertainty in the

system. Baily and Elliott do not entirely disa- (or other central banks). They do cite global
gree, but they point to three specifics: imbalances, but only in connection with
(1) the new securitisation model, flattening the US yield curve. Moreover, the
(2) excessive leverage, and drivers of the US crisis in the Baily-Elliott list
(3) credit insurance. of causes, as well as in the Calomiris list, are
Mussa does not mention this category almost exclusively US-centric in that other
beyond a few oblique hints. jurisdictions did not share most of the short-
In the final category (behaviour of large comings that they identify, such as the tax
financial institutions), Calomiris and Baily deductibility of mortgage interest payments.
and Elliott are together in citing poor risk So what do I think? What is my narrative
management practices, but do not entirely for the root causes of the crisis?
agree on the reasons. Mussa shares the view
that imprudent risk taking was involved. For Supervisory sins
the record, Calomiris pays more attention My view, in contrast to the conventional sto-
to compensation policies and practices; the ries, to a substantial degree, macroeconomic
word does not appear in the first part of the policies in the United States and the rest of
Baily-Elliott chapter or in Mussa’s chapter. the developed world were jointly responsi-
In the context of an international bank- ble for the crisis although they had help from
ing conference, my major criticism of these supervisory sins, largely of omission.
analyses, with the limited exception of In the United States, fiscal policy con-
Mussa’s chapter, is that they treat what is tributed to a decline in the US saving rate,
clearly a global financial (and economic) cri- and monetary policy was too easy for far too
sis as if it was solely a US event caused by US long, thereby fuelling the global credit boom.
regulatory and policy failures. In Japan, the mix of monetary and fiscal poli-
cies distorted the global economy and finan-
Apportioning the blame cial system; here again monetary policy was
Much of the rest of the world would like to too easy for too long, also fuelling the fires of
believe that the US deserves full blame for the global credit boom. In recent years, many
the crisis. Perhaps it does, but simply being other countries also had very lenient mone-
the epicentre is not the same as being the tary policies and included other Asian coun-
sole cause. I remain to be convinced that tries, energy and commodity exporters and,
policies elsewhere in the world were irrel- in effect, a number of countries within the
evant to the crisis. Eurozone, as well as the United Kingdom
Baily and Elliott do note that housing and Switzerland.
prices rose rapidly in many countries and
state that this fact points to a global driver of Design flaws
what happened, which they hint had some- The impressive accumulation of foreign
thing to do with low interest rates. However, exchange reserves by many countries
when they come to discussing low interest distorted the international adjustment
rates, they do not blame the Federal Reserve process and took some pressure off the

macroeconomic policies of the United States net savings in the latter year.1 It is a stretch
and other countries. However, I am among a of the imagination to think that a flow of net
minority of economists who believe that the saving of this size added significant down-
phenomenon of global imbalances played ward pressure on the US and other yield
little or no role in causing the economic and curves around the world that could not have
financial crisis. Instead, the imbalances and been resisted by central banks.
the crisis were jointly caused by flaws in the Baily and Elliott are careful not to blame
design and implementation of macroeco- the foreigners for our problems, which is
nomic policies and the resulting global credit more than I can say for many other US
boom. observers and officials past and present.
I won’t argue this point in great detail, However, their basic argument, and that of
but I would cite two facts: Calomiris with regard to the influence of
First, we have witnessed at least two other capital inflows, though common in the lit-
periods of large global imbalances; those of erature generally, lacks a factual or analytical
the late 1970s and 1980s – they did not lead base.
to the extent of financial excesses like what
we have more recently experienced. Worldwide housing boom
Second, the ‘global savings glut’ hypoth- We do not know what would have hap-
esis is a flawed analysis; not only was it in pened if global imbalances had been
reality a dearth of global investment, as was smaller; the presumption is that US interest
demonstrated by the IMF staff at the time, rates would have been higher, starting with
but in addition the analysis focused, in its the federal funds rate. I would think that it
simplest form, on net inflows and on gross therefore follows, if the foreigners can push
official inflows. In fact, on average over the US interest rates down or up, the Federal
period 2002 to 2007 official inflows to the Reserve should have been able to push
United States were less than 25 per cent of them up as well.
total gross inflows. We had a global credit boom; monetary
policies have something to do with credit
Peak years booms, with the size of balance sheets, and
The peak years were 2003 at 32 per cent and with ‘aggregate liquidity’ using the Baily-
2004 at 26 per cent – before the boom year of Elliot terminology. The credit boom did
2005. Moreover, the Chinese current account not just fuel a housing boom in the United
surpluses (the net flow to the rest of the States, but also contributed towards housing
world which is the relevant metric in terms booms in many other countries, some to a
of the savings glut) were only $69 billion and greater extent than in the United States.
$161 billion in 2004 and 2005 respectively. However, in addition to housing booms,
The rest of China’s reserve accumulation the credit boom fuelled significant increases
in gross terms amounted to a recycling of in the prices of equities and many other
capital inflows. The net savings from China manifestations of financial excess. We are not
amounted to about three per cent of global talking here about pricking bubbles; we are

talking about fuelling a global credit boom types of financial institutions that were less
and about the associated pricing of risk. well capitalised and subject to less close
supervision. Traditional banks gradually, but
Benign conditions radically, transformed their business models
Financial-sector supervision and regu- in order to compete with the less-regulated
lation, or the lack thereof, also played a role institutions. The global financial system
in the crisis. But the many sins of omission became overleveraged; the US financial sys-
and few sins of commission were commit- tem in particular but not exclusively. When
ted over several decades, not primarily over confidence finally and fully drained from the
the past 10 years. As is reported in the Mussa system, funding dried up and financial insti-
chapter, they started in the 1960s. Moreover, tutions collapsed.
without the benign economic and financial New forms of financial engineering
conditions that prevailed in the wake of the were part of the story, but innovation has
dot-com boom, and the associated belief been a feature of domestic and international
that ‘this time it is different’, this crisis would finance for decades. In many cases, the asso-
have taken a different form. ciated innovations were poorly understood,
As Calomiris hints, benign conditions resulting in a failure of risk recognition,
lead to lax lending and credit standards, just which is a necessary precondition for good
as night follows day. In principle, financial- risk management.
sector supervision could have helped to
curb the excesses, but it did not do so in the Imprudence at large
United States or in many other countries Financial engineering helped to distort
around the world. incentives facing financial institutions and
contributed to the market dynamics once
Shadow banking the crisis got underway, but this was not the
In some cases, notably including the United cause of the crisis or a major root cause.
States but also elsewhere, regulation and Finally, some words relating to the
supervision were simply incomplete. The imprudence of large private financial insti-
rise of what is now known as the shadow tutions, in particular those with global
financial system had been going on for reach; we can agree that they were impru-
decades in many countries: money mar- dent in many dimensions. Size has been a
ket mutual funds, special purpose invest- problem, and the sheer complexity has led
ment vehicles, hedge funds, private equity to decisions to rescue particular institutions
firms, etc. In many cases, these entities were in whole or in part. However, the global
highly leveraged and/or used short-term scope of the operations of these institutions
funding to finance longer-term invest- was not a major contributing factor to the
ments contributing to Mussa’s “inherent crisis per se.
instabilities.” In my view, the two major sources of
We saw a gradual shift in financial inter- the global financial crisis of 2007-09 were
mediation from traditional banks to other failures in macroeconomic policies together

with financial supervision and regulation. the National Bureau of Economic Research
I would assign principal blame to failures (NBER) will date the most recent recession
in macroeconomic policies by a small mar- as only slightly longer, perhaps 18 months,
gin, which is more blame than is assigned from December 2007 to June 2009. The US
by most observers, including the authors of recession of 1981-82 coincided with a global
these presentations. recession centred on 1982; global growth
I do not see this as inconsistent with that year was less than one per cent.
the view that there were structural flaws in Nineteen-eighty-two was the year that
national and global financial regulatory and the global debt crisis broke out. The debt cri-
supervisory systems, which had been build- sis was the consequence of the reversal of US
ing for a number of years, that need to be financial conditions from negative real inter-
addressed in the wake of the crisis. It may est rates to positive rates – macroeconomic
well be that a crisis of this magnitude was causes – and the excesses of international
necessary to uncover those flaws. Whether bank lending in originating loans and syn-
they would have been revealed without the dicating them to smaller banks around the
macroeconomic failures is debatable. world.
By the end of 1982, most international
Final thoughts banks located in the United States and
Drawing upon over three decades of expe- those within other major industrial coun-
rience with financial crises in this country tries were insolvent on a mark-to-market
and around the world, I would add one final basis. However, fortunately at the time, the
thought. The only other global economic secondary market in sovereign loans was
and financial crisis of the post-World War underdeveloped. In the wake of the debt
II period was the crisis in the early 1980s, crisis, blame was heaped upon the interna-
centred on 1982. In many respects, that cri- tional banks for causing the crisis through
sis was also made in the United States. US reckless lending.
macroeconomic policy mistakes produced
rip-roaring inflation and an extended period Volatile mix
of negative real short-term and long-term A number of reforms were instituted, includ-
US dollar interest rates that fuelled a global ing the US requirement that syndication fees
credit boom; in particular by extending credit be spread over the life of loans and the capi-
to emerging market economies. tal standards that were agreed later in the
In late 1979, the Federal Reserve finally decade stemming from the Basel I Accord.
began to address the problem of US infla- In many respects the crisis of the early 1980s
tion. We had a brief six-month recession was a lot like this crisis, including the fact that
associated with a flirtation with credit con- the global financial system was blamed for
trols. The recession was followed by a brief the crisis and came under tremendous strain.
12-month recovery and expansion, before Its causes included principally a volatile mix
we plunged back into recession in mid-1981 of macroeconomic and financial supervisory
and this lasted 16 months. It is likely that and regulatory components. •

North Asia
Articles & Papers
Fed monetary and regulatory policy: lessons from the crisis 55
Janet L.Yellen
The post-crisis fix: regulatory or monetary policy remedies? 61
Stephen S. Roach
Risk orientation in regulation and supervision 75
Patrick Raaflaub and Gabe Shawn Varges
Regulation, supervisory lessons from Japan since the 1990s 87
Kazuo Ueda
Enhancing cross-border regulation after the 2008 crash 99
Richard Neiman
What we thought we knew and what we didn’t know 107
The ‘business of bribery’ sparks anti-corruption drive 113
Gavin Sudhakar
Public or private accounting and the Sarbanes-Oxley Act 123
Alex J. Pollock
‘Innumerate bankers, systemic idiocy & accounting standards’ 129
Lord Adair Turner
Lessons for the forex market from the global financial crisis 141
Michael Melvin and Mark P. Taylor
Exports and financial shocks: new evidence from Japan 147
Mary Amiti and David Weinstein
A case of mistaken identity: the illusion of ‘too big to fail’ 153
Avinash Persaud
Regulation
Fed monetary and regulatory

policy: lessons from the crisis
San Francisco Fed’s Janet L. Yellen, et al1
calls for an end to the monetary and regula-
tory dichotomy that exists at the Fed’s heart.
IN this paper, I will try to lay out some monetary policy and the performance of the
broad themes concerning the implica- macroeconomy depend greatly on main-
tions of the financial crisis for regulatory taining a stable and healthy financial system.
reform and monetary policy. My com- And a sound economy makes the work of
ments are my own and do not necessarily regulators much easier because economic
reflect the views of my colleagues in the downturns put considerable stress on the
Federal Reserve. financial system. In addition, the insights
we derive from our supervision of bank-
In the past, monetary and regulatory poli- ing organisations are helpful in formulating
cies have generally been viewed as separate monetary policy. And the economic analysis
domains with distinct objectives. The pri- that underpins monetary policy improves
mary focus of monetary policy has been on our understanding of the risks confronting
attaining the macroeconomic goals of low financial institutions. Nonetheless, policy-
inflation and a stable economy. In the United makers have generally viewed monetary and
States, these goals find their expression in the regulatory questions as separate disciplines,
Federal Reserve’s dual mandate of maximum and we have designed our strategies and
employment and price stability. By contrast, carried out our policies accordingly.2
regulatory policy has generally pursued sig-
nificantly different ends: protecting the safety Important implications
and soundness of individual financial institu- The painful events of the past two years have
tions and reducing systemic risk. fundamentally challenged this dichotomisa-
Of course, monetary and regulatory tion of monetary and regulatory policies. It is
policies do not exist in total isolation and no longer obvious that setting policies to sta-
the Federal Reserve, an institution with bilise the economy on the one hand and to
responsibilities in both domains, has long safeguard the financial system on the other
recognised some important linkages. For can be cleanly separated – either in concep-
example, it’s clear that the effectiveness of tion or implementation.3 This experience has

important implications for both monetary conducting a horizontal assessment of inter-
and regulatory policy. Here I will focus on the nal processes for evaluating capital adequacy
conceptual issues, leaving aside vital ques- at the largest US banking organisations and
tions concerning implementation, such as will shortly undertake a similar horizontal
the appropriate division of authority among review of incentive compensation practices.
different regulatory bodies – a subject that is Overall, the crisis has exposed serious
under discussion in the United States. deficiencies in our micro-prudential regu-
latory structure. We clearly need to address
Regulatory responsibilities gaps, such as inadequate authority or tools
Let me start by considering our regulatory to properly supervise the so-called shadow
responsibilities. Government agencies have banking system, including major investment
long practiced micro-prudential supervision banks, non-bank lenders, and vital financial
and regulation – that is, oversight of individ- insurance providers such as AIG.
ual financial institutions aimed at preserving
their safety and soundness. Indeed, micro- Finding the balance
prudential supervision – including on-site A broad consensus exists that we need to
examinations, surveillance, guidance, regu- make these changes. But, it is critical to rec-
lations, and enforcement – is the first line ognise that carrying bigger sticks as micro-
of defence against systemic risk. The crisis prudential supervisors entails tradeoffs
has taught us valuable lessons on how to between stability and efficiency – between
strengthen supervision going forward. managing systemic risk and cultivating a
For example, we need to develop fertile environment for economic growth.
stronger and more effective capital and Admittedly, we may well have been operat-
liquidity standards, strengthen our oversight ing far off the optimal tradeoff curve in recent
of risk management practices, and insure years!
that compensation arrangements do not Still, in designing a new regulatory
create incentives that could compromise framework, we must be aware that stronger
safety and soundness.4 In the United States, capital standards that reduce leverage might
we also gleaned important insights on how hamper the flow of funds to businesses
to improve our consolidated supervision of and households in ways that could impede
bank holding companies through this year’s investment and consumption. Of course,
stress test of the 19 largest banking organi- finding the right balance is an immense
sations, as part of the Supervisory Capital challenge. To strike that balance between
Assessment Program. stability and growth, we should examine
what other policy weapons should be in our
Horizontal institutional reviews arsenal. Perhaps the most important are in
We intend to make such horizontal insti- the area of macro-prudential oversight,
tutional reviews involving multidisciplinary which we increasingly understand is an
teams an important component of our essential complement to micro-prudential
supervision going forward. Currently, we are supervision.

Now, what exactly does macro-prudential How are we to measure and safeguard
supervision entail? To me, it means identify- against such highly correlated investment
ing and correcting behaviours and structures strategies? Research is under way now to
in financial markets that create excessive risk provide some answers.5 One promising
before they mushroom into something that strategy is to implement a system that would
threatens the entire financial system. This require banking organisations to build capi-
requires real-time collection and analysis of tal buffers in good times that could be run
data from a wide variety of financial institu- down under stressful conditions.
tions and markets, the deployment of tools Such a system could serve as an auto-
to mitigate the inherent pro-cyclical tenden- matic stabiliser, mitigating the buildup of lev-
cies of financial markets, and new resolution erage in booms and the destabilising impact
powers to deal with the failure of any institu- of broad-based deleveraging in downturns.
tion that poses a threat to financial stability.
Macro-prudential supervision takes a Macro-prudential supervision
very different perspective than its micro- Other practices may also be ripe for macro-
prudential sibling. It’s akin to caring for an prudential supervision. They include pro-
entire ecosystem rather than individual cyclical underwriting standards, shortcomings
trees. It is targeted at spillovers and exter- in the provision of liquidity and credit risk
nalities that contribute to systemic risk even protection during crises, and payment and
when they don’t directly harm individual clearing systems.6 For example, markets for
institutions. An example is an investment over-the-counter derivatives, including credit
strategy that is highly positively correlated default swaps, lack the stabilising mecha-
across institutions. nisms associated with central exchanges.7
A key issue in macro-prudential super-
Herd mentality vision concerns the too-big-to-fail problem
Taken in isolation, each institution may of systemically important financial institu-
appear to be adequately managing liquid- tions. A number of approaches have been
ity, capital and exposure to risk. But, when suggested to limit the systemic risk from
many large institutions invest in the same large, interconnected financial institutions.
class of assets, a downturn in that asset class These include capping the size of these insti-
can cause a rush to the exits as everyone tries tutions, moving some activities to exchanges
to sell at the same time. That’s exactly what or clearing firms, requiring them to hold
happened in 2007 and 2008 in the markets more capital, and reducing their odds of
for mortgage-related securities, with disas- failure by requiring them to hold debt that
trous effects that we know too well. In the automatically converts to equity in a crisis
worst case, correlation can feed contagion situation. It is also essential to devise effec-
that spreads across the globe as institutions tive means to resolve large, highly intercon-
seek to rapidly deleverage and protect liquid- nected financial institutions in an orderly
ity. This presents a regulatory challenge of manner to minimise the damage to the
the first order: financial system.

In the United States, the Federal Deposit rate cuts in a time of market disruption can
Insurance Corporation uses a well-tested be effective at stopping a deleveraging cycle
and highly effective procedure for resolving from turning into an uncontrolled crash.
commercial banks and thrifts. But, for non- And higher rates than called for based on
depository financial institutions, the stand- purely macroeconomic conditions may help
ard bankruptcy process is all that’s available. forestall a potentially damaging buildup of
We’ve seen that the mere hint a financial leverage and an asset price boom.
institution is headed for bankruptcy can This raises the broader – and very con-
set off a run, depriving it of vital short-term tentious – issue of whether monetary
funding and leaving it incapable of paying policy should seek to lean against poten-
creditors. As recent events attest, in the cases tially dangerous swings in asset prices. The
of systemically important institutions, the answer is far from clear, because the use of
end result can be market turmoil, cascading monetary policy for these ends necessarily
declines in valuations, and panic. compromises the attainment of other macr-
oeconomic goals. Because such use of mon-
Management role etary policy is costly, high priority should be
Macro-prudential supervision has the assigned to developing regulatory tools to
potential to lower systemic risk and thereby address systemic risk.
create a more secure financial system that Even so, the crisis of the past two years
will contribute to macroeconomic goals as has prompted many of us to re-examine
well. But, monetary policy may also play a the widely held view that monetary policy
role in managing systemic risk. One notable should respond to asset prices only to the
feature of boom-and-bust cycles has been extent that they influence the anticipated
highly pro-cyclical leverage at primary deal- trajectories of inflation and unemploy-
ers, such as investment banks. ment. Further research into the connections
Recent research by Tobias Adrian and among monetary policy, the banking and
Hyun Shin suggests that monetary pol- financial sectors, and systemic risk is needed
icy affects these cycles in asset growth.8 to help answer this question.11
Specifically, they find that periods when
monetary policy is“tight”relative to the pre- In summary
dictions of an estimated Taylor rule are asso- In summary, the events of the past few years
ciated with weaker growth in holdings of compel us to re-examine many of our long-
repurchase agreements by primary dealers.9 held ideas and practices in both monetary
By contrast,“easy”monetary policy is associ- and regulatory policy. I am gratified that
ated with rapid increases in financial institu- researchers around the world are looking
tion balance sheets that can add to systemic hard at these questions. In addition, I am
risk.10 These results suggest that monetary encouraged by the sense of purpose and co-
policy could play a role in restraining unde- operation exhibited by my colleagues at cen-
sirable swings in leverage and, by extension, tral banks, governments, and international
reduce systemic risk. In particular, interest organisations in their efforts to develop

policies that will help us avoid the kind of Adrian,Tobias, and Hyun Song Shin. 2008b.“Financial Inter-
crisis we have just experienced. Thank you. • mediaries, Financial Stability, and Monetary Policy.” In Main-
taining Stability in a Changing Financial System. Kansas City,
End Notes MO: Federal Reserve Bank of Kansas City, pp. 287-334.
1 I would like to thank John Williams and Sam Zucker- Adrian,Tobias, and Hyun Song Shin. 2009.“Money, Liquidity,
man for assistance in preparing these remarks. and Monetary Policy.” American Economic Review: Papers &
2 At times, the connections between monetary policy Proceedings 99(2), pp. 600-605.
and regulation have become more apparent. For exam- Bernanke, Ben S. 2009. “Financial Reform to Address Sys-
ple, the abolition of Regulation Q in the United States temic Risk.” Speech at the Council on Foreign Relations,
had a direct bearing on how monetary policy affected Washington, DC, March 10.
the economy and the appropriate monetary policy Caruana, Jaime. 2009. “The International Policy Response
response to shocks (see Mauskopf 1990). to Financial Crises: Making the Macroprudential Approach
3 See Shirakawa (2009) for further discussion on this. Operational.” Remarks at the Federal Reserve Bank of
4 See, for example, Crockett (2009) and Tarullo (2009) Kansas City Symposium,August.
for discussions of these issues. Crockett,Andrew. 2009. “Rebuilding the Financial Architec-
5 See Caruana (2009), Adrian and Brunnermeier (2009). ture.” Finance & Development 46(3, September), pp. 18-19.
6 See Bernanke (2009) and Dudley (2009) for further Curdia, Vasco, and Michael Woodford. 2009. “Credit
discussion of these and related issues of macro-pru- Spreads and Monetary Policy.” Federal Reserve Bank of
dential regulation. New York Staff Report 385 (August).
7 See Duffie and Zhu (2009) for an analysis of the prob- Dudley, William C. 2009. “Some Lessons from the Crisis.”
lems with clearing credit default swap contracts. Remarks at the Institute of International Bankers Member-
8 See Adrian and Shin (2008a). ship Luncheon, New York City, October 13.
9 Taylor (2007) describes a different channel, but comes Duffie, Darrell, and Haoxiang Zhu. 2009. “Does a Central
to the same conclusion that monetary policy can con- Clearing Counterparty Reduce Counterparty Risk?” Rock
tribute to undesirable booms and busts. Center for Corporate Governance at Stanford University,
10 See Adrian and Shin (2008b, 2009).They find evidence Working Paper No. 46 (July).
that asset growth is linked to housing construction. Gertler, Mark, and Peter Karadi. 2009. ‘A Model of Uncon-
11 Increasingly macroeconomists are incorporating bank- ventional Monetary Policy.’ Manuscript, NewYork U (April).
ing and financial frictions in their macroeconomic mod- Mauskopf, Eileen. 1990. “The Transmission Channels of
els. See, for example,Curdia and Woodford (2009) and Monetary Policy: How Have They Changed?” Federal
Gertler and Karadi (2009). Reserve Bulletin 76(12, December).
Shirakawa, Masaaki. 2009.“International Policy Response to
References Financial Crises.” Remarks at the Federal Reserve Bank of
Adrian, Tobias, and Markus K. Brunnermeier. 2009. Kansas City Symposium,August.
“CoVaR.” Federal Reserve Bank of New York Staff Report Tarullo, Daniel K. 2009.“In the Wake of the Crisis.” Speech
No. 348 (August). at the Phoenix Metropolitan Area Community Leaders’
Adrian,Tobias, and Hyun Song Shin. 2008a.“Liquidity, Mon- Luncheon, Phoenix,AZ, October 8.
etary Policy, and Financial Cycles.” Federal Reserve Bank Taylor, John B. 2007. “Housing and Monetary Policy.” In
of New York Current Issues in Economics and Finance 14(1, Housing, Housing Finance, and Monetary Policy. Kansas City,
January/February), pp. 1-7. MO: Federal Reserve Bank of Kansas City, pp. 463-476.

Regulation
The post-crisis fix: regulatory or

monetary policy remedies?
Chairman of Morgan Stanley Asia, Stephen
S. Roach, discusses the probable imposition
of macro-prudential regulations.
UNDER the auspices of the US Congress, undoubtedly has considerable merit, it may
the newly constituted Financial Crisis not be enough to prevent another crisis from
Inquiry Commission (FCIC) held its occurring in the not-so-distant future. In my
first hearings in Washington on January opinion, also needed is a major reworking of
13-14 this year. Established by Congress the mandate that guides the role and con-
in the aftermath of the bankruptcy of duct of monetary policy.
Lehman Brothers, its function is reminis- Specifically, the addition of a finan-
cent of congressionally-sponsored hear- cial stability mandate could go a long way
ings held in 1932 by the so-called Pecora in forcing central banks to face up to the
Commission. destabilising perils of asset bubbles and the
imbalances they have spawned in the mix of
As was the case some 78 years ago, the global saving as well as on the real side of
current generation of Wall Street captains increasingly asset-dependent economies.
was grilled on the specifics of the Great Crisis
of 2008-09. Like earlier times, this high-pro- No silver bullet
file exchange could well be a key to driving There is no quick fix in a post-crisis world
legislation that could shape the US financial – no silver bullet that would inoculate an
system – and an asset and debt-dependent ever-changing world from the next inevita-
US economy – for generations to come. ble crisis. However, the world can surely do
a much better job of crisis prevention that it
Twin concerns did in the free-wheeling decade before the
The early betting is that post-crisis remedies onset of the sub-prime crisis in the summer
will be concentrated in a new approach to of 2007.
regulatory oversight – specifically the impo- Significantly, it should avoid a backward
sition of new“macro-prudential”regulations looking fix that addresses the problems that
aimed at the twin concerns of systemic risk gave rise to this most recent crisis. A myopic
and financial stability. While this approach approach would invariably miss the excesses

that sow the seeds of the next crisis. Instead, funds and private equity activities. In that
the post-crisis fix needs to be as broad- key respect, it is the functional equivalent of
based and comprehensive as possible – in Glass-Steagall II.1
essence, throwing out a big net that would
limit as many destabilising risks as possi- Fostering stability
ble. The broad fix should both contain both A re-instatement of Glass-Steagall-like
regulatory reforms and a new approach to restrictions on the US financial system is
monetary policy. Only then, will there be a one example of a new “macro prudential”
meaningful chance for a safer and sounder approach to regulatory policy that seems to
post-crisis world. have gained favour in the current post-crisis
debate. The goal of such proposals is to put
Glass-Steagall resurrection? regulations in place that foster stability of
Where the Washington debate ends up is the system as a whole. The inference is that
anyone’s guess. Right now, the regulatory the former approach on “micro-prudential”
approach has the upper hand. A resurrection regulations, which were directed at the sta-
of a Glass-Steagall type separation between bility of individual institutions, could lead to
the commercial banking function and riskier investor herding and other counter-produc-
capital market activities is certainly a possi- tive trends that could be destabilising to the
bility. Senators McCain and Cantwell have broader financial system.
introduced such a proposal – in essence, Other macro-prudential proposals under
repealing the decade-old Gramm-Leach- active consideration include counter-cyclical
Bliley Act (also known as the Financial capital provisioning for banks which would
Services Modernisation Act of 1999). This require a build-up of reserves in a boom and
effectively repealed the original Glass- less onerous capital requirements in a down-
Steagall framework. turn, as well as proposals to revamp bonus-
Meanwhile, none other than former driven compensation schemes of Wall Street
Federal Reserve Chairman, Paul Volcker, executives and risk-takers.
has offered a similar proposal that would
offer full government backstop support (i.e. Asleep at the switch
deposit insurance and lender of last resort The so-called resolution authority to unwind
access) to the utility-like commercial bank- failed financial institutions is another option
ing functions of deposit gathering and lend- in the macro-prudential tool-kit – aimed,
ing – but no such support to the proprietary in this instance, at the critical moral hazard
and speculative capital market activities of implications of large financial services firms
financial institutions. that have become“too big to fail.”
The Volcker proposal, which has now The problem with fixating post-crisis
been formally endorsed by the Obama remedies on a macro-prudential regulatory
administration, is very specific in arguing solution is that it ignores the 800-pound
that commercial banks be prohibited from gorilla that is also in the same room – mis-
involvement in proprietary trading, hedge directed monetary policies. Yes, regulators

were asleep at the switch in the Era of Excess. it is not a question of either/or. While some
So, too, were their political overseers in the macro-prudential proposals have consid-
US Congress. But the Federal Reserve was erable merit, the role of monetary policy
hardly an innocent bystander. Excessive during and after this crisis also needs to be
monetary accommodation, beginning in the examined very carefully. I reject the sug-
late 1990s, was a conscious outgrowth of the gestion that post-crisis remedies should be
Greenspan-Bernanke view that monetary outsourced to regulators. The US financial
policy should not be used to prevent asset system post-crisis needs to strike a balance
and debt bubbles and the distortions they between better regulation, more disciplined
foster in the real economy. monetary policy, and more responsible
political oversight. Prudential regulation of
Standard argument financial institutions – whether it is macro or
Instead, the Fed believed that it had both micro – still involves very specific judgment
the power and the wisdom to use monetary calls affecting the performance of individual
policy to clean up the post-bubble carnage. companies. While such intervention may be
The breadth and depth of the current crisis appropriate at times, it is not a substitute for
and recession draws that presumption into more disciplined monetary policy.
serious question. Whatever the balance between the two
Yet this remains a very contentious issue avenues of control of the financial system, it
in the current macro-policy debate. For Ben would be dangerous to put too many eggs
Bernanke, the debate goes to the heart of in the same basket. While some macro-pru-
his macro-philosophy – not just as a cen- dential proposals have considerable merit,
tral banker but also as an academic before the role of monetary policy during and in
he came to Washington. In an early 2010 the aftermath of this crisis also needs to be
speech, Bernanke reiterated his long-stand- examined very carefully.
ing view that blame for the current crisis rests
on the laxity of regulatory oversight rather The past is history
than on inappropriate monetary policy.2 He As the body politic comes to grips with
underscored the standard argument that America’s post-crisis carnage, it must also
monetary policy is too blunt an instrument take a long hard look in the mirror. The fail-
to deal with asset bubbles – despite the fact ures of the political oversight function were
that bubble-related distortions on the real yet another weak link in the increasingly
side of the US economy ended up engulf- unstable pre-crisis equation. With these
ing nearly 80 per cent of the GDP (personal considerations in mind, it is important to
consumption and residential construction, stress that any post-crisis fix be framed in the
combined). context of a comprehensive and forward-
When imbalances in the real economy looking approach.
are that large, reliance on the blunt instru- By contrast, the narrow and backward-
ments of macro-stabilisation policy might looking approaches of the past are doomed
not be such a bad idea after all. In my view, to failure – and to the painful likelihood

of yet another crisis in the not-so-distant That’s not to say that central banks are
future. The experience of the past 10 years lacking in the tools and skills to restore
underscores how difficult it is to break benchmark interest rates to pre-crisis con-
the habit of monetary accommodation in ditions. The issues in this case boil down to
bubble-dependent economies. Each suc- judgment and will – specifically, political will.
cessive post-bubble shake-out has required That’s because the policy rate holds the keys
increasingly looser monetary policy. The to the kingdom of the financial system – and
only way out of this vicious circle is a judi- the support that system provides to the real
cious and highly disciplined “exit strategy” side of the global economy.
– in this case, the unwinding of the unprec-
edented monetary stimulus that was put in Asymmetrical issues
place to arrest the great crisis and recession In my opinion, the biggest risk to the exit
of 2008-09. Unlike the fairly mechanis- strategy remains an asymmetrical response
tic withdrawal of the special liquidity (and pattern of the policy interest rate – quick to
capital) injections of quantitative easing slash in a downturn, a crisis, or as a result of a
that have been put in place in the past year post-bubble shake-out, but slow to normal-
and a half, there is nothing neat and easy ise in the subsequent healing and recovery.
about a post-crisis normalisation of the pol- The post-equity bubble profile of the US
icy interest rate. federal funds rate in the early part of this
Figure 1. The Asymmetries of Fed Policy
FED FUNDS
DATE TARGET
January 2001 6.50%

December 2001 1.75%
Reduction 475 bps
Number of Cuts 11 over 12 months
Average Reduction 43 bps
Speed Per Month -40 bps
June 2004 1.00%

June 2006 5.25%
Increase 425 bps
Number of Hikes 17 over 24 months
Average Increase 25 bps
Speed Per Month +18
bps
August 2007 5.25%
December 2008 0 to 0.25%
Reduction 500 to 525 bps
Number of Cuts 10 over 17 months
Average Reduction 51 bps
Speed Per Month -30
bps

decade is perhaps the best – and most rel- in the aftermath of the bursting of the equity
evant – illustration of this bias. Over the 12 bubble. Putting it another way, the speed of
months of 2001, the benchmark short-term the normalisation – averaging out to 18 basis
interest rate was cut 11 times from six per points per month over a 24 month interval
cent to 1.75 per cent by a total of 425 basis – was less than half the speed of the easing –
points; it was then reduced by another 75 an average of 40 basis points per month over
bps to one per cent in two additional instal- a 12 month period (see Figure 1).
ments by mid-2003.
A year later, with its mission presumably Check the numbers
“accomplished,” the Fed embarked on the This asymmetry was justified by two key
road to post-bubble normalisation – taking considerations – persistently low inflation
the funds rate up in 17 separate incremen- and the ongoing fragility of a post-bubble
tal instalments of 25 bps per move – from jobless recovery. In retrospect, the delayed
one per cent in June 2004 to 5.25 per cent normalisation was not without serious unin-
in June 2006. This underscores the asym- tended consequences.
metrical biases of the Fed’s post-bubble As seen through the lens of the real fed-
reaction function. Once the normalisation eral funds rate, it meant that the US central
process finally began in mid-2004, it took bank maintained an extremely accommoda-
the US central bank twice as long to bring tive policy stance long after the emergency of
the policy rate back to its appropriate post- the post-bubble shakeout had run its course
bubble setting as it did to slash the funds rate (see Figure 2).
Figure 2. The Fed’s Policy Rate

24
% Morgan Stanley Forecast
20 Nominal Fed Funds Rate, %
Real Fed Funds Rate, %
16 Average of Real Fed Funds Rate over 1970-2006
12
-4
-8
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09
Source: Haver Analytics, Morgan Stanley Research

Notwithstanding the ex post justifica- a striking sense of déjà vu, America’s central
tion for monetary accommodation in recent bank has once again been quick to ease
years, the numbers speak for themselves: aggressively – hardly surprising in the midst
Since 2000, the real federal funds rate has of the great crisis and recession – but equally
been less than its long-term average of 1.9 reluctant to restore policy settings to pre-
per cent in all but one year. Over this same crisis norms.
period, the real funds rate has been less than This approach can, and has been
zero about half the time. repeatedly justified by a risk manage-
ment approach to monetary policy. After
Fuelling the bubbles all, history demonstrates that the bursting
In the decade just ended, for whatever rea- of asset and credit bubbles typically takes
son, the Fed ran the most accommodative a lasting toll on the real side of underlying
monetary policy since the 1970s – hardly a economies. As a result, central bankers have
comforting precedent. Notwithstanding the opted repeatedly to err on the side of cau-
recent contentions of Ben Bernanke, it’s hard tion in implementing normalisation strat-
to believe that the Era of Excess leading up egies in the context of fragile recoveries of
to the Great Crisis didn’t draw considerable post-bubble economies. At the same time,
sustenance from such easy money. this rationale is very much at odds with the
With the benefit of hindsight, it now “emergency” feature of aggressive crisis-
appears that the Fed’s asymmetrical reac- driven policy responses.
tion function kept US monetary policy in This raises the key question of the post-
a highly accommodative stance well into trauma reaction syndrome: If extraordi-
2006. In my view, that played a key role in nary circumstances cause policy rates to be
fuelling the next round of even larger bub- slashed to unusually low levels, once those
bles – twin bubbles in both the property and same circumstances have been resolved and
credit markets. the emergency is effectively over, then why
Unfortunately, the same movie appears shouldn’t there be an equally prompt sus-
to be running in the current cycle. Going pension of the emergency measures?
into the bursting of the subprime bubble in
the summer of 2007, the federal funds rate ‘Earning’ prosperity
stood at 5.25 per cent. Then, beginning in Putting this in another way – if the US
September of that year, it was slashed to economy is in a weak recovery as the Fed
its current level of near“zero”in 10 separate seems to be indicating, shouldn’t the policy
moves over a 17-month period. And now rate at least be set at weak-recovery levels?
the Fed – once again citing sustained low Given the long lags of monetary policy, such
inflation and a shaky post-crisis economic forward-looking concerns seem especially
recovery and now making explicit refer- relevant. This critical balancing act lies at the
ence to an “indefinite” period of monetary heart of the asymmetries of discretionary
accommodation – is sending very clear sig- monetary policy adjustments.
nals of another delayed normalisation. With There is another key factor that drives the

asymmetrical post-crisis reaction function of have been more derelict in carrying out their
central banks – the desire to foster a steep responsibilities than the custodians of the
yield curve that then enables crisis-torn financial system. Any post-crisis fix must
banks to “earn” their way back to prosper- address this glaring fault head on.
ity. By allowing, if not encouraging, banks to
play the spread between rock-bottom short- Ideological debate
term borrowing rates and higher yielding Adding a“financial stability”provision to the
intermediate and longer-term market-based policy mandates of central banks would go
investments, central banks can accelerate a long way in avoiding this type of problem
the healing of earnings-constrained finan- in the future. Notwithstanding a predict-
cial institutions. In the US, the Fed discov- able outbreak of post-crisis remorse, central
ered this approach in the early 1990s in the banks simply cannot be relied upon to break
aftermath of the savings and loan crisis; it bad habits on their own. Experience sug-
was even more effective in boosting earn- gests that they have a hard time saying“no”
ing for beleaguered banks in the aftermath to the siren song of the latest untested theory
of the bursting of the equity bubble in 2001 that is invariably concocted to explain away
and 2002.3 asset and credit bubbles. Recent history is lit-
However, the bank earnings subsidy of a tered with false claims of those in denial over
steep yield curve is hardly without cost in the the twin perils of asset bubbles and macro
broader macro sense – especially if it tempts imbalances.
central banks to stay too easy for too long Discretionary policy-making has failed
in a recovery and sets up asset dependent in this important respect. It got caught up in
economies for yet another fix from the next an ideological debate over the risks of bub-
bubble. bles and imbalances. Such temptations can
only be avoided by more of a rules-based
New policy mandate approach – specifically by a financial stabil-
It is a key aspect of the moral hazard ity mandate that is hard-wired into the legal
dilemma – providing banks with the comfort obligation between central banks and the
that the central bank will do everything in its body politic. This is especially the case for
power to allow surviving post-crisis financial America’s Federal Reserve – long the most
institutions to earn their way back to recov- powerful central bank in the world, yet at
ery. Unwinding the yield curve subsidy is yet the same time, the one monetary authority
another critical consideration in evaluating that played the greatest role in condoning
the efficacy of the asymmetrical post-crisis and nurturing the Era of Excess that nearly
pattern of the policy interest rate. brought the world to its knees.
This financial crisis has unmasked some Over the past 75 years, the US Congress
of the most serious policy blunders by central has intervened on several occasions to refo-
banks since the 1930s. While the so-called cus America’s monetary authority, and now
sub-prime crisis and the severe global reces- needs to do so again. For example, Fed
sion it spawned have many culprits, none policy blunders are widely viewed as central

to the Great Depression. In response, the its policy rate higher than price stability and/
Employment Act of 1946 was enacted; this or full employment mandates might oth-
required the Fed to aim its policy arsenal erwise require.5 In such frothy climates, the
toward avoiding a repetition of the massive monetary authority would also be required
unemployment that occurred in the 1930s. to exercise greater regulatory discipline to
Then came the double-digit inflation of the manage the capital adequacy of financial
1970s – another outgrowth of poor mon- institutions, as well as the leverage of return-
etary policy – and the Congress passed the seeking borrowers.
Humphrey-Hawkins Act 1978 (more for-
mally known as the Full Employment and Policy rate power
Balanced Growth Act 1978), which added Central bankers typically object to this
price stability to the Fed’s mandate. Now, approach. Both Ben Bernanke and Alan
after a decade of asset bubbles and related Greenspan have argued that the surgi-
saving and current-account imbalances, the cal precision of regulatory policies is more
Congress needs to step in again – this time appropriate to deal with asset bubbles than
adding“financial stability”to the Fed’s exist- the blunt instrument of the policy interest
ing dual mandate.4 rate. In the end, it may not be a question of
How would this work? Like full employ- either/or – but more a strategy of using both.
ment and price stability, the concept of Regulatory action – to say nothing of
financial stability is very much open to inter- the central bank’s bully pulpit – can send an
pretation. One thing it should not entail important message to market participants.
would be setting price targets for key asset But the policy rate is a far more powerful
markets. Instead, financial stability criteria enforcement mechanism. The point is not
should reflect a combination of quantitative to prick every bubble that arises but to inter-
asset pricing and valuation metrics, together vene when excesses in asset markets give
with an assessment of asset-related linkages rise to dangerous distortions to the real side
to the expansion of debt and the risks of of asset-dependent economies.
imbalances in the real economy. And that, of course, was precisely the
case in the period leading up to the sub-
‘Bow to the wind’ prime crisis, when bubble-dependent US
There were few doubts of an equity bubble consumption and homebuilding activity
in the late 1990s, or more recently of a con- ended up surging to nearly 80 per cent of
fluence of property and credit bubbles. Nor total GDP. In such instances, using the blunt
were there any doubts that such bubbles had instruments of monetary policy to arrest the
important spill-over effects into the real side outsize excesses of bubble-prone economies
of the US economy. is both appropriate and desirable.
Should such situations arise in the future, Yes, such pre-emptive moves could well
as they undoubtedly will, a financial stabil- entail a“growth sacrifice”– an economy that
ity mandate would require the central bank would grow slower than a more free-wheel-
to“lean against the wind”– in effect, setting ing approach might otherwise suggest. But

the growth that would be sacrificed was systemic risks are identified, addressed and
artificial from the start. Moreover, if handled appropriate measures implemented.
correctively – namely, early enough – such In essence, systemic risks are all about
a sacrifice need not entail a recession. The spill-overs – across financial institutions,
resulting growth shortfall would be far pref- asset markets, financial products, and econ-
erable to the severe downside of wrenching omies. By definition, no one central bank can
post-bubble adjustments in financial mar- address these complications alone. It would
kets and asset-dependent economies such be like putting pressure on one end of a water
as those that are now playing out. A financial balloon. In an increasingly interconnected
stability mandate offers a far more robust world, systemic risk regulators all need to
framework than the current ad hoc scheme be on the same page in this critical aspect of
for evaluating the hows and whens of the policy formulation and implementation. To
exit strategy. Under the prevailing asymmet- do otherwise runs the risk of a fragmented
rical approach that plays to the downside of approach to global risk management and
post-bubble growth and inflation risks, exit regulation – creating market-specific oppor-
strategies are invariably delayed – thereby tunities for “regulatory arbitrage” that could
setting the stage for yet another round of well end up exacerbating global imbalances.
ever-mounting excesses.
Under a financial stability mandate, New framework needed
there would undoubtedly be more symme- Recent G-20 summits in London and
try to the exit strategy – forcing the authori- Pittsburgh suggest that global leaders want
ties to weigh the perils of asset and credit to get serious about establishing a new glo-
bubbles against the costs of the growth sac- bal policy and regulatory architecture. If that
rifice. That may well mean a more rapid nor- were the case, then collaborative consulta-
malisation of monetary and fiscal policy than tions between national authorities in the
previous policy regimes might have oth- area of systemic risk assessment would be
erwise suggested. While that is not exactly an important place to start.
a riskless approach in today’s fragile post- Yet it is not enough to discuss systemic
crisis climate, I believe it is worthy of serious risks periodically at high-profile meetings
consideration. such as G-20 summits. A new framework
needs to be established that explicitly incor-
Global implications porates international policy co-ordination
The financial stability mandate would also into the global architecture. Such an effort
empower central banks to take on the new may well require a global systemic risk man-
and important responsibility of systemic ager to co-ordinate the surveillance and early
risk regulators. This is one of the new areas warning responsibilities that would mitigate
of focus in the post-crisis debate on which systemic risks.
there is a broad consensus. The key here, This functionality should reside in an
like in so many macro issues, lays in execu- international organisation – either the Bank
tion – specifically, the mechanisms by which for International Settlements (BIS) or the

International Monetary Fund (IMF). But it hard at work in crafting their own individual
should be delegated to the professional staff approaches to global issues.
of the BIS or the IMF who would then need This mismatch reflects a dangerous
to be insulated from any pressures from presumption – that the best global policies
their politically-selected boards of directors. are the sum of the best national policies.
This could be an important transformational Nothing could be farther from the truth.
step for the G-20 – converting the rhetori- A new and expanded policy mandate is
cal flourishes of periodic communiqués into not a sure-fire fix for all that ails a post-crisis
ongoing operational capabilities. world. Nor is it an inoculation against future
crises. But it is an important step in the right
Contentious issue direction. In the rush to regulatory reform,
A robust global architecture demands noth- the vengeance of a polarising populism has
ing less if the world is ever to cope with sys- fixated on the compensation of risk takers as
temic risks and the global imbalances they the major post-crisis remedy. Yet it will take
spawn. The global implications of the post- far more than that to create a sounder finan-
crisis exit strategy have recently become an cial system.
increasingly contentious issue of debate. Risk-taking was excessive, not just
That’s especially the case these days in devel- because of misaligned bonus incentives, but
oping Asia, where liquidity driven surges in also because the prices of leverage and risky
equity and property prices are worrisome, to assets were set far too low by misdirected
say the least. central banks. New proposals for pay guide-
This has sparked yet another global lines, regulatory consolidation, or counter-
blame game. Asians pin the excesses on cyclical capital provisioning will work only
reckless liquidity injections made in America if they are set in the context of the clearly
and Europe. The West blames it all on defined goals and principles of financial
Chinese currency policy. While there is some stability.
validity to each line of reasoning, the dispute
goes back to the deep-rooted global imbal- Learning the lessons
ances that lie at the heart of this crisis. Learning the lessons of this crisis is an exer-
This is a classic example of why a glo- cise in shared responsibility. Like the rest of
balised world needs global policy-making us, regulators, politicians, and central banks
architecture. The G-20 cannot take on hardly deserve special dispensation from a
responsibility for avoiding crises without critical reappraisal. In the end, they must be
having a clear understanding of how to held accountable for their failed stewardship
manage post-crisis exit strategies. of the financial system. They allowed the
A failure to address the global dimen- bedrock of policy discipline to be supplanted
sions of a financial stability mandate would by the ideology of self-regulation – the very
be a major impediment for global rebalanc- last thing that increasingly complex financial
ing. Yet that’s exactly the direction the world markets and asset-dependent economies
is headed. National governments are now needed. Never again should the authorities

have such open-ended discretion. I have notion that the world has once again been
argued that the rules-based approach of a engulfed by the proverbial 100-year tsunami.
new financial stability mandate for central This all too convenient justification is
banks and regulators must be a key ele- nothing more than a cop-out by those who
ment of the post-crisis financial architec- were asleep at the helm during the Era of
ture. At the same time, I would be the first Excess.Yes, cycles of fear and greed date back
to concede that the ideological corruption of to the inception of the market economy.
financial stewardship was a symptom of the And those powerful animal spirits were very
ever-seductive excesses of the growth of the much at work this time, as well.6
political economy.
In what has been dubbed the ‘Era of Micro remedies
Excess’, this was premised on the mistaken But I take strong issue with the apologists
belief that financial engineering – namely, who claim that little could have been done
using a credit bubble to borrow against a to avoid the devastating repercussions of
property bubble – could create a new and the so-called subprime crisis. Instead, there
lasting period of vigorous growth in the glo- is compelling reason to hold the stewards
bal economy. It’s easy to blame the United of the financial system – especially those in
States but the entire world was more than Washington as well as those on Wall Street –
delighted to go along for the ride. accountable for much of the blame.
In free-market systems, the body politic
Insatiable appetite renders the ultimate judgment on matters of
Yes, bubble-dependent American consum- governance. The emphasis above has been
ers led the way on the demand side of the on monetary policy and, specifically, on a
equation. But export-dependent econo- new mandate for central banks. That is not
mies in Asia and even Europe were equally meant to take the place of other regulatory
delighted to sustain their growth impera- reform proposals that have been offered
tives by producing the goods that fed the in recent months. But as the debate now
insatiable appetite of the American con- unfolds, I worry that too much attention
sumer. Nor was there much of a complaint is now being focused on micro remedies –
from resource-dependent economies in the ignoring the macro issues that have come to
Middle East, Australia, New Zealand, or a head in this wrenching period of crisis and
Canada. recession.
It was the ultimate virtuous circle – one
that unfortunately depended on the folly of Cultural extremes
virtual consumption and the reckless policies In that same vein, politicians and policy
that spurred such excesses. makers face a number of other key macro
In short, this crisis arose out of the challenges. The choice between the quick fix
timeworn quest for a shortcut to economic and the heavy lifting of global rebalancing
growth. It didn’t have to happen. I categori- is especially critical. It is tempting to recre-
cally reject the “inevitability excuse” – the ate the old strain of economic growth that

got the world into serious trouble in the first a necessary – but not sufficient – condition
place. for a more robust post-crisis architecture.
Why not, for example, let Americans Our problems also have a very important
go back to excess consumption and the human dimension – namely, they are an
Chinese revert to saving and exporting? outgrowth of the poor judgment that was
After all, as many argue, both societies are endemic in a reckless era of self-regulation.
culturally inclined toward those extremes. I By purging the governance of the sys-
don’t buy that logic for a second, but I cer- tem of untested and misdirected ideological
tainly concede that there is a compelling biases, the authorities will be much better
political expediency in maintaining such a positioned to avoid the dangerous interplay
status quo. between asset bubbles and global imbal-
Nor should politicians be let off the hook ances in the future.
in seeking artificial insulation from mount-
ing economic pressures through trade fric- Political vision
tions and protectionism. These risks are No, I do not harbour the illusion that such
particularly worrisome in the current climate. steps will banish the threat of financial cri-
Ultimately, it boils down to a choice between ses in the future. But to the extent the body
the collective interests of globalisation and politic rises to the occasion, the inevitable
the self-interests of“localisation.” In times of next crisis should be far better contained
prosperity and low unemployment, bellig- than this one.
erence on trade policy can be dismissed as This raises the biggest question of all: Do
political posturing. politicians have the vision and the courage to
look beyond their normal short-term hori-
Policy blunders zons and make the tough choices that could
But with exceptionally high unemploy- provide a longer-lasting cure for a crisis-torn
ment in the aftermath of a severe recession world? This could well be the biggest test of
and a weak recovery, politicians are likely all for us all in the aftermath and recovery
to remain under serious pressure to protect from the recent crisis.
increasingly beleaguered workers. The risks This is not an impossible task. It takes
of protectionist policy blunders are espe- focus and a rigorous analytical framework
cially worrisome in the aftermath of the to pull it off – and, yes, the courage to incur
Great Crisis. Only through a better under- enormous political risk. I remember all too
standing of globalisation – especially today’s well the widely presumed impossibility of
strain that is now bearing down on long- curing the Great Inflation of the late 1970s
sheltered white-collar knowledge workers and early 1980s.
– can the body politic avoid such dangerous
temptations.7 Only way out
In the end, we can’t delude ourselves into Policy makers and politicians were utterly
thinking that the lessons of this crisis rest convinced that inflation was deeply
solely in new rules and regulations. They are entrenched in the institutional fabric of the

system – a system that appeared unwilling that provides comparable political cover for
to pay the price for the cure. Paul Volcker an assault on asset and/or credit bubbles
begged to differ. And with great courage, and the imbalances that they spawn in the
he led the assault that broke the back of real economy. The mandate shaping US
inflation. macro policy is seriously in need of a major
It will take a similar approach – and reworking.
an equally heroic leader – to face up to the
imperatives of the exit strategy. A failed exit Brave new era
strategy that is compromised by the political With a new mandate would come a
economy of growth only risks another – and new compact between Wall Street and
even more serious – crisis in the future. The Washington. And that is long overdue. In the
growth sacrifice of an early exit is the only brave new era of self-regulation, the scale
way out. and complexity of Wall Street turned out to
It must be managed wisely and judi- be a breeding ground for destabilising sys-
ciously – and with great sensitivity to the temic risks.
innocent victims of this crisis and recession. The policy and regulatory pendulum
It is time to break the daisy chain of asset now needs to swing the other way. And
and credit bubbles – and the global imbal- there is good reason to believe that this proc-
ances they spawn. If we fail, there may not ess in now under way. But there is always a
be another chance. risk that the post-crisis response will be too
extreme, shackling the US financial system
Volcker’s ‘symbolic’ role and ultimately hobbling American competi-
The prominent role of Paul Volcker in the tiveness. Wall Street still excels in providing
post-crisis policy debate is symbolic of what effective tools for credit intermediation that
appears to be a basic flaw in the American are essential to productivity-enhancing allo-
strain of the political economy of growth. cation of capital. This role needs to be pre-
Volcker’s assault on inflation some 30 years served at all costs.
ago occurred only because the US body While Wall Street deserves its fair share
politic said “enough.” Through passage of of blame for the Great Crisis, so does
the Humphrey-Hawkins Act of 1978, the Washington. Predictably, politicians, policy
Fed then had the political cover it needed to makers, and regulators were all delighted
focus on price stability as an explicit objective during the boom. Equally unsurprisingly,
of monetary policy. they are not so thrilled with the bust and
The single mandate, which up until then consequent fallout.
had focused and aligned policy towards the
objective and achievement of full employ- Recipe for instability
ment, needed to be modified in response Yet the populist blame game offers little in
to a major shock to the system – runaway the way of a constructive remedy. A more
inflation. Yet there is nothing in the current basic realisation is needed: growth for the
dual mandate of America’s central bank sake of growth is a recipe for instability at

best and disaster at worst. In the Great Crisis ary 3, 2010. Bernanke was even more explicit in making
of 2008-09, the world came very close to the this point in an extended interview with the editors of
once unthinkable worst-case scenario. Time that accompanied his recent selection as ‘person
That takes us to that undeniably sticky of the year’. The Fed Chairman said: “I don’t think that
point where the rubber must meet the road monetary policy was a particularly important source of
in the post-crisis era: Recognition of the pos- the crisis.” See www.time.com December 16, 2009.
sibility of a growth sacrifice – whether it is an 3 This shows up very clearly in the income statement
outgrowth of inflation control or financial of US banks over the 1999 to 2002 period. Over that
stability – must be incorporated more explic- time frame, loan-provisions for FDIC-insured commer-
itly into political economy of growth. cial banks surged from $21.8 billion in 1999 to $48.2
That remains the most critical challenge billion in 2002; however, that $26.2 billion increase in
in the aftermath of the Great Crisis and loan write-offs was more than offset by a $44.4 billion
Recession. And it defines the fulcrum on increase in net interest income from $192 billion in
which Wall Street and Washington will need 1999 to $236.4 billion in 2002.This earnings buffer was
to take a careful look at new approaches to very much an outgrowth of the Fed’s post-equity bub-
both regulatory and monetary policy. ble yield curve steepening tactics. In the current cycle,
A more sustainable financial system – to it is much more of an uphill battle. While yield curve
say nothing of a more stable and safer global steepening helped boost net interest income by $16.7
economy – demands nothing less. • billion in 2008, that was more than offset by a $95 bil-
lion spike in loan-loss provisions from $57.4 billion in
Editor’s note 2007 to $152.4 billion in 2008.
The publisher would like to thank Morgan 4 Not surprisingly, the US Congress has now weighed
Stanley Asia and the Reserve Bank of India in with a major legislative initiative that would, in effect,
for allowing the Journal of Regulation & Risk punish the Federal Reserve for its dereliction of duty in
North Asia to print an edited version of this the years leading up to the Great Crisis. While the bill
paper, originally presented by Stephen S. proposed by US Senator Christopher Dodd, Chairman
Roach, on February 12, 2010, at the bank’s of the Senate Banking Committee, would strip the Fed
conference in Mumbai, the theme of which of much of its existing regulatory authority, it does not
was: “Challenges for Central Banks in the address the need for a financial stability mandate in shap-
Context of the Crisis”’. ing monetary policy decisions.
5 See William R. White, “Should Monetary Policy Lean
References Against Credit Bubbles or Clean Up Afterwards?” Based
1 See remarks by Paul A. Volcker before the Statutory on remarks made at the monetary policy roundtable at
Congress of the European People’s Parties in Bonn, Ger- the Bank of England on September 30, 2008.
many, December 9, 2009, as well his testimony before 6 See George A.Akerlof and Robert J. Shiller,Animal Spirits:
the Banking, Housing and Urban Affairs Committee of How Human Psychology Drives the Economy, and Why
the US Senate on February 2, 2010. It Matters for Global Capitalism, PrincetonU Press 2009.
2 See Ben Bernanke, “Monetary Policy and the Hous- 7 See Stephen S. Roach, “Perils of a Different Globalisa-
ing Bubble,” speech before the Annual Meeting of the tion” in The Next Asia: Opportunities and Challenges of
American Economic Association, Atlanta, Georgia, Janu- a New Globalisation,Wiley 2009.

Regulation
Risk orientation in regulation

and supervision
FINMA’s Patrick Raaflaub & Gabe Shawn
Varges* detail how the new Swiss supervi-
sory authority is setting its priorities.
RARELY does a supervisory author- local industry players, politicians and the
ity have an opportunity to rethink its public. A variety of considerations – among
fundamental mission and approach. others a desire to configure a well-posi-
This is an opportunity which we at the tioned supervisory authority that is more
Financial Market Supervisory Authority able to deal with cross-sectoral issues and
(FINMA), Switzerland’s new integrated with more complex and internationally
financial services regulator, are currently active players – led to the approval of the
having and which we highly value. recommendation to put under one roof the
banking/securities, insurance, and money
The materialisation of this opportunity is laundering authorities.2 Previously, these
taking three main forms: First, how do we authorities were separate even though
define who we are and what we wish to good co-operation existed among them.
accomplish? Second, what do we expect
of the companies that we supervise? Third, Twist of history
how do we go about carrying out our regu- It is an interesting twist of history that the
latory and supervisory work? idea for a combined Swiss regulator came
A common theme in each of these areas together increasingly during a time when
is risk, as we will demonstrate in this article. financial markets were under severe strain
While by itself not a complete guidepost, following the collapse of the overleveraged
risk serves as a key driver in shaping our ‘new economy’in the 2001-2003 period and
approach, our priorities, and our expecta- that the resulting product (FINMA) came
tions of what the companies that we super- into existence in the middle of another
vise should be doing. financial crisis.3 Indeed, FINMA’s birth in
Given the importance of financial serv- January 20094 coincided with the intense
ices in the Swiss economy,1 the question of activity being pursued in many jurisdic-
how best to regulate and supervise the sec- tions, including Switzerland, to stabilise
tor has long been of central interest among financial markets following the failures at

Lehman Brothers, AIG, and other financial of even more importance, is defining, con-
institutions. In Switzerland, major efforts sistent with such mandate, the authority’s
became necessary to address capital and strategic goals and priorities for addressing
other weaknesses at one of its two largest the immediate and long-term risks of the
banks, a task which straddled precisely the industries and companies it oversees. An
months immediately prior and following equally critical task is fashioning the archi-
the inception of FINMA. tecture, governance, managerial approach,
and culture that will help the supervisor
‘What if’ questions execute and deliver on its goals.
While the seeming coincidence indicated While Article 5 of the law governing
above may have taken time away from FINMA broadly sets out its formal brief,6
some items on our ‘first 180 days to-do- FINMA is given considerable room to deter-
list’ – such as optimising our organisational mine how it will operate. This is consistent
structure5 – it also served to symbolically with FINMA’s status as an independent
remind both us as regulators and the mar- institution established under public law.
ketplace of why robust, well-prioritised This status not only allows FINMA to set
supervision is indispensable. During this its priorities and make its supervisory deci-
time we often remarked that one element sions free from political influence but gives
of a supervisor’s role is to imagine what it functional and financial independence7,
could go deeply wrong with a given market, including the ability to determine required
product or seemingly solid financial institu- resources, recruit staff, and set compensa-
tion. Being conscious of the ‘way down’ part tion. The latter is critical to be able to attract
of the potential downside is not a sign of and retain quality staff with the right skills
pessimism. It is a reflection of being realisti- and experience.
cally aware of the full risk spectrum. As an integrated supervisor, FINMA’s
Beyond the more formal techniques of scope is expansive. This is both a chal-
stress testing and scenario planning, this lenge and an advantage. FINMA supervises
mindset also helps the supervisor to ask banks, insurers, stock exchanges, collective
the tough ‘what if’ questions, probing into investment schemes, securities dealers and
the improbable all while recognising that other financial intermediaries. The broad
little economic gain can be had without an nature of this remit means that FINMA
appropriate degree of risk taking. We think must cast its eye across a large landscape, be
this is a healthy outlook, one which we attentive to a plethora of issues simultane-
hope more boards of directors and control ously, and appropriately deploy resources.
functions of companies are adopting. The breadth of FINMA’s mandate is
also a plus. Not only does it lead to oppor-
Setting priorities tunities for leveraging horizontally and for
One matter is the formal powers and tasks otherwise optimising supervisory resources,
that an enabling law provides a supervisory but it provides FINMA with a more com-
authority. Another matter and, in some ways plete view of the financial marketplace.

We believe this is particularly valuable in In 2009, seven strategic goals were set. The
light of the increasing interdependencies considerations behind these priorities are
across borders, markets, sectors, and even touched on later in this article. It is worth
products. Indeed, prudential oversight can pointing out that a foremost objective – and
be hampered when regulators see only a one facilitated by FINMA being a new insti-
corner – their corner – of the playing space. tution – was to set the right tone as we pon-
We are finding that being under one roof dered where we wished to be many years
is helping us ‘scope out’ the full field and down the road and what should be the key
to identify and harness the interplay of its multi-year drivers.
various players. While some might call this
a macro view, we prefer to simply call it a Market stability, integrity
better vantage point for the whole market One clear theme emerged: to be able
and for each constituent component. to address the formal goal of protecting
“creditors, investors and insured persons”,
Checks and balances FINMA should give, above all, attention to
To help us advance our mission, and do the stability and integrity of the market and
so in accordance with the principles of the financial system. We felt that to better
good governance, FINMA’s structure com- protect each individual creditor, investor
prises an independent Board of Directors and insured person, FINMA in conjunction
(all external, non-executive members), a with the Swiss National Bank and other
Director or CEO and an Executive Board. important government agencies has to help
The members of the Board of Directors are increase systemic stability and the crisis-
appointed (and terminated if necessary) resistance of the financial market and its
by the Swiss Federal Council. The Director major players. Therefore, limited resources
is appointed (and terminated if necessary) could be prioritised where possible toward
by the FINMA Board of Directors with the this goal, rather than toward more individu-
Swiss Federal Council having the right to alised, but less systemically impactful activi-
object on both counts. ties, such as direct handling of consumer
The appointment and dismissal of the complaints or consumer education.9
other members of the Executive Board Several years from now we would hope
require the approval of the FINMA Board to be in a position of higher prudential
of Directors. Each of these elements is part effectiveness, with better economic and risk
of checks and balances integral to FINMA’s analytical capabilities. We feel that these
governance, as is the fact that FINMA is ulti- along with our more traditional skills and
mately accountable to the Swiss Parliament tools could help us better understand the
and is subject to external audits from the market context in which our supervised
Swiss Federal Audit Office.8 companies operate and identify earlier eco-
An initial and vital task for FINMA’s nomic risks that they may cause, they may
Board of Directors and Executive Board was transmit, or of which they may become
to articulate FINMA’s strategic direction. victims. Taking the recent financial crisis as

an example, it would have been helpful for more effective and efficient regulation and
regulators worldwide to have had a deeper supervision. This does not mean that we
grasp of the complexity behind the various will neglect any responsibility given to us by
linkages surrounding AIG (and Lehman law. Nor does it mean that we will not give
Brothers) and the risks that these repre- attention to problems at an individual com-
sented. Even without going into the detail pany level or focus only on large companies.
of what is precisely being measured, the What it does mean is that we will
IMF’s depiction below of these10 provides a increasingly give more proportional and
good sense of the complexities. risk-adjusted attention to a matter by taking
In better understanding the market, we into account the size, intensity and dura-
feel we will also be in a better position to tion of its potential impact on the market
devise smarter tools and to calibrate more or on important sectors of the market. This
exactingly when and how intensely to use includes looking for material risks but also
them. Our long-term goal is not more but for smaller risks that together could come to
Figure 1 A Diagrammatic Depiction of Co-Risk Feedbacks

constitute a material risk. A risk focus is not risk policy which needs to be communi-
a one-dimensional search for single colos- cated widely within the organisation and
sal threats. It necessarily includes looking on which employees should be regularly
for dependencies and correlations among trained. Another expectation of companies
risks of all sizes since these could combine that we supervise is that they have sound
to also create significant exposures. remuneration systems. We do not, nor think
it wise, to regulate the size of remuneration,
Core expectations but we do require the Board of Directors of
Being better aware of what we expect of our large companies to ensure that remu-
ourselves also helps us to fine-tune our neration: a) does not create incentives
expectations of those we supervise. While to inappropriate risk-taking, b) is subject
there are various ways to express this, the to proper governance, and c) is properly
following summarise core expectations risk-adjusted.11
which encompass a good deal of what is We give great weight to remuneration
behind FINMA’s various regulatory and systems as we are aware that highly enticing
supervisory initiatives: financial incentives can sometimes trump
culture and even controls. The prospect of
[1] Avoid engaging in any activity for which a high bonus can, if only subconsciously,
you do not know or understand the risk. make a risk seem less risky and ultimately
For us the key pre-condition here is not compromise the objectivity of risk assess-
models or technical prowess; rather, it is cor- ments. In our circular on remuneration
porate culture. Having a risk-aware culture we specifically require Board of Director
that allows for open discussion on risks and leadership on compensation as well as the
opportunities and for challenging as needed involvement of control functions in the
is an essential ingredient for avoiding taking design, implementation, and monitoring
risks unawares or, as the saying goes, `on a of the overall compensation system. This
wing and a prayer’. is intended to create a healthy check vis-à-
As the recent financial crisis has shown, vis management. Conflicts can arise when
another key factor is active oversight of risk those who stand to gain the most from a
by the Board of Directors. As the highest gov- remuneration system craft and administer
ernance organ of the company, the Board of it without adequate oversight or controls.
Directors should set the tone for prudent risk
taking, for exercising due diligence, and for [2] Don’t pursue any activity for which you
ultimately saying no to risks whose contours are not equipped to effectively manage the
or implications are not well understood. risk.
The Board of Directors should be part While the will to act sensibly on risk is
of the discussions regarding risk propensity important, will by itself is insufficient. A
and tolerance and should formally define company may be aware of a risk but still be
or approve the firm’s risk appetite. It should unprepared to properly manage it, or it may
also ensure that this becomes part of the overestimate its capacity to manage it.12 For

example, the recent financial crisis showed considerations; takes into account the
that some companies were not fully aware of long-term interest of the company;
the risk of investing in subprime mortgages • taking steps to effectively manage the
or CDS. It also demonstrated that some risk, not just to catalogue and observe
companies were aware of the risk but were it (a weakness we sometimes per-
not in a position to hedge, reserve against, or ceive among certain risk management
otherwise manage it. In some instances this functions);
was due to the company not fully under- • testing periodically the design and oper-
standing the forces that could affect the value ational effectiveness of risk systems;
of these instruments, not appreciating how • having robust controls in place to reduce
far these investments could fall, or overesti- the chance of deviation from agreed-
mating their company’s ability to counteract upon risk measures occurring without
or cope should such a fall occur. necessary governance approval, includ-
ing that of the Board of Directors for
Skills, tools and resources potentially material risks;
Therefore, we expect the companies we • ensuring that appropriate action is taken
supervise to be equipped to manage risk by in respect of personnel, no matter how
making continuing investment in the devel- senior, who disregard risk, compliance
opment and maintenance of the right skills, or other important company policies.
tools and resources as well as the right gov-
ernance and controls. This includes: [3] Don’t look at any risk in isolation …
• having properly positioned, authorised, search for interconnectedness.
and resourced risk and other control As stated earlier, supervisors need to increase
functions; their ability to see the larger context of risks
• ensuring that the identification of risks and spot earlier possible linkages among
is early and thorough; seemingly disparate risks. So too do com-
• communicating identified risks on a panies. This kind of ‘connecting the dots’
timely basis to the right persons and requires concerted effort and has to be sup-
company structures consistent with ported by proper reporting and assessment
a sound governance process – this systems.
includes ensuring that the Board of The ability to spot linkages rests on
Directors is promptly informed of mate- having an enterprise-wide view so as to
rial risks and takes necessary action; know what other parts of the company
• ensuring that the assessment, modelling are doing and which risks each is taking
and decision on each risk is objective or is exposed to (failure to do this prevents,
and sound; takes into account a healthy among other things, proper measuring of
measure of remote probabilities, includ- risk concentrations, as happened at some
ing through proper scenario and stress companies during the recent financial cri-
testing; is not only quantitative but sup- sis where subsidiaries or units had expo-
plemented by appropriate qualitative sures in the same product area or to the

same counterparty without each knowing environments necessarily require equal
this or without this being fully grasped at focus on what lurks over the horizon. Some
the group or headquarters level). It also risk management functions may tend
includes understanding the correlation of to overweigh already known risks at the
the various categories of risks and taking expense of not doing enough to consider
into account company-specific but also what might still come. A company asking
industry and market-wide risks. itself questions such as those outlined below
Connecting the dots also means having can help ensure that it is also positioned for
the capacity to effectively aggregate all risks understanding tomorrow’s, not just yester-
to form and keep an up-to-date total risk day’s risks: Does our company have a dedi-
picture faced by a company. This is critical cated emerging risks group? How robust
for decision-making. Without it a singular are its analyses in identifying trends and
risk may appear acceptable, but when such future threats in all relevant areas? Are the
risk is examined in light of the aggregate risk necessary functions and people represented
picture it may show that accepting it would on such body so as to have as many angles
tip adversely the total risk-reward scale. as possible with regard to the future land-
This also highlights the importance of hav- scape? What percentage of our risk efforts
ing a well-defined (and Board-approved) is dedicated to identifying and preparing for
risk appetite and risk limits. emerging risks? How much time does the
Board of Directors spend in this area? What
[4] Learn from past mistakes but also invest forward-looking risk indicators do we have
more effort anticipating the risks to come. in place? Are our company’s business strat-
To a supervisor there is nothing more dis- egy, risk appetite, and risk management
heartening than to see a company repeat resources adjusted early enough in antici-
previous errors or misjudgments. This can pation of emerging risks?
occur when identified shortcomings are
not followed by prompt remediation and Risk as a ‘prioritiser’
lessons-learned type of training. It can also A risk approach also helps FINMA carry
happen when earlier missteps are forgot- out its regulatory and supervisory work.
ten as a result of changes in the company’s The risk focus not only helps prevent that
Board of Directors or senior management. In a major threat, current or future, is missed;
this respect control functions play a special it is of benefit also as a prioritisation tool for
role as they usually have more continuity managing. It can help order agendas and
and are therefore better positioned to help facilitate discernment of difficult choices in
prevent corporate amnesia. the face of competing needs.
As indicated earlier, FINMA is working
Look to the future to make headway on the challenge of how to
But while the past is an important refer- regulate and supervise more effectively and
ence point, rapid changes in the social, more efficiently. This forces us to seek a bal-
technological, economic, climatic, and legal ance between prevention and enforcement

and between principles and more concrete the “who” question. On which institutions
rules where needed. Principles create more should we focus our attention?
flexibility at the potential cost of less predict- The main goal of this is not to create any
ability, while rules create more predictability hard-and-fast lists but to move more in the
at the potential cost of unnecessary rigidity direction of using our time and resources
and possibly more burden on companies. on any institution in closer proportion to its
In tackling these challenges, we have found risk significance. Factored in are many ele-
that a risk-guided approach helps us make ments, such as the sector and activities in
better decisions on the trade-offs involved. which the institution is active, its size and
It is also contributing towards shaping pol- financial significance, its complexity, and
icy responses on three specific fronts: the its overall risk profile. The risk profile may
what, the who, and the how in respect of be influenced not only by the kinds of risks
regulation and supervision. the company takes but how prepared it is to
manage such risks.
The ‘what’ This type of approach is allowing us to
Increasingly, we are using a risk approach to set certain priorities. For example, we are
help define specific areas that merit super- giving heightened focus to institutions that
visory and, if needed, regulatory attention. are of such magnitude that their instability
Some examples of these are: activities that or failure could have major or even systemic
may be particularly susceptible to causing economic impacts; groups, conglomerates,
or transmitting market-disrupting or mar- and other particularly complex companies;
ket-distorting risks or to being subject to companies involved in particularly risky
such risks; capital adequacy and solvency; products or markets, including on a cross-
liquidity risk; funding and credit risk; invest- border basis; companies that repeatedly
ment risk; cross-border risk; overall market, come uncomfortably close to the minimum
operational and other important risks. capital or other financial regulatory stand-
The risk approach is also allowing us to ards; and companies displaying material
look at more qualitative areas such as the weakness in governance or deficient risk
soundness of the basic business model and management or control systems.
strategy of a company; company prepared- As we advance further, we hope to be
ness on crisis management and contingency able to refine further our approach to more
planning (for various market scenarios and reliably capture, for example, those compa-
even for any potential winding down of any nies showing patterns of financial instabil-
of its businesses); and the quality of stew- ity or which could pose a concentrated risk
ardship of the company, including a strong such as by having a particularly high market
Board, capable managers, and effective share in a key market segment.
control functions
The ‘how’
The ‘who’ Finally, we are finding that the risk
The risk approach is also helping us with approach is also helping us define priorities

with regard to the ”how”, i.e. the ways and companies to better self-govern and volun-
means by which we should regulate13 and tarily pursue‘best practices’; rules and guide-
supervise. This may be expressed as clusters lines, such as those related to compensation,
of efforts. These clusters are: where mere encouragement may not suffice;
• Calibrating the nature, frequency and inspections and audits (some of which may
intensity of supervision. This relates to be outsourced to third parties); warnings and
predicating any important supervisory sanctions, such as suspension or withdrawal
activity on the risk profile of the company of the right to operate.
in question, its complexity and other fac- Another important aspect of the “how”
tors discussed earlier. It involves adjust- relates to two areas: internal and external
ing accordingly the supervisory activity, leveraging and networking. As suggested
its timing, and its degree of intensity. It earlier, the very conception of FINMA as
also includes endeavouring to supervise an integrated regulator rests on the premise
economic activities of similar nature and that integration can facilitate leveraging of
similar risk in a more consistent way, resources. In FINMA’s 14-month existence
whether the activity is located within a we have found that being integrated is of
banking or an insurance entity. As risks value not simply to optimise resource usage
shift, this approach permits more a tai- and increase cost efficiency but also to cross-
lored and nimble response and quicker fertilise internal know-how and explore
shift of focus. areas where greater supervisory or regula-
• Deploying the right tool from a wider tory consistency across sectors could bring
arsenal of tools. This is about aiming to value. We are using mixed project teams
match more closely a tool with the per- staffed with members from the various areas
ceived problem or need. For example, we supervise. We aim to make our work on
there may be a need to better monitor the supervision of groups more cross-secto-
companies, to more forcefully enforce, to ral. Our effort on the so called‘too-big-to-fail
cover regulatory gaps, or to induce cer- challenge’16 looks at banks and insurers. Our
tain conduct among companies. Each of commitment to governance and risk man-
these types of needs necessitate careful agement is demonstrated through having
review in order to select the most appro- put in place senior-level FINMA-wide func-
priate tool.14 tions for each of these areas.
The range of tools include risk rat-
ing companies and using tiering or peer Feedback and ideas
schemes to monitor or analyse compara- Leveraging and networking is also criti-
tively similarly-positioned companies; vari- cal for FINMA at an external level. This
ous quantitative and qualitative reporting takes the form of close co-operation locally
requirements, assessments and stress-test- with Swiss governmental and supervisory
ing, some designed to help provide a type of authorities, such as the Swiss National Bank
early-warning radar;15 focused risk dialogues and our Federal Department of Finance. It
with companies; sensitising and encouraging also includes working with industry groups,

academia, and many others who can supply our mission and our work. We are finding
us feedback and ideas. that having a risk focus is invaluable for mak-
Another critical external dimension to ing better decisions in respect of the institu-
our work is our international efforts. We are tions we supervise and the ways to optimise
keenly aware that global and regional chal- our work as a supervisor.
lenges cannot be resolved solely by national Some insights that our predecessor
solutions. We also know that in order to be authorities already had gained – such as the
effective, the development of international imperative of having a true consolidated
standards requires the active participation of view of groups and conglomerates – have
national regulators and that a national regu- been reinforced during our first 14 months
lator stands to improve its own performance of operation. Other newer insights have
by learning from what regulators in other emerged, such as a deeper appreciation of
countries are doing. the need (a) to be earlier aware of material
An essential component of FINMA’s risks building up in the financial system or
strategy is therefore to contribute to key moving across borders and (b) to look at risk
international bodies and initiatives on a pri- not only on company-by-company basis but
oritised basis. We are active members and on a basis that aggregates the risks of indi-
in some cases hold leadership positions on vidual companies and seeks to spot trends,
expert task forces and committees of inter- commonalities, and potential impacts on
national bodies such as the Basel Committee critical parts of the market, on the financial
on Banking Supervision, the International system as a whole, or on public trust and
Association of Insurance Supervisors, the confidence.
International Organization of Securities If we can improve the above capabili-
Commissions, and the Joint Forum. Equally ties – all while continuing carefully selected
importantly, we pursue close co-operation activities from a more traditional supervisory
with regional bodies, such as the European approach – we feel that we will be better
Union and its various bodies, and with able to fulfil our responsibilities to custom-
specific countries through regular bilateral ers, shareholders, and other relevant stake-
dialogues. These efforts helps FINMA to holders of the companies we supervise. We
develop a more complete understanding of will also advance further toward meeting
the risk picture regionally and globally and another responsibility we are given by law,
of the tools and remedies available to regula- namely contributing to “the general func-
tors in this regard. tioning of the financial markets” and “the
competitiveness of Switzerland as a financial
Conclusion centre”.17 •
As an integrated regulator, FINMA is still
young but our experience so far suggests we End notes
have embarked in the right direction. Being * Mr Raaflaub is CEO of FINMA. He holds a Doc-
new and being one team under one roof is torate in Economics and Political Science. Mr.Var-
helping us to rethink, reform, and advance ges is Head of Governance of FINMA. He holds

M.A. and Juris Doctor degrees and is an Attor- markets.” Article 5, Act on the Swiss Financial
ney-at-Law. Photograph by Edouard Rieben. Market Supervisory Authority, 2007.
1. Banking and insurance represent about 11 per 7. Financial independence is also furthered by the
cent of the Swiss GDP and five per cent of fact that FINMA does not receive state money.
employment. Assets of Swiss banks and insur- It covers 100 per cent of its expenses through
ers are some 8.9 times the level of GDP. Source: fees and assessments paid by supervised entities
OECD, Economic Surveys, Switzerland, Vol. under a “user pays” principle.
2009/20, December 2009, Supplement 2, p. 59, 8. FINMA also has its own internal audit and com-
referring to figures as of end 2008. pliance functions, and has now created FINMA-
2. The bodies merged were the Swiss Federal wide governance and risk management functions.
Banking Commission (SFBC), founded in 1934; 9. Supervisors in some jurisdictions which have
the Federal Office of Private Insurance (FOPI), tended to devote a disproportionate part of
founded in 1874; and the Anti-Money Laundering their time and resources to these kinds of indi-
Control Authority, founded in 1997. vidualised efforts are now facing various kinds
3. Two main taskforces were involved in formulating of pressures, including the possibility of losing
recommendations.The first (the Zufferey Expert responsibility for prudential oversight.
Group) offered numerous new regulatory and 10. The illustration is from the International Mon-
organisational options and completed its work etary Fund, “Assessing the Systemic Implications
in November 2000. One option considered was of Financial Linkages”, Global Financial Stability
integrating the then existing supervisory authori- Report,April 2009.
ties. A second taskforce (the Zimmerli Expert 11. Switzerland was one of the first countries to
Group) was commissioned by the Swiss Federal act in response to the April 2009 Financial Sta-
Council in November 2001.This group delivered bility Board Principles for Sound Compensation
its recommendations in three instalments in Practices. FINMA issued a draft remuneration
2003, 2004 and 2005. circular for public comment already in June 2009.
4. Parliament approved the Federal Act on the The final version of the circular was issued in
Swiss Financial Market Supervisory Author- October 2009 and came into force on January
ity (FINMASA) on June 22, 2007. The Federal 1, 2010. In 2010 FIMMA is focusing on super
Council ratified the implementing provisions for visory activity to advance and monitor company
FINMASA on October 15, 2008, with the Act preparation for implementation of the Circular,
entering into full force on January 1, 2009. which is fully required as of January 2011. For
5. This is a task on which we continue to work, others institutions it is recommended that they
though we were able by September 2009 to take into account the principles of the Circular
already achieve one milestone: streamlining the for their remuneration practices as best practice
management structure and reducing the number guidelines.
of members on the Executive Board to improve 12. A recent FINMA survey would suggest that
decision-making and achieve other efficiencies. some financial institutions may tend to be more
6. FINMA’s purpose is described as “protecting optimistic about their overall risk, as well as gov-
creditors, investors, and insured persons and ernance, preparedness than a more objective
ensuring the general functioning of the financial assessment would support.

13. Specific regulatory elements in place or being at various international organisations as
contemplated by FINMA on the banking, securi- well as in some countries to identify each
ties and insurance sides are beyond the scope of of those financial institutions which are of
the present article. such size or economic significance that it
14. Some of these supervisory instruments are set would be difficult for national or interna-
out in Articles 29-37 of the Act on the Swiss tional authorities to allow it to go bankrupt
Financial Market Supervisory Authority, 2007. or otherwise fail for fear of major damage
15. Examples of this include our tools for stress test- to the local or international financial system.
ing on the banking side, the Swiss Solvency Test The efforts include contemplating possible
for insurers and the Swiss Qualitative Assess- measures to help prevent any such failure, to
ment. The latter is currently limited to insurers. reduce the impacts if a failure were to occur,
See “Governance, Risk Management, and Internal and to prepare for a more orderly wind-down
Controls at Swiss Insurers: Observations from should the viability as an on-going concern of
the first Swiss Qualitative Assessment”, February any such institution become compromised.
1, 2010 on www.finma.ch 17. Article 5, Act on the Swiss Financial Market
16. The term refers to efforts being pursued Supervisory Authority, 2007.

North Asia
J ournal of reg
Articles & Papers

Issues in resolving
ulation & risk
north asia
systemically important
Volume I, Issue III,
financial institution
Autumn Winter 2009-2010
Resecuritisation s Dr Eric S. Rosengren

in banking: major
challenges ahead
A framework for
funding liquidity Dr Fang Du
in times of financial
Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
from bad to worst
Derivatives: from
disaster to re-regulati Stephan Schoess,
on
Black swans, market Professor Lynn A. Stout
crises and risk: the
human perspectiv
Measuring & managing e
risk for innovative Joseph Rizzi
financial instrumen
Red star spangled ts Dr Stuart M. Turnbull
banner: root causes
of the financial crisis
The ‘family’ risk: Andreas Kern & Christian
a cause for concern Fahrholz
among Asian investors
Global financial
change impacts David Smith
compliance and
risk
The scramble is on
to tackle bribery David Dekker
and corruption
nce Who exactly is subject
Complia
Penelope Tham & Gerald
Subscribe
to the Foreign Corrupt
Legal &
Li
Practices Act?
Financial markets
remuneration reform: Tham Yuet-Ming
one step forward
Of ‘Black Swans’, Umesh Kumar
stress tests & optimised & Kevin Marr
to the
risk management
subject
Challenging the
value of enterprise David Samuels
actly is
risk management
Who ex s Act? Rocky road ahead
Practice
for global accountanc Tim Pagett & Ranjit
Jaswal
y convergence
Corrupt
The Asian regulatory Dr Philip Goeth
Rubik’s Cube
Foreign Yuet-Ming
, DLA Alan Ewins and Angus
Ross
er, Tham mines the
In this pap consultant, exa Asia.
g Kong FCPA in
Piper Hon ious effects of the
pernic h
y of whic
anies – man legis-
reds of comp anies. The US
by hund comp even-
Practices were Fortune 500 these scandals by
Corrupt to
today
Foreign in the e responded FCPA in 1977.
The US nnings ial latur s to the
its begi enacting
the
provision
A), has rgate Spec the
Act (FCP n the Wate o- tually e are two main isions, and
era, whe ntary discl e Ther bribery prov SEC and the
Watergate called for volu mad the anti-
r had – Both the
Prosecuto companies that ard FCPA nting provisions. J) have juris-
to Rich Justice (DO
sures from contributions aign. accou
rtment of the SEC
ble US Depa . Generally, s and
questiona presidential camp the FCPA provision
Nixon’s
1972 diction over accounting against issuers
revealed cutes the s as s
these disclosures ents prose bribery provision ative proceeding
paym anti-
However, ble dom
estic d the administr and
questiona had been channelle civil and companies
not just through prosecutes ry provisions
funds that n business. whereas the DOJ anti-bribe
but illicit nts to obtai ti- s for the edings.
n governme to subsequent inves individual proce
Risk mana
gement
to foreig Exchange through criminal
mation led rities and
The infor that
the US Secu h revealed
gatio ns by
) whic to ery prov ision makes it Of ‘Black
ion (SEC
Commiss issuers kept “slus
h funds”
cal The
anti-brib bribery provision ing Swans’, stre
and politi ’s anti- ey or anyth -
optimised ss tes
risk manag ts &
many US n officials The FCPA ide mon
s to foreig offer or prov als (“foreign”meanor
pay bribe illegal to n offici obtain
parties. up with
a volun tary
of value
to foreig
) with the
inten t to
business
to ement
later came h any cor- “non-US” directing Standard &
The SEC e under whic payments ing business, or for Poor’s
programm outlines the
disclosure eported
which self-r the SEC was
illicit
given
retain
n. can inclu
de sponsor- positive bene David Samuels
poration any perso of value of a holi- fits of bank
with likely ation, use
perated it would Anything ent, testing on stress
and co-o ance that The resul
t l and educ employm the bottom
mal assur nt action. for trave of future It is ea is no
an infor enforceme $300 ship home, promise s. Ther big challe line.
than USD s and meal a robust appro nge for banks to build
be safe from sure that more (a mas-
day
drink
disclo ents unts, of worst-case ach to managing the downturn
was the ble paym e disco capital adequ
questiona been mad 147 scena
stress risk uncov
million in in the 1970s) had by definition,
are triggered
rios that, almos er risk conce acy progra
ntrations and ms to
unt t encies,
sive amo unlikely or
unpreceden by apparently to and; applyi risk
ng these impro depend-
Nort h Asia ted drive
Risk events. busine vemen
lation & through perfor ss selection – for examp ts
of Regu However, solvin
Journal g the adjust mance analys le,
fying the risk problem of is and risk-
concentratio identi- into ed pricing that takes
Contact
cies that give ns and depen account. stress test results
rise to worst- den-
vital if the case outcom
industry is es is Top-le
vidual banks to thrive – vel oversight
are and if indi-
past two years to turn the lessons Buildin
to competitive of the proces g a more robust and
Banks that advantage. s for uncovering compr ehensive
tackle the issue threats to the
be lauded by
investors and head-on will prise is clearly, in part, enter-
coming years regulators ance challe a corporate
Christopher Rogers
nge.The board govern
most impor
of industry
recuperation
in the must
have the motiv and top execut -
tantly, will ives
tained profita be able to delive and, scrutinise and ation and
the clout to
bility gains. r sus- able call a halt to
that are well Meanwhile, activities if apparently
placed to take banks term these are not profit-
consolidatio advantage interests of in the longer
n process need of the the the enterprise -
can understand to be sure intended risk or do not fit
the risks embed they profile of the
portfolios of ded in the But contrary organisation
General Secretary
potential acquis ing to popular .
To improve itions. corporate govern opinio n, improv-
ance is not
and strengthen enterprise risk manag tion of puttin
g the ‘right’ just a ques-
investor confid ement
banks can take ence, we think board members in executives
and
the lead in appropriate place and
Better board three related incent giving them
and senior areas: ives.
sight and executive over- For the bank
contro to make the
agement; re-inv l of enterprise risk sions when
they are difficu right deci-
igorated stress man- busine
testing and ss growth lt, e.g. when
or when risk looks good
Journal of managemen in the upturn,
Regulation t looks expen
& Risk North sive
Asia
163

Regulation
Regulation, supervisory lessons

from Japan since the 1990s
Former BoJ Policy Board member, Kazuo
Ueda, details significant changes to Japan’s
regulatory environment in recent years.
THE regulatory and supervisory struc- change regarding financial crisis resolution.
ture of Japan’s financial industry has The FSA, unlike the MoF until 1997, cannot
been a fairly simple one. Until the late make independent decisions on the use of
1990s, most regulatory and supervisory public money for resolving financial crises.
functions belonged to the Ministry of In order to fill the gap, a committee headed
Finance (MoF). Following widespread by the Prime Minister – the Financial Crisis
criticisms, fiscal policy and financial Management Council – now exists to make
administration was separated. decisions on the use of exceptional measures
involving fiscal resources during a financial
The Financial Supervisory Agency (FSA) crisis. I will return to this point later.
was established in June 1998 and since then
has been in charge of inspection and super- Broader interpretation
vision. Furthermore, drafting of laws and In addition to the FSA, the BoJ has carried
other rule-making functions concerning the out inspections (on-site examinations) of
financial system were moved from the MoF the financial institutions that have current
to the FSA in July 2000. Similarly, the plan- accounts with the BoJ. The BoJ law stipu-
ning and execution of measures directed at lates that the bank can enter into contracts
crisis prevention and containment went to with financial institutions to carry out on-site
the FSA after disbandment of the Financial examinations in order to fulfill its objective of
Reconstruction Committee. the maintenance of financial system stability.
One exception to this structure is that The BoJ seems to interpret the role of inspec-
the FSA delegates the surveillance of secu- tion more broadly. The BoJ (2004) states that:
rities and financial futures markets to “The Bank conducts on-site examinations
the Securities and Exchange Surveillance and off-site monitoring of financial institu-
Commission. The transfer of the finan- tions that hold current accounts with the
cial regulatory responsibility from the MoF Bank, so that it can assess their business
to the FSA has created one substantive operations and financial condition, and,

where it is necessary from the perspective The government injected capital to 57
of maintaining financial system stability, financial institutions – 12.4 trillion yen, of
urge institutions to make improvements. which at the time of writing about 75 per
The Bank uses the information it acquires to cent has been returned. The government
improve the payment and settlement sys- also created programmes to purchase assets
tem, and to better understand the financial from financial institutions; the purchases
intermediary function of financial institu- amounted to approximately 10 trillion yen
tions when conducting monetary policy.” and most of this has been recovered when
factoring in the inclusion of capital gains.
Off-site monitoring In the early 1990s the government, effec-
It is noteworthy that non-bank financial tively the MoF, employed a scheme whereby
institutions such as securities companies, healthy financial institutions could take over
money market dealers and securities finance troubled ones by providing financial assist-
companies have accounts with the BoJ and ance from the DICJ that was within the
are thus more likely, than in the case of the payoff cost of troubled financial institutions.
absence of transactions with the BoJ, to As the crisis turned more serious in the mid-
obtain lender of last resort status from the 1990s, it obviously became difficult to find
BoJ. The practice of regular on-site exami- financial institutions capable of taking over
nations and the possibility of LLR lend- those in trouble. Consequently, the govern-
ing have provided the BoJ with significant ment decided to establish bridge banks to
power to collect a diverse range of informa- which private banks and the BoJ provided
tion on financial institutions through off-site capital.
monitoring.
After the burst of the stock price and land Safeguarding deposits
price bubble in the early 1990s, the Japanese In 1995, in order to contain depositor fears
financial system experienced serious stresses about the health of financial institutions,
for more than a decade.The bad loan-related the government also announced the policy
losses of depository institutions amounted to to protect all deposits. Furthermore, again
about 110 trillion yen; some 20 per cent of in 1995 the government decided to use tax-
GDP. As a consequence, many banks, secu- payers’ money to resolve the crisis emerging
rities and insurance companies went under. with a group of non-bank financial institu-
Of the 110 trillion yen losses of deposi- tions called Jusen (special housing loan cor-
tory institutions, the government took a loss porations). The government also took the
of 10.4 trillion yen and the banks assumed decision to use taxpayers’ money to resolve
the rest. This in turn meant writing down problems with credit unions. At this stage,
bad loans out of current profits and provi- however, the use of public money was not
sion of financial assistance to debt holders extended to larger financial institutions. In
of insolvent banks by the Deposit Insurance general, public opinion was fiercely opposed
Corporation of Japan (DICJ) that collected to“assisting”financial institutions.
insurance premiums from banks. In the autumn of 1997, the failure of a

medium-size securities company, Sanyo council, determines if exceptional measures
Securities, triggered a panic in Japan’s finan- – such as capital injection, to full protection
cial system and led to the failure of three of all liabilities, and temporary nationalisa-
other financial institutions in the same tion of financial institutions – are necessary
month. Public opinion quickly reversed and to contain potential systemic risks. As a
turned in favour of using public money for result, the BoJ involvement in crisis manage-
resolution of the financial crisis. ment is now in principle confined to lending
to solvent but illiquid financial institutions,
Public money lending to financial institutions receiving
The government decided to use pub- public support based on the decision of the
lic money to resolve problems concern- Prime Minister, and lending to DIC with
ing larger financial institutions by injecting government guarantee.
capital. Despite the initial round of capital What can we say about the performance
injection, which was in total 1.8 trillion yen of Japan’s regulatory structure, then, in light
to 21 banks, stresses in the financial system of the history of Japan’s financial system and
did not dissipate and the Long-term Credit regulatory response during the past two
Bank of Japan and Nippon Credit Bank faced decades?
serious attack by the market. In 1998, the To begin with, it may be appropriate to
government decided to temporarily nation- discuss why regulators were unable to check
alise these banks and injected a second the formation of a stock and land price bub-
round of capital, amounting to 7.5 trillion ble, especially, the land price bubble. After all,
yen, to 15 large banks in early 1999. Stresses the MoF possessed huge power to influence
continued into the early 2000s, but finally the behaviour of Japanese financial insti-
with significant bad loan write-downs and tutions; it was effectively supervising and
economic turnaround, the financial system monitoring all financial institutions.
finally began to emerge from the crisis in the
mid-2000s. Uneven deregulation
In response to the normalisation of the There is a view that blames the uneven pace
financial system, the government discontin- of financial deregulation that had taken
ued the programme to protect all deposits. place in Japan since the late 1970s. Large
Since 2005, protection by deposit insurance sales of government debt and other forces
has been confined to transactions bal- led to significant liberalisation of the bond
ances and other deposits (up to 10 million market, while liberalisation of retail deposit
yen). Separately, in order to cope with sys- rates and the availability of other financial
temic risks, the government established the instruments lagged behind. Large compa-
Financial Crisis Management Council that nies left banks and went to the bond market
consists of the Prime Minister, the Minister of to raise funds, but deposits continued to flow
Finance, Commissioner of the FSA, the Chief into banks. Rigorous separation of banking
Cabinet Secretary and the BoJ Governor. and securities businesses remained in place.
The Prime Minister, after discussions at the Banks competed fiercely for loans. An easy

way out was to focus on land and equity- banking system. During the mid-1990s,
related loans. While these factors appear to banks and insurance companies lent 13 tril-
go some way toward explaining the forma- lion yen to seven Jusens, of which six trillion
tion of the bubble, it still leaves unanswered yen became non-recoverable. Lending by
the failure of the regulatory authorities to banks and insurance companies to other
check the growth of real estate and equity- non-banks was even larger at around 50
related lending at an early stage. trillion yen. A significant portion of this was
also channelled into real estate related loans.
Failure to prevent bubbles The MoF was surely aware of the situation,
Hoshi and Okazaki (2002) point out that but once again did not crack down on the
while the MoF was aware of the growth of problem.
these loans, it was more worried about ris- The bank inspections failed to find major
ing real estate prices and the consequences problems with bank behaviour. After its fis-
for income distribution than the possibility of cal year 1988 inspection – in which the MoF
financial instability arising from the possible emphasised the significance of its activities
burst of the bubble. The MoF did ask finan- as they were seen to place importance on
cial institutions to slow down real estate risk management by financial institutions
lending in 1985. Since 1986, the MoF had – the MoF concluded that “on the whole,
ordered financial institutions to report regu- credit risk is prudently and properly man-
larly on real estate related loans. In 1987 at aged.” However, financial institutions had
the request of the MoF, financial institutions enormous exposure to the property market.
agreed to voluntarily contain the growth of
such loans. But lending and the rise in prop- Non-bank lending effect
erty prices continued. It appears that the As has been argued, in addition to direct
MoF did not employ strong enough policy lending by banks to real estate and construc-
measures. tion companies there were indirect expo-
Aggravating the situation was a Japanese sures through non-banks. Furthermore,
version of the “shadow banking system.” significant portions of loans in general were
Banks lent huge amounts to non-bank backed by land as collateral. Neither the reg-
financial institutions which in turn lent ulator nor financial institutions seem to have
to residential and commercial real estate taken the trouble to calculate the vulnerabil-
related projects. Included among these were ity of financial institutions to changes in land
the so-called Jusen, special housing loan prices. Kumakura (2008) points out that the
companies that started as entities specialis- director of the BoJ’s inspection department
ing in residential mortgage loans but later warned in 1986 that financial institutions’
expanded business to the extension of com- lending was too concentrated within a small
mercial mortgage loans. As the MoF’s guid- number of industries. However, there is no
ance to contain the rise in real estate related sign that such a concern led to significant
lending became tougher, financial institu- action by the BoJ.
tions increasingly lent through the shadow Japan’s experience during this period is

an example of the difficulty of taking proper two years later – in May 1989 and by August
care of tail risks. After all, with the excep- 1991 moved the discount rate up to six per
tion of 1974, land prices in Japan had never cent. As with the MoF’s policy of restricting
declined in the post-war period. credit to the real estate sector, the BoJ’s rate
Any statistical analysis that relied on past increases seem to have come a little too late
data would have placed a negligible prob- and the absolute size of the rate increases
ability to the possibility of significant land may have been too large.
price declines. It was not easy for inspec- To summarise, both the MoF and the BoJ
tors to warn of such risks of declines in land recognised the relationship between easy
prices. In the end, the manifestation of a monetary conditions and rising asset prices.
“tail risk” hit the Japanese financial system They seem however, to have been fairly opti-
extremely hard. mistic about the long-term upward trend
of asset prices. In other words, they were a
MoF dictat captive of“this time it’s different”psychology.
The MoF did employ a very strong weapon Even when they worried about this, as in the
in March 1990 when it ordered banks to limit BoJ’s case in 1987, they did not take decisive
the growth of loans to the real estate indus- action at an early stage.
try to the growth of total loans. This appears It also appears that either the depart-
to have exerted strong negative effects on ments within the MoF and the BoJ in charge
property prices, but probably came too late of bank inspection were not equipped with
and may have made the downturn in land ways to assess, measure, investigate, research
prices overly severe. and model systemic risks; and when they
During all this, the question that needs became concerned as the situation deterio-
to be asked is what was the BoJ doing on the rated, their views were not effectively used in
monetary policy side? As is almost always macroeconomic policy-making as the risks
the case with large bubbles; this bubble became more apparent and tangible.
turned on easy monetary policy. Responding
to the deflationary effects on the economy Period of inaction
of yen appreciation in the mid- to late In retrospect, the mid-1990s can be seen as a
1980s, the BoJ lowered the discount rate period when the authorities could have acted
five times from 5.0 per cent to 2.5 per cent more decisively and promptly to resolve the
between January 1986 and February 1987. emerging financial crisis but failed to do so
In its economic outlook report in the sum- and allowed the vicious cycle between a dys-
mer of 1987, the BoJ noted that“we have to functional financial system and a stagnating
be very cautious about the risk that the rise economy to play itself out.
in asset prices (which is supported by easy Looking at the BoJ, one is struck with
monetary conditions) will jeopardise income the slow speed with which the BoJ recog-
equality and the health and stability of the nised the effects of the deterioration in the
economy in the long run.” The BoJ, how- financial system on the economy.The Nikkei
ever, started the process of raising rates only 225 declined by more than 50 per cent by

October 1990. The fall in the index of urban the public and this made it even more dif-
land prices only emerged more in 1992, but ficult to use taxpayers’ money further for the
the BoJ must have known the state of the resolution of the crisis.
property market at a much earlier stage. The amount decided upon was too small
Looking at the BoJ’s economic reports, how- to address the problems of the entire finan-
ever, one does not find reference to the nega- cial system. More importantly, the decision
tive effects of the balance sheet deterioration was not quite made with a view to resolving
of financial institutions on the economy until the crisis but rather to cater to the interests of
the fourth quarter of 1993. a specific segment of the financial industry.
This seems to have reflected the superior-
Failure of the hawks ity of the fiscal policy wing of the MoF over
Anecdotal evidence suggests that the pru- the financial regulatory wing at the time and
dence wing of the BoJ was more concerned provided an example of the risk of having a
about the state of the financial system and financial regulator within a fiscal authority.
a possible vicious cycle between the finan- Stresses in the financial system became
cial system and the economy. However, this even more serious in the late 1990s and led
did not seem to have affected the monetary to the closure of many financial institutions.
policy wing before it became too late. A clear trigger of all this was the failure of
On the MoF’s side, the key issue was the Sanyo Securities in November 1997.
delay in the decision to use public money Karube and Nishino (1999) provide a
to resolve the financial crisis. As previously detailed account of the process in which
explained, the absence of the decision to use attempts to bail out Sanyo all failed. I would
taxpayers’ money until the mid-1990s led to like to focus on the decision by the BoJ to not
the reliance on “taxes” on financial institu- extend an LLR loan when Sanyo failed.
tions and for the BoJ to construct schemes
to address bad loan problems and naturally Sanyo’s default
limited the scope of such operations. Sanyo declared bankruptcy on November
A significant turning point came when 3. The BoJ had known in advance that this
the deterioration of the balance sheets of would create a default in the interbank
Jusen became very apparent in 1995. The market. Of course, such information was
banking bureau of the MoF was still work- made available through on-site and off-site
ing on the assumption that no taxpayers’ examinations and through a wide range
money could be used to address the situa- of market intelligence as the central bank.
tion. Powerful lobbying activities by agricul- According to Karube and Nishino (1999),
tural banks that would have been hit hard the BoJ’s Financial and Payment System
without the use of public money forced the Department was worried about sys-
budget bureau to make a decision to use 685 temic risk implications of Sanyo’s default.
billion yen in taxpayers’money to resolve the The Credit and Market Management
situation. Non-transparency in the process Department, however, thought differently.
of decision-making was criticised harshly by Sanyo was a small player in the interbank

market and the amount of default would described by Karube and Nishino is very
accordingly be small. Any spill-over effect of interesting.
the default that might arise could be coun- Key members of the BoJ were still scepti-
teracted by the BoJ’s fund provision. After cal of the view that a bankruptcy of a secu-
all, Japan was undergoing the Big Bang of rities company could be a systemic event.
the financial system and the market needed They also worried about the possible effect
to take care of itself. The BoJ made no seri- of such a loan on the balance sheet of the BoJ
ous move to extend an LLR loan to protect if it defaulted. In the end, the then governor,
creditors of Sanyo. In a discussion on the Yasuo Matsushita, decided to provide a loan.
legal aspects of the scheme to close Sanyo It now seems clear that the default of
in the Tokyo District Court, when the chief Sanyo Securities was a systemic event.
judge asked if it was not appropriate to use Despite its close dealings with securities
LLR, the BoJ clearly said it was not. companies and market intelligence, the BoJ
was unable to correctly foresee what was to
Serious problems come. Again, it seems that it is not enough to
Sanyo’s default was in fact small – one bil- be close to the market. One needs to be able
lion yen in the call market and 8.3 billion yen think about all sorts of interconnectedness,
in the JGB repo market. For a few days the interdependencies and relationships within
market remained calm. In the second week the broader financial system.
of November, however, market rates started Having said this, I would add that it was
to move up (see Fig. 1, page 96) and financial a good thing that the BoJ had the power to
institutions that were perceived to have provide LLR loans to securities companies.
some serious problems no longer were able As I later argue, had the liabilities ofYamaichi
to borrow in the market. On November 14, a Securities not been protected, its bankruptcy
city bank – Hokkaido Takushoku Bank – was would have created a serious stress in the
unable to meet the reserve requirement. international financial system.
On November 16, the decision was
made to transfer key businesses of Hokkaido More orderly approach
Takushoku to Hokuyo Bank. The BoJ It has to be said that had the Bank of Japan
decided to provide an LLR loan to Hokkaido rescued Sanyo’s creditors, the outcome may
Takushoku until the transfer was complete. not have been that different. Many of the
Sanyo’s default in the repo market spilled financial institutions that went down would
over toYamaichi Securities, which now found have gone down anyway. But the proc-
it difficult to raise funds in the repo market. ess could at least have been slightly more
This firm went down on November 24 and orderly.
on November 26, Tokuyo City, a regional There have certainly been many mer-
bank also went under. In both cases the BoJ its for the participation in the resolution
provided LLR loans. scheme of failing financial institutions of
The discussion within the BoJ on whether the central bank that has good intelligence
or not to provide an LLR loan toYamaichi as on the market; that is, there is a positive

externality for a central bank to combine 1998. To summarise, after Yamaichi’s fail-
monetary policy-making and financial ure, the BoJ understood well the systemic
stability responsibilities. risk implications of the failure of these large
financial institutions and the BoJ’s moves
Resolute action during the resolution of the failures seemed
Despite the initial hesitation to extend an to have kept international repercussions at a
LLR loan to Yamaichi, once the decision was minimum.
made it was well executed. The emergency There remains a key question concern-
liquidity assistance by the BoJ was carried ing the BoJ’s involvement in financial stabil-
out via Fuji Bank. This was because Fuji was ity issues; has it been useful for monetary
a main bank for Yamaichi and held accounts policy decisions? The information generated
for the entire Yamaichi group, not just about the BoJ’s involvement in financial sta-
Yamaichi itself. Such a decision was made bility issues has been an important factor in
possible by the BoJ’s close knowledge of the the Bank’s monetary policy decisions. The
structure of transactions in the market. More results of on-site examinations of financial
importantly, the BoJ explained carefully to institutions are regularly reported to the pol-
the global financial community – especially icy board. Results of the interviews carried
overseas authorities – the consequences out by BoJ staff with financial institutions
of the liquidity assistance for global credi- and non-financial firms are brought to the
tors to Yamaichi; the overall intention of the attention of the board.
assistance would be an orderly unwinding of
the existing positions and that the Japanese Monthly reports
authorities would bear any losses incurred When banks experience serious liquid-
fromYamaichi’s failure. ity problems, as in the period 1997-2003,
Long-Term Credit Bank of Japan (LTCB), board members are informed of the amount
which was temporarily nationalised in of daily deposit outflows from the banks.
October 1998, was more active in the glo- Since the early 2000s, the prudence wing of
bal financial market. It had a huge presence the BoJ has reported monthly to the board
in the interbank and derivatives markets. on the state of the financial system, cover-
Market participants feared that the nation- ing such topics as the capital adequacy ratios
alisation of LTCB might constitute an event of financial institutions, their funding liquid-
of default in the contracts of transactions in ity risk and the exposure to interest rate and
these markets. If so, serious turmoil could stock price risks. Since 2006, the Financial
have developed in the markets. The BoJ Stability Report has been published twice a
worked closely with ISDA and explained to year, immediately prior to publication of the
the market that loans from DICJ would cover board’s bi-annual economic outlook.
all possible losses in the markets. As a result, Some examples will be discussed later.
disruptions in the market were avoided. The The BoJ lowered the policy rate by 25 basis
BoJ assumed a similar role in the case of the points on September 9, 1998. The minutes
failure of Nippon Credit Bank in December of the board meeting on that day show that

board members were significantly influ- monetary policy from policies to maintain
enced by the state of the financial system. financial stability. One example where the
Thus, a member noted that“financial institu- knowledge of the market has affected the
tions were adopting stricter screening criteria BoJ’s operations is the BoJ’s heavy reliance on
for firms’ borrowing of operating funds and fund provision in the term markets. This was
firms had become nervous about extending certainly necessary during the quantitative
trade credits.” easing period, but already in late 1998 the
BoJ supplied huge amounts of term funds in
Cautious lending attitudes an attempt to reduce term premiums gen-
Another member expressed the view that erated by stresses in the financial system.
“the availability of funds to small firms was Similarly, in response to the re-emergence of
limited due to the cautious lending attitude term premiums in the second half of 2007,
of financial institutions. ”Turning to mone- the BoJ was one of the first central banks that
tary policy, one member argued for a reduc- increased term fund supplying operations
tion in the policy rate by saying that“a credit on a large scale.
crunch was observed in some parts of the On the other hand, despite inputs from
economy,” and suggested that “the Bank’s staff close to the financial system, the BoJ’s
injection of ample funds into the markets economic outlook did not seem to have
would relax the cautious attitude of financial reflected the severity of the global financial
institutions.” turmoil as early as one would have liked.
Hopefully, such remarks reveal that Although the BoJ’s economic outlook report
members had access to information on mar- flagged the risk of serious deterioration of
kets and financial institutions beyond what the global financial system and its effect
can be inferred from movements in inter- on the global economy, it did not turn very
est rates and other asset prices. It is hard to bearish until October 2008.
judge, however, whether such information
on the state of the financial system affected More difficult job
members’ economic outlook and hence The Financial Stability Report was unable to
affected monetary policy, or had direct effects forecast what was to come, even as early
on monetary policy. as spring 2007. However, it was pointing
With the decision to lower the policy out the risk of increases in real estate non-
rate to 0.25 per cent, the BoJ started to seri- recourse loans as early as in 2005, which
ously feel the constraints created by the zero needs to be commended in the light of what
lower bound on nominal interest rates. As a subsequently happened. Have international
result, the BoJ increasingly moved into the considerations made the job of the MoF/
area of what people now call credit easing. FSA/BoJ more difficult? It is to be argued that
Needless to say, implementing credit easing on a number of fronts they certainly have.
policy properly requires substantial knowl- There is first the level playing field
edge of the state of the financial system. It issue between domestic and foreign finan-
also becomes rather hard to distinguish cial institutions. Since the late 1980s, the

regulators have taken pains to persuade securities company version of DIC, the Japan
Japanese banks to increase their capital Investor Protection Fund, but refused to do
adequacy ratios on the one hand and, on the so and established a separate fund. It was
other, endeavoured to prevent the interna- not until 2002 that the two funds merged.
tional minimum capital requirements from Systemic risks now easily transcend
becoming excessively high for Japanese national boundaries. As explained in the
banks. Consideration of the pro-cyclicality previous section, the BoJ tried hard to
problem of capital regulation might have explain and to work together with interna-
meant lowering the minimum requirements tional authorities to contain the international
for Japan during its financial crisis. However, repercussions of the failure of Japanese
such a possibility does not seem to have been financial institutions in the late 1990s.
pursued in earnest. The challenge facing the
authorities has become worse with the cur- Serious instability
rent crisis, but this is probably not the best During the past two years, Japan’s financial
occasion to go into the issue in more detail. system experienced serious instability as a
Equal treatment of domestic and foreign result of the global financial turmoil.This was
financial institutions within the domestic so, despite minimal participation of Japanese
market is also not straightforward. During financial institutions in the global credit
Japan’s financial crisis, foreign securities market binge. Financial stresses travelled
companies in Japan were asked to join the through the money market, the corporate
Figure 1. Money Market Rates in Tokyo in the fall of 1997

Money Market Rates in Tokyo
1.2
Tokuyo City Bankruptcy
0.8
Yamaichi Bankuruptcy
TIBOR3M
%
0.6
CALLRO/ N
0.4 S anyo
Bankruptcy Hokkaido
Takushoku
Bankruptcy
0.2
0
16
20
24
28
13
17
21
25
29
11
15
19
23
1
7
1/
1/
1/
2/
2/
0/
0/
0/
0/
1/
1/
1/
1/
1/
2/
2/
2/
2/
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
/1
97
97
97
97
97
97
97
97
97
97
97
97
97
97
97
97
97
97
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19

bond/CDS markets, the equity market, and among global authorities to exchange infor-
even the JGB market and the property mar- mation and step in when necessary. Japan’s
ket. The spillovers mainly came through par- experience during the past two decades sug-
ticipation of foreign financial institutions in gests there are lessons to be learnt concern-
these markets. The BoJ and the government ing the relationship between the structure
have used a number of measures to contain of financial regulation/supervision and the
such stresses. I would point out that given outcome of policies.
the spillovers which took place in the mar-
kets, prompt policy moves were necessary Moral of the tale
and that involvement of the BoJ was crucial Being an integrated regulator does not mean
for their containment. that it is a good systemic stability regulator.
During Japan’s financial crisis, its finan- There are always loopholes and the regula-
cial institutions experienced serious diffi- tor must be able to think in systemic stability
culties in borrowing in US dollars. The LLR terms. It is difficult to discern the long-term
function in this case was partially fulfilled by trend of asset prices. It is also not easy to
the MoF who lent its international reserves identify ex ante triggers of systemic risks;
to financial institutions. The BoJ also played a being alert to systemic stability issues does
role by lending yen in the term market which not guarantee good performance.
financial institutions swapped into dollars. There is a huge gap between recogni-
The terms of the swap were extremely unfa- tion of risks and policy action to improve the
vourable for many Japanese financial institu- situation. Having a systemic stability regula-
tions, obliging them to substantially curtail tor within a fiscal authority runs the risk of
international operations. financial stability policy objectives subordi-
In the context of the current crisis, finan- nated to fiscal policy objectives or a wider
cial institutions around the world experi- political interest. The information the central
enced similar difficulties. The currency swap bank collects from its interaction with mar-
market became dysfunctional. The Fed was ket participants as an implementer of mon-
obliged to step in as an international lender etary policy is useful for spotting emerging
of last resort. Such a framework is useful, vulnerabilities in the financial system and for
but it is unclear how formal it should be. the resolution of crises. And having strong
The roles assumed by authorities will not be financial stability responsibilities allow the
symmetric because the market or govern- central bank to collect huge amounts of
ments would be in need of a global vehicle information on financial institutions and the
currency or at least some international cur- market.
rency . . . and not just any currency. Such information can be used to main-
Which currency will be in demand tain financial stability, for forming economic
should depend on the situation and whether outlook or, more directly, for monetary policy.
authorities want to step in; it should also But central banks have not yet established a
depend on the nature of the problem. What formal approach to using such information
is necessary seems to be the willingness optimally on any of these three fronts. •

Cross-border regulation
Enhancing cross-border
regulation after the 2008 crash
New York State’s banking watchdog
Richard Neiman calls for closer worldwide
supervisory co-operation.
IN the wake of the financial crisis, an briefly discuss the dual banking system in
effective framework for cross-border the US and the scope of state supervision.
supervision of financial institutions The dual banking system that consists of
has become an even more compelling complementary state and federal oversight
imperative. Financial and technologi- is one of the unique aspects of the US frame-
cal innovation has rapidly facilitated work for financial services regulation; this
interconnected global markets, but our directly impacts cross-border issues. This
supervisory infrastructure has failed to dual supervisory system may seem like a
keep pace. very interesting approach, especially if you
are coming from a country with a more cen-
The idea of one supranational global tralised model. In the course of US history
regulator – whether a dream come true or a we have found a unique equilibrium in dual
nightmare – is still only imaginable. So how oversight that confers the benefits of both a
should we move forward as an international centralised and a decentralised structure.
community? What strategies will best pro-
mote financial stability through cross-border Institutional partnerships
supervision that is conducted primarily by Close interaction with local regulators at
national regulators? I believe the answer is state level provides benefits to financial
threefold: (1) Harmonisation of standards, institutions, especially those with unique
with appropriate flexibility to address local business models such as community banks,
situations; (2) Co-operation in examina- private/niche banks, or foreign banking
tion and enforcement activities, including organisations that in turn facilitate inter-
expanded use of supervisory colleges; and, (3) national trade. In New York, we charter just
Expansion of the resolution process, to pro- over 100 domestic banks and supervise
vide for the orderly unwinding of systemi- these institutions in partnership with either
cally significant non-bank financial firms. the Federal Deposit Insurance Corporation
Before elaborating on these points, I will (FDIC) or the Federal Reserve. Twenty of

our banks are members of the Federal Oversight Panel for the $700 billion Troubled
Reserve System, including industry lead- Asset Relief Program (TARP) which issued
ers such as the Bank of New York Mellon, a Special Report on regulatory reform in
Goldman Sachs, M&T Bank and Deutsche January 2009.
Bank. With this diverse supervisory per- Substantial reforms are anticipated both
spective and a well-established partnership in the US and internationally. However,
with the Federal Reserve Bank of New York, the task is so complex that we risk losing
it is no coincidence that New York State momentum. Both nations and international
also licenses most of the foreign bank- bodies must not lose the will and urgency to
ing organisations operating in the US. We reform the financial system in order to move
supervise 137 foreign branches, agencies towards the imperative for implementation
and representative offices, with more than of more effective supervision of international
US$1.6 trillion in assets – which is almost firms.
90 per cent of the nationwide assets held by A critical first step in enhancing cross-
foreign banking organisations. border supervision relates to standard-set-
ting. Greater harmonisation of standards
State level regulation will help to eliminate both the potential for
The New York State Banking Department international regulatory arbitrage by which
(Banking Department) also regulates a institutions could seek the most lax regu-
broad range of institutions, including com- latory environment, or be used in certain
mercial banks, credit unions, mortgage jurisdictional havens for criminal use of the
bankers and brokers, licensed lenders, sales financial system.
finance companies, money transmitters and The goal is laudable, but convergence in
cheque cashers. It should be noted that the rule-making embodies tension between the
US insurance industry is regulated at state benefits of uniformity and the need for flex-
level. In fact, the various states oversee a ibility, as regulators must fulfill their respon-
wider mix of institutional types than does sibility to respond appropriately to local
the federal government, which is primar- conditions. This tension can be, but need not
ily limited to the supervision of depository be an obstacle; in fact, it can even be a cata-
institutions. This breadth gives the states a lyst for progress.
distinctive perspective on market trends and
reform principles that cut across the finance Setting uniform standards
industry. The US experience of this tension through
I provide this perspective not just as a the state-federal dynamic has ultimately
state banking superintendent. I started my been a creative force. While progress has
career with the Office of the Comptroller not been strictly linear, there is a clear
of the Currency (OCC) and worked exclu- trend in terms of the structured flexibility
sively for national banks. I am involved of states to act at the local level in the con-
at national level in the regulatory reform text of mutual accountability with state and
process as a member of the Congressional federal partners. This has led to improved

industry standards nationwide. The most be seen in the implementation of the Basel II
recent example relates to consumer protec- capital framework. I thoroughly support the
tion and the scope of federal pre-emption, effort to establish international capital stan-
as in certain circumstances federal law may dards, but progress on this issue will come
override state law. The federal chartering about in stages. If we take two steps forward
agency, the OCC, took an overly broad but one step back we will still be making
interpretation of pre-emption in 2004; this progress. In the case of Basel II, the financial
in effect exempted the largest banks in the crisis has made clear that the FDIC was cor-
country from complying with higher state rect in taking one step back and insisting on
consumer protection and anti-predatory retention of the leverage ratio for the US.
lending laws. It has taken action by the US What was sometimes misinterpreted
Supreme Court in order to restore balance as intransigence has now become an occa-
which I anticipate will be further clarified by sion and opportunity to refine Basel II. Far
legislation. from frustrating international progress, this
appropriate use of regulatory discretion by
New national baseline a national supervisor actually re-invigorated
But this aberration in state-federal relations the work of creating even more effective
that was provoked by the OCC’s sweep- international capital standards, which helps
ing pre-emption policy is the exception that to ensure that we will reach our shared goal
proves the rule: there is an appropriate zone of a more stable banking system.
for local authorities to set standards above When entering into international agree-
a national floor and those local standards, ments, the ultimate question for jurisdictions
once tested, may in turn become the model with high standards is the degree to which
for a new national baseline. The states were a partial relaxation of those standards in
correct in detecting the emerging subprime the adoption of a uniform baseline would
mortgage problem and were the first to take contribute to a local increase in safety and
action through anti-predatory lending laws soundness, through the reduction of risks
and landmark settlements. stemming from other jurisdictions where
Over decades, state leadership relating uniformity would result in increased rigor.
to consumer protection issues has led to
improved national standards for the finan- Timely case in point
cial services industry with regard to product In other words, if more and less robust regu-
disclosure and protection of home equity. latory regimes meet somewhere in the mid-
Results like this demonstrate that it is worth dle in setting a new common supervisory
the effort of engaging in this dialectic proc- framework, is it still a net gain in terms of risk
ess, whether it is state-federal or among reduction for those who agree to technically
international partners. lower the bar? The question of whether the
On the international stage, a compelling US should abandon the leverage ratio for the
example of the benefits as well as the practi- sake of greater uniformity in the adoption of
cal limitations of harmonising standards can Basel II is a timely case in point.

The issue is further complicated by the such as mortgage bankers and brokers are
fact that determining whether such a net solely supervised at the state level. But the
gain in risk reduction is produced involves states co-operate in setting licensing and
a qualitative and not just a quantitative examination standards for this diverse sec-
judgment. The same supervisory stand- tor through the Conference of State Bank
ards on paper could be more or less effec- Supervisors (CSBS). There is something
tive in reducing risk and promoting stability akin to positive peer pressure in this colle-
depending upon the quality of execution. gial gathering of state regulators that is very
The right standards need to be paired with effective, and effective especially in the sense
robust examination and enforcement activi- of accountability in the implementation of
ties that are co-ordinated among home and agreed principles.
host supervisors. With most state-licensed branches of
foreign banks in the US, intrastate co-ordi-
Examination and enforcement nation is critical to minimise overlap and
Here I return to the concept of mutual reduce burden for foreign banking organi-
accountability. As with intra-national co- sations with activities that cross state lines.
ordination, effective home-host supervision For over 10 years, the states, through CSBS,
is dependent upon it. In the US the flexibility have had in place agreements, both between
that states have in order to create, examine, states and state-federal, for nationwide co-
and enforce local laws and rules affecting ordination in the supervision and examina-
the finance industry is structured through tion of foreign banking organisations. These
mutual accountability to other states and to agreements are important in streamlining
federal regulatory counterparts. This struc- the oversight process. However, more could
ture does not imply that any of the individ- be done to reduce burden for foreign banks
ual supervisors held within this covenant of operating in multiple states.
accountability is inadequate or incapable of
the task of sole supervision. Harmonising procedures
Rather, it is an affirmation that multiple I could envision additional flexibility for
regulators bring a much needed diversity of state-licensed foreign branches to oper-
perspectives to complex issues in the rapidly ate under ‘home state rules’, similar to the
evolving financial services market place. Just arrangements extended to domestic banks
as multiple judges are used in the Olympics that are chartered in another state. While
to achieve a fair score for competitors, mul- national legislation would be required to
tiple regulators yield better results in setting fully implement this, there is much that the
a robust framework for the examination states can do through CSBS and using their
process. own initiative. I am in the process of holding
In the US, state-chartered depository such discussions within California – another
institutions are subject to dual regulation state that has a large foreign bank presence
by either the Federal Reserve or the FDIC. – in order to explore opportunities to harmo-
Independent non-depository institutions nise licensing procedures.

The same type of co-operation that we with regulators from around the world and
are striving for in the US between states and we have developed very strong supervisory
the federal government should hold true at relationships with those home countries. In
international level: we need to strengthen fact, supervisory colleges may be formed as
mechanisms of accountability for operational an outgrowth of bilateral agreements; the
efficiency and vigilant supervision. That is college then creates an additional forum in
precisely what nations are doing under the which sub-groups of supervisors can form
auspices of the G-20 and the International new international connections and focus
Monetary Fund (IMF). On the front lines of on concerns common to their markets. This
bank examinations we need to more fully flexibility is one of the benefits of the super-
realise the potential of supervisory colleges visory college structure.
to enhance the quality of supervision. The flexibility of supervisory colleges
and similar voluntary oversight bodies is
Key functions well-suited as a first response mechanism to
Supervisory colleges are working groups evolving challenges in supervision. Areas in
composed of the relevant regulators of an which mechanisms for formal oversight are
international banking organisation, co-ordi- yet to be fully established include, for exam-
nated by the home country supervisors. Key ple, the over-the-counter (OTC) derivatives
functions of a supervisory college include market. The OTC derivatives market will
information sharing, assessment of cross- benefit from this oversight structure which
border risk exposures, co-ordinated inspec- can be implemented immediately. The
tions and examinations. This supervisory process of developing a formal supervisory
co-operation is increasingly important as structure for the ‘shadow banking’ system
banking organisations continue to organise also benefits from early learning which will
their operations along business lines with develop and emerge from new voluntary
the result that risk management for a New oversight structures.
York activity may be located in the home
office. Bid for transparency
While supervisory colleges cover institu- Currently, 41 supervisory bodies from 15
tions with a range of risk profiles, this cross- countries participate in the OTC Derivatives
border market surveillance is particularly Regulators Group (the Group). The Group
significant in identifying and responding to is discussing how to regulate central coun-
emerging systemic risks. terparties and data repositories and dialogue
The existence of the supervisory college includes the specific types of information
does not eliminate the need for, or prevent that should be requested of data repositories
individual regulators within the college from in order to assist with regulation of the mar-
establishing parallel mechanisms for co- ket or market participants.
operation such as bilateral agreements and Data repositories for credit default swaps
memorandums of understanding. In New and trades will bring more transparency to
York, we have close to 20 agreements in place the market and help to assess counterparty

exposures. Sub-groups have also been heel. Views on the efficacy of supervisory
formed to focus on issues of particular rele- colleges are also relevant to the debate in
vance to the individual supervisors’missions. Europe regarding the creation of expanded
I am proud of the early lead New York has EU-level authority. I do not believe it is an
taken in chartering one of the first clearing- either/or choice; supervisory colleges can
houses and the trade repository for credit provide a complement to increased co-oper-
default swaps; our participation in the Group ation through EU regulatory bodies.
will further inform our mission as well as the Proposals to develop EU-wide supervi-
movement to promote standardisation and sion that go beyond existing bodies which
disclosure for this diverse market. focus primarily on co-ordination, also
amount to a dual banking system and raise
Supervisory colleges issues that are similar to state-federal con-
Supervisory colleges are also the appropriate cerns in the US.
approach for co-ordination among jurisdic- Harmonisation of rules and consistency
tions with disparate legal and supervisory in the supervisory approach across the EU
structures that would hinder more formal will need to be accomplished while recog-
and binding approaches to cross-border nising the responsibility of member coun-
supervision. For example, I considered it tries to protect their residents. When diverse
critical to personally attend the supervisory economies need to work together for the
college in China earlier this month. New good of the region, some form of dual over-
York has recently licensed branches of the sight appears to be the natural outcome.
Industrial and Commercial Bank of China, We can learn from each other in finding the
China Merchants Bank, and the China optimal balance.
Construction Bank.
These are the first branches of banks Resolution authority
from mainland China to open in the US in Another area in which an optimal structure
over 17 years and reflect the growing trade is needed is the resolution process for inter-
between our countries and New York’s role national firms. I would like to focus on the
as a hub for global finance. The non-bind- issue of creating a resolution authority in the
ing, although still effective mechanism of the US for systemically significant non-banks.
supervisory college is the best practical fit for When faced with the failure of Lehman
engaging with supervisors from jurisdictions Brothers, the government found itself with-
such as China that have legal systems and out the regulatory structure to ensure the
other dynamics that are very different from orderly unwinding of the firm. The market
those in the US uncertainty provoked by the Lehman bank-
ruptcy is still evident. Bankruptcy proceed-
EU co-operation ings have a tendency to exacerbate market
I appreciate that some believe the non- destabilisation triggering call provisions
binding nature of the supervisory college is a that upend contractual arrangements that
critical weakness in the concept – its Achilles could otherwise have remained in place, and

simply do not provide sufficient means to a firm as a compliance discipline, especially
ensure interim operations. in identifying and aggregating counterparty
The Obama Administration and mem- risk and other contingent liabilities.
bers of Congress are supporting various While I support the concept of a living
proposals to expand resolution authority for will as part of a firm’s contingency planning
systemically significant institutions, such as – much like the liquidity contingency plan-
bank holding companies, insurance com- ning mentioned previously – it is an insuf-
panies and other non-banking financial ficient safety net in the event of a systemic
organisations. financial panic.
While the process of regulatory reform
in the US covers many fronts, the resolution Conclusion
authority issue is one of the most central. It is Effective cross-border supervision has been
a key to approaching the thorny problems of described from the domestic perspective;
the moral hazard – ‘too big to fail’ and dem- coming from a state like New York with a
onstrates the inter-connectedness of inter- broad international presence, I would offer
national financial conglomerates. the following conclusions:
Detractors characterise expanded reso- First, the progress of regulatory reform,
lution authority as a permanent bailout including the creation of new or expanded
approval for large firms, with the attendant authorities to manage systemic risk is criti-
moral hazard concerns. The opposite is true; cal – but architecture alone is not a panacea.
a proper resolution method demonstrates There are no structural shortcuts to effective
that large firms will be allowed to fail. It oversight. Countries with diverse regulatory
would also provide a way to assess firms that frameworks were all deeply impacted by the
are outside the FDIC deposit insurance pro- recent financial crisis.
gramme for implementation of a new form Second, there is a continuing role for non-
of insurance premiums commensurate with binding regulatory bodies. Strengthening
the external risks they present to the finan- the quality of these mechanisms should be
cial system. our primary focus, given the reality of diverse
This would provide additional protec- legal structures among jurisdictions that can
tions against the need to put taxpayer dollars hinder more formal associations. Structures
at risk. This is far superior to an ad hoc use such as supervisory colleges have great
of public funds in times of economic distress potential as market surveillance tools and as
and helps to counter pro-cyclical trends. stepping stones to forge closer international
ties and greater convergence in standards
‘Living wills’ and supervisory protocols.
Some have suggested ‘living wills’ as a solu- And finally, no system, no protocol will
tion to the resolution of systemically signifi- result in quality oversight of the diverse and
cant firms. In a living will, the firm outlines increasingly interconnected global financial
how it would conduct an orderly unwinding markets apart from mutual accountability
of operations. Such an exercise has value for and trust between supervisory partners. •

Macroeconomics
What we thought we knew

and what we didn’t know
The IMF’s Olivier Blanchard, Giovanni
Dell’Ariccia and Paolo Mauro, outline a
new macroeconomic policy framework.
The crisis of 2008 has forced economic inflation was stable, the output gap was
policymakers to react in ways not antici- likely to be small and stable and monetary
pated by the pre-crisis consensus on how policy did its job. We thought of fiscal policy
macroeconomic policy should be con- as playing a secondary role, with political
ducted. In this paper, the authors review constraints limiting its usefulness. And we
the main elements of the pre-crisis con- thought of financial regulation as mostly
sensus, identify those that were wrong, outside the macroeconomic policy frame-
and outline possible contours of a new work. Admittedly, these views were more
macroeconomic policy framework. closely held in academia; policymakers were
more pragmatic. Nevertheless, the prevailing
The Great Moderation (Gali and Gambetti consensus played an important role in shap-
2009) lulled macroeconomists and policy- ing policies and institutions.
makers alike in the belief that we knew how
to conduct macroeconomic policy. The cri- Central bank priorities
sis clearly forces us to question that assess- Stable and low inflation was presented as
ment. In a recent IMF Staff Position Note the primary, if not exclusive, mandate of
(Blanchard, Dell’Ariccia and Mauro 2010, central banks. This resulted from the repu-
which includes a bibliography), we review tational need of central bankers to focus on
the main elements of the pre-crisis con- inflation rather than activity and the intellec-
sensus; we seek to identify what elements tual support for inflation targeting provided
were wrong and what tenets of the pre-crisis by the New Keynesian model. In the bench-
framework still hold; and we take a tentative mark version of that model, constant infla-
first pass at the contours of a new macroeco- tion is indeed the optimal policy, delivering
nomic policy framework. a zero output gap, which turns out to be the
To caricature: we thought of monetary best possible outcome for activity given the
policy as having one target, inflation, and imperfections present in the economy. This
one instrument, the policy rate. So long as “divine coincidence” implied that, even if

policymakers cared about activity, the best institutions and aimed at correcting market
they could do was to maintain stable infla- failures stemming from asymmetric infor-
tion. There was also consensus that inflation mation or limited liability. Given the enthu-
should be very low (most central banks tar- siasm for financial deregulation, the use of
geted two per cent inflation). prudential regulation for cyclical purposes
Monetary policy focused on one instru- was considered improper mingling with the
ment, the policy interest rate. Under the functioning of credit markets.
prevailing assumptions, one only needed to The decline in the variability of out-
affect current and future expected short rates, put and inflation led to greater confidence
and all other rates and prices would follow. that a coherent macro framework had
The details of financial intermediation were been achieved. In addition, the successful
seen as largely irrelevant. An exception responses to the 1987 stock market crash,
was made for commercial banks, with an the LTCM collapse, and the bursting of the
emphasis on the“credit channel.”Moreover, tech bubble reinforced the view that mon-
the possibility of runs justified deposit insur- etary policy was also well equipped to deal
ance and the traditional role of central banks with asset price busts. Thus, by the mid-
as lenders of last resort. The resulting distor- 2000s, it was not unreasonable to think that
tions were the main justification for bank better macroeconomic policy could deliver,
regulation and supervision. Little attention and had delivered, higher economic stability.
was paid, however, to the rest of the financial Then the crisis came.
system from a macro standpoint. Core inflation was stable in most
advanced economies until the crisis started.
Keynesian glory days Some have argued in retrospect that core
Following its glory days of the Keynesian inflation was not the right measure of infla-
1950s-’60s, and the high inflation of the tion, and that the increase in oil or hous-
1970s, fiscal policy took a back seat in the past ing prices should have been taken into
two-three decades. The reasons included account. But no single index will do the
scepticism about the effects of fiscal policy, trick. Moreover, core inflation may be stable
itself largely based on Ricardian equivalence and the output gap may nevertheless vary,
arguments; concerns about lags and political leading to a trade-off between the two. Or,
influences in the design and implementation as in the case of the pre-crisis 2000s, both
of fiscal policy; and the need to stabilise and inflation and the output gap may be sta-
reduce typically high debt levels. Automatic ble, but the behaviour of some asset prices
stabilisers could be left to play when they did and credit aggregates, or the composition
not conflict with sustainability. of output, may be undesirable. When the
Financial regulation and supervision crisis started in earnest in 2008, and aggre-
focused on individual institutions and gate demand collapsed, most central banks
markets and largely ignored their macr- quickly decreased their policy rate to close
oeconomic implications. Financial regula- to zero. Had they been able to, they would
tion targeted the soundness of individual have decreased the rate further. But the zero

nominal interest rate bound prevented them importance of having“fiscal space,”as some
from doing so. Had pre-crisis inflation (and economies that entered the crisis with high
consequently policy rates) been somewhat levels of government debt had limited ability
higher, the scope for reducing real interest to use fiscal policy.
rates would have been greater. Financial regulation contributed to the
Markets are segmented, with specialised amplification that transformed the decrease
investors operating in specific markets. Most in US housing prices into a major world
of the time, they are well linked through economic crisis. The limited perimeter of
arbitrage. However, when some inves- regulation gave incentives for banks to cre-
tors withdraw (because of losses in other ate off-balance-sheet entities to avoid some
activities, cuts in access to funds, or internal prudential rules and increase leverage.
agency issues) the effect on prices can be Regulatory arbitrage allowed some financial
very large. When this happens, rates are no institutions to play by different rules from
longer linked through arbitrage, and the pol- other financial intermediaries. Once the cri-
icy rate is no longer a sufficient instrument. sis started, rules aimed at guaranteeing the
soundness of individual institutions worked
Drawbacks exposed against the stability of the system. Mark-to-
Interventions, either through the accept- market rules, coupled with constant regula-
ance of assets as collateral, or through their tory capital ratios, forced financial institutions
straight purchase by the central bank, can into fire sales and deleveraging.
affect the rates on different classes of assets, If the conceptual framework behind
for a given policy rate. In this sense, whole- macroeconomic policy was so flawed, why
sale funding is not fundamentally different did things look so good for so long? One
from demand deposits, and the demand for reason is that policymakers had to deal with
liquidity extends far beyond banks. shocks for which policy was well adapted.
The crisis has returned fiscal policy to For example, the lesson from the 1970s that,
centre stage for two main reasons. First, with respect to supply shocks, anchoring of
monetary policy had reached its limits. expectations was of the essence was well
Second, from its early stages, the recession understood when the price of oil increased
was expected to be long lasting, so that it again in the 2000s. Success in moderat-
was clear that fiscal stimulus would have ing fluctuations may even have sown the
ample time to yield a beneficial impact seeds of this crisis. The Great Moderation
despite implementation lags. The aggres- led too many (including policymakers and
sive fiscal response has been warranted regulators) to understate macroeconomic
given the exceptional circumstances, but risk, ignore tail risks, and take positions
it has further exposed some drawbacks of (and relax rules) which were revealed to be
discretionary fiscal policy for more “normal” much riskier after the fact. The bad news?
fluctuations – in particular lags in formulat- The crisis has shown that macroeconomic
ing, enacting, and implementing appropriate policy must have many targets. The good
fiscal measures.The crisis has also shown the news? It has also reminded us that we have

many instruments, from “exotic” monetary incurring the risk of higher inflation in the
policy to fiscal instruments, to regulatory event of an unexpectedly strong pickup in
instruments. demand. This issue, on the Fed’s mind in the
It will take some time, and substantial early 2000s, is one we must return to.
research, to decide which instruments to Part of the debate about monetary policy,
allocate to which targets. It is important to even before the crisis, was whether the inter-
start by stating that the baby should not est rate rule, implicit or explicit, should be
be thrown out with the bathwater. Most extended to deal with asset prices. The crisis
of the elements of the pre-crisis consensus has added a number of candidates to the list,
still hold. Among them, the ultimate targets from leverage to measures of systemic risk.
remain output and inflation stability. The This seems like the wrong way of approach-
natural rate hypothesis holds, at least to a ing the problem. The policy rate is a poor tool
good enough approximation, and policy- to deal with excess leverage, risk taking, or
makers should not assume that there is a apparent deviations of asset prices from fun-
long-term trade-off between inflation and damentals. A higher policy rate also implies
unemployment. Stable and low inflation a larger output gap.
must remain a major goal of monetary pol- Other instruments are at the policymak-
icy. Fiscal sustainability is of the essence, not er’s disposal – call them cyclical regulatory
only for the long term, but also in affecting tools. If leverage appears excessive, regula-
expectations in the short term. tory capital ratios can be increased; if liquid-
ity appears too low, regulatory liquidity ratios
Questions for economists can be introduced and, if needed, increased;
The crisis has shown that large adverse to dampen housing prices, loan-to-value
shocks do happen. Should policymakers ratios can be decreased; to limit stock price
aim for a higher target inflation rate in nor- increases, margin requirements can be
mal times, in order to increase the room for increased. If monetary and regulatory tools
monetary policy to react to such shocks? Are are to be combined in this way, it follows
the net costs of inflation much higher at, say, that the traditional regulatory and prudential
four per cent than at two per cent, the current frameworks need to acquire a macroeco-
target range? Is it more difficult to anchor nomic dimension. This raises the issue of
expectations at the former? Achieving low how co-ordination is achieved between the
inflation through central bank independ- monetary and the regulatory authorities. The
ence has been a historic accomplishment. increasing trend toward separation of the
Thus, answering these questions implies two may well have to be reversed. Central
carefully revisiting the benefits and costs banks are an obvious candidate as macro-
of inflation. A related question is whether, prudential regulators.
when the inflation rate becomes very low, The crisis has forced central banks to
policymakers should err on the side of a extend the scope and scale of their traditional
more lax monetary policy, so as to minimise role as lenders of last resort. They extended
the likelihood of deflation, even if this means their liquidity support to non deposit-taking

institutions and intervened directly (with too late to fight a standard recession. Can
purchases) or indirectly (through acceptance we strengthen and improve the automatic
of the assets as collateral) in a broad range stabilisers? A distinction is needed here
of asset markets. The argument for extend- between truly automatic stabilisers – those
ing liquidity provision, even in normal times, that imply a decrease in transfers or increase
seems lucid. If liquidity problems come from in tax revenues when incomes rise – and
the disappearance of deep-pocket private rules that allow some transfers or taxes to
investors from specific markets, or from the vary based on pre-specified triggers tied to
co-ordination problems of small investors as the state of the economy. The first type of
in traditional bank runs, the central authority automatic stabiliser comes from the com-
is in a unique position to intervene. bination of rigid government expenditures
with an elasticity of revenues with respect
Policy implications to output of approximately one, from the
A key lesson from the crisis is the desirabil- existence of social insurance, and from the
ity of fiscal space to run larger fiscal defi- progressive nature of income taxes. The
cits when needed. In future, the required main ways to increase their macroeconomic
degree of fiscal adjustment (after the recov- effect would be to increase the size of gov-
ery is securely under way) will be formida- ernment, make taxes more progressive, or
ble, in light of the need to reduce debt while to make social insurance more generous.
swimming against the tide of aging-related However, these reforms would be war-
challenges in pensions and health care. Still, ranted only if they were based on a broader
the lesson from the crisis is that target debt set of equity and efficiency objectives. The
levels should be lower than those before the second type of automatic stabiliser appears
crisis. more promising.
The policy implications for the next dec- On the tax side, one can think of tem-
ade or two are that, when cyclical conditions porary tax policies targeted at low-income
permit, major fiscal adjustment is necessary households, such as a flat, refundable tax
and, if economic growth recovers rapidly, rebate, a percentage reduction in a taxpayer’s
it should be used to reduce debt-to-GDP liability, or tax policies affecting firms, such
ratios substantially, rather than finance as cyclical investment tax credits. On the
expenditure increases or tax cuts. The recipe expenditure side, one can think of temporary
to ensure that economic booms translate transfers targeted at low-income or liquid-
into improved fiscal positions is not new, ity-constrained households. These taxes or
but it acquires greater relevance as a result of transfers would be triggered by the crossing
the crisis. Medium-term fiscal frameworks, of a threshold by a macro variable. •
credible commitments to reducing debt-to-
GDP ratios, fiscal rules (with escape clauses Editor’s note
for recessions), and transparent fiscal data The publishers thank VoxEU – www.voxeu.
can all help in this regard. org – and the IMF for allowing the Journal to
Discretionary fiscal measures come reproduce this paper.

Compliance
The ‘business of bribery’

sparks anti-corruption drive
Management consultant Gavin Sudhakar of
Sapling Solutions argues the effectiveness
of current global FCPA regulations.
Due to the recent global financial crisis, its practical applicability in the current global
risk management and compliance moni- economy.
toring has been the top priority of regu- In late 1977, after the Lockheed
latory enforcement officials. Trends have Corporation bribery and Watergate cor-
shown that punishing wrongdoers with ruption scandals, President Jimmy Carter
hefty penalties and re-aligning the FCPA signed the FCPA into law.1 As the first nation
regulation during crisis periods will to enact an anti-bribery statute, it was the
lead to a reputable American brand and intent of the US Congress to criminally
regain confidence in the global market. prosecute corporations and individuals that
bribe foreign officials when engaging in
In the ‘’business of bribery’’ it is not business dealings. In 1988, under the global
uncommon to influence human behaviour demands of the Organisation for Economic
for a favourable outcome by means of finan- Co-operation and Development (OECD)
cial incentives. In a global competitive capital Convention, President Ronald Reagan
market, multinational organisations have amended the FCPA to include foreign com-
used bribery as a means of promoting firms’ panies which, as“domestic concerns’’, com-
interests for centuries. On the other hand, mit an offence under US jurisdiction.
individuals have used bribery as a commer-
cial necessity to conduct day-to-day busi- Wider scope
ness across the globe. In 1998, President Clinton signed the
This article argues the effectiveness of the International Anti-Bribery and Fair
enforceable legal framework used by devel- Competition Act by further amending“FCPA
oped countries across the world to combat liability (criminal and civil) to include foreign
bribery as an illegal offence. In particular the nationals, foreign business and public inter-
Foreign Corrupt Practices Act (FCPA) in the national organisations (such as the United
United States has been used as a bench- Nations, the International Committee
mark to argue several points pertaining to of the Red Cross, various international

development banks, and the World Health FCPA violations. Training internal employees
Organisation) that while in US territory, on FCPA appears to be optional rather than
do any act in furtherance of a prohibited a mandatory compliance requirement.
payment”.2
After 22 years of initial enactment of the Confusing, vague
FCPA statute, this article critiques its practi- From the standpoint of FCPA statute devel-
cal applicability and argues its timeliness opment, companies view the language of
and effectiveness. In conjunction with the FCPA as confusing, vague and also subject
OECD global initiative against bribery of to individual interpretation. Companies are
foreign public officials in international busi- forced to answer to both the US Department
ness transactions,3 we provide several sound of Justice (DoJ) and the US Securities and
recommendations for consideration by the Exchange Commission (SEC) for the same
US legislative branch and legal agencies. In violations under different applied standards.
addition, through relevant legal case analy- The due diligence requirements for compli-
sis, the article also recommends a clear and ance and ethics standards applied by the DoJ
consistent FCPA global compliance frame- and SEC are vague, with too many loopholes
work as a guideline for multinational cor- and short on timely judicial guidance.4
porations and individuals that operate in a The accounting provision requirement
highly competitive global market. standards applied under this statute by both
the DoJ and SEC are unclear when it comes
Quick, dirty solution to “good faith effort” in balancing between
Generally, compliance departments are subsidiaries and internal control. On the
poorly staffed, with limited access to finan- other hand, accounting irregularities in
cial resources and training. Companies view bribery, violating book and records require-
FCPA violations as a“business of nexus and ments, appear to remain an acceptable
routine governmental action”to promote its norm in-country business practice. Having
presence in developing nations and emerg- a “wilful blindness” to bribery and fiduciary
ing markets. Management often takes the duties seems to be the trending strategy that
view that the negative publicity, penalties multinational companies have opted for as
and legal fees associated with FCPA viola- opposed to taking a self-risk assessment
tions outweigh its huge profits by bribing approach in day-to-day business transac-
foreign officials. It appears to be a “quick tions to promote a sustainable global oper-
and dirty solution” for a new market entry ating model.
or to increase the firm’s footprint in existing Individual reactions to the FCPA statute
markets. appear to take the stance that“this is a green
In the fear of losing market share, little if field market and bribing foreign officials is an
any due diligence is done when partnering exception for routine governmental action.”
with third party vendors. There are mini- Further, few are unaware of the existence of
mal internal controls to monitor employees, the FCPA statute, which is mainly due to lack
especially marketing and sales teams, for of knowledge and training. In the midst of

acquiring business contracts, the name of the awareness by showing the importance of
game appears to be“doing whatever it takes the statute against white-collar crime (as
to get the contracts binding.” Individuals illustrated by US v. Kellogg Brown & Root
seem to react to FCPA as a “nuisance” and LLC (KBR) & Halliburton Company.5) The
the notion that “let’s worry about any vio- complaint states that between the years
lation and penalties when, and if, we get 1995 to 2004,“senior executives at KBR and
caught in wrongdoing.” others, devised and implemented a scheme
Being on the right side of the bargain, the to bribe Nigerian government officials to
price-to-pay and the timeline also seem to assist in obtaining multiple contracts worth
be a major factor in wrongdoing. In addition, over $6 billion to build liquefied natural gas
the notion seems to be “it’s a foreign land (LNG) production facilities on Bonny Island,
with in-country corruption and a legal sys- Nigeria.”
tem to worry about rather than domestic US In order to conceal the illicit payments,
agencies’rules and regulations.” KBR and its members formed a sham joint
venture with a UK agent and a Japanese
Tantamount to porn agent. In addition, this joint venture was
These FCPA reactions seem to be a reso- used to“funnel illegitimate fees”to Nigerian
nating behaviour pattern across all country government officials. KBR as a part of this
jurisdictions when it comes to operating in allegation pleaded guilty to the scheme “to
or entering emerging markets. Given the violate the FCPA by authorising, promising
lack of awareness, training and moral con- and paying bribes to a range of Nigerian
science, these reactions are tantamount to government officials, including officials of
porn and will resonate for many decades to the executive branch of the Nigerian gov-
come. ernment, NNPC officials, and NLNG offi-
This section on case law analyses the cials, to obtain the EPC contracts. KBR also
recent FCPA enforcement against global pleaded guilty to four counts of violating
corporations and individuals, and sets the the FCPA related to the joint venture’s pay-
stage to uncover the legal standards applied ment of tens of millions of dollars in “con-
by the enforcement agencies in prosecuting sulting fees”to two agents for use in bribing
violators. FCPA cases related to corporations Nigerian government officials.”6
will be analysed as well as subsequent cases
relating to individuals. In addition, this sec- Guilty plea
tion will uncover the fundamental reasoning Halliburton, as the parent corporation of
behind US federal FCPA enforcement activi- KBR, pleaded guilty to failing to have ade-
ties and relate to core reasoning due to lack quate internal controls, in particular for
of robust compliance and ethics policies and working with third-party venders, foreign
procedures. sales agents and the FCPA statute. In addi-
In recent years, FCPA federal enforce- tion, it failed to detect, deter or prevent KBR’s
ment actions against global corpora- violations and continued to make pay-
tions have generated public and private ments to“agents”with numerous books and

records and false information. According to According to court documents presented
company policies, Halliburton’s legal depart- as evidence in this case, DoJ/SEC claims that
ment’s due diligence investigation of its for- despite incorporating a group/regional com-
eign“agents”lacked any specificity regarding pliance programme, Siemens employees
the agent’s roles and responsibilities. lacked adequate resources and had minimal
Halliburton’s third-party due diligence pol- training and supervisory controls regard-
icy also lacked governance and clear trans- ing compliance roles and responsibilities. In
actional documentation, specifically in terms addition, Siemens’ compliance policies and
of books, records and vendor management, procedures lacked guidelines in conducting
which is a clear violation of the FCPA statute. due diligence processes on its consultants
and agents.
Poor due diligence Despite the many “red flags” reported
KBR/Halliburton’s reluctance to main- by outside legal and audit committees with
tain a robust compliance monitoring pro- respect to FCPA compliance and serious vio-
gramme and, in the absence of clear and lations, Siemens senior management took
consistent books and records, (its) policies a “blindfold” approach to the issue without
along with poor due diligence procedures taking affirmative action to audit recom-
in managing third-party vendors, were the mendations. In addition to the foregoing,
main factors leading to FCPA enforcement. “there were extremely limited internal audit
In the case of United States v. Siemens AG,7 resources to support compliance efforts.
the SEC charged Siemens Aktiengesellschaft All of these factors undermined the
(Siemens AG), a German global corpora- improved policies because violations were
tion, with FCPA violations for lack of a FCPA difficult to detect and remedy and resources
compliance programme, internal financial were insufficient to train business people in
controls and adequate books and records. anti-corruption compliance.”
As a part of plea agreements with DoJ/SEC,
Siemens AG, without admitting or denying Compliance monitor
culpability,“agreed to pay a US$448.5 million Due to the lack of operational compliance
fine and Siemens Argentina, Bangladesh, governance shown by Siemens senior man-
andVenezuela each agreed to pay a $500,000 agement in mitigating this compliance pro-
fine, for a combined total criminal fine of gramme, the issue led to many additional
$450 million.”8 FCPA enforcement actions. By pleading to
Siemens made at least 4,283 corrupt pay- these allegations, “Siemens AG agreed to
ments between March 2001 and September retain an independent compliance monitor
2007, worth more than $1.4 billion, to gov- for a four-year period to oversee the con-
ernment officials in Africa, the Americas, tinued implementation and maintenance
Asia, Europe and the Middle East. An addi- of a robust compliance programme and
tional 1,185 payments, totalling $391 million, report to the company and the Department
were alleged to have been used for commer- of Justice on its progress. Siemens AG also
cial bribery and embezzlement. agreed to continue to co-operate in full with

the Department in ongoing investigations of account.” By pleading guilty through a plea
corrupt payments by company employees agreement with the DoJ, Stanley agreed to
and agents.” fully co-operate with the Department in an
In recent years, trends have shown that ongoing investigation.
harsh criminal and civil action has been In the case United States v. William J.
taken against individuals who “knowingly’’ Jefferson,11 the former US Congressman
violate FCPA statutes. As the individuals from New Orleans was sentenced to 13
are always responsible for corporate actions, years in prison for bribing Nigerian offi-
governmental moves against individuals cials and using his official power to “solicit
remain at the highest standards. bribes”. In a trial by jury and based on case
details, Jefferson was convicted for using
Bribery, kickbacks “his influence and his power to enrich
As illustrated in the United States v. Albert himself and his family.” Jefferson unsuc-
Jack Stanley (KBR), UK Citizens, “former cessfully appealed to the Supreme Court
officer and director of KBR pleads guilty on November 13, 2009, which upheld his
to foreign bribery and kickback charges conviction and sentence. This case sets the
in a scheme to bribe Nigerian govern- legal standard and the precedence that no
ment officials in order to obtain contracts.”9 individual, including government elected
Stanley, 65, who worked under former US officials, is above regulation in terms of the
Vice- President Dick Cheney when the lat- FCPA statute.
ter headed Halliburton, admitted that he Legal trends show that the agencies are
paid approximately $182 million in bribes increasing prosecutorial actions aggressively
to Nigerian government officials as a part of against individuals and corporations. The
contract negotiations.10 emerging legal trends in standards applied
In a two-part criminal count against him, by the governing courts in punishing wrong-
Stanley was charged with, 1) conspiracy to doers are articulated in jury instructions such
violate the FCPA and, 2) conspiracy to com- as the case of United States v. Green.12
mit mail and wire fraud. He was sentenced
to seven years in prison and ordered to pay Element of conspiracy
$10.8 million in restitution” in a plea-bar- Taking the approach of applying FCPA stat-
gain agreement in connection with KBR- utes as a globally applicable legal standard
Bonny Island projects in Nigeria. Under and framework as a means of combating
this kickback bribery scheme,“Stanley hired bribery, the standard applied by US courts
the consultants to help Halliburton and its in enforcing this statute is defined by the
predecessor firms arrange deals to build element of conspiracy. The courts have
LNG projects not only in Nigeria, but also instructed the jury by defining the term
in Egypt,Yemen and Malaysia. “conspiracy” as a “kind of criminal partner-
From 1991 to 2004, the consultants ship” in the context of violating the FCPA
directed a total of $10.8 million of the pro- statute and the government has to prove
ceeds back to Stanley through a Swiss bank its prima facie case beyond reasonable

doubt. Despite several conflicting admin- reasoning for Congress’ bipartisan view on
istrative viewpoints within and among the FCPA regulation as not being an integral
enforcement agencies, the release of the part of US foreign policy. Congress’ regula-
DoJ’s report provides a few guidelines to tory actions should consider both domestic
upcoming trends in FCPA enforcement. This and foreign policy in order to consistently
forthcoming disclosure by individuals and apply the FCPA statute. In a globally com-
corporations to the DoJ-Attorney General’s petitive marketplace, a recent trend that has
(AG’s) for opinion have proven to be some- emerged is that FCPA regulation has created
what helpful specifically during mergers unfair business competition, particularly
and acquisitions dealings in protecting the towards the American business community.
reputation of the American brand. In 2009, If the intent of Congress is to promote a
the DoJ released only one such opinion (in fair and competitive environment in order
September) with respect to a request from a to prosper in the international market and
medical device manufacturer.13 bring a true reputation to the American
brand, its policy towards punishing entre-
Political initiatives preneurship and innovative business activity
In light of the recent global financial cri- needs to be reconsidered.
sis, the US Congress has taken a tougher Through trends observed in recent legal
stance in proposing to implement a “super cases, there seems to be a major discon-
regulatory” framework to regulate the capi- nect between the Export-Import (Ex-Im)
tal market. Using the FCPA statute as a glo- Bank funding activities, regulatory oversight
bal benchmark, the intent of Congress is to and reporting suspicious activities to the
restore the reputation of the American brand law enforcement officials. Congress needs
and promote confidence in US business by to reconsider the overall banking import-
punishing wrongdoers. export governance and amend the Banking
Based on recent case law and the stand- Import-Export Regulation to include clear
ards applied using FCPA statutes, it is clearly reporting channel requirements in Ex-Im
evident that this intent is more of a political Bank financial activities specific to monetary
initiative rather than one which will ensure transactions related to FCPA statute.
major regulatory change in the conduct of On the judicial side of this argument,
business internationally. FCPA regulation and enforcement lacks clear
History has clearly shown that since the authority lines across the Secretary of State,
inception of the 1977 FCPA statute, there Secretary of Defence, State of Treasury, DoJ,
has been limited participation and action by AG, SEC, FBI, Economic Affairs, National
Congress to promote the true value of this Security Agency and many other govern-
statute. Due to lack of unanimity in the glo- mental agencies. Due to conflicting complex
bal fight against bribery by government offi- policies and procedures adhered to by these
cials, Congress’true legislative intent appears agencies, recent legal trends have shown
to be lost in the midst of mere political party that FCPA enforcement activities are elabo-
differences. These differences are the main rate, expensive and time-consuming. Even

though violation of “domestic concern” may governance. As such, OECD Conversion
be investigated and prosecuted only by the only consists of 30 member countries; it has a
DoJ, SEC and DoJ FCPA, investigative teams long way to go in reaching out to the emerg-
lack the necessary funding and resources. ing countries to realise its true objective.
Due to lack of resources, bandwidth, cor- The trends indicate it is clear that the flow
rupt bureaucratic systems, sufficient foreign of official bribery-related activities are driven
in-country law enforcement support and from the developed to developing nations.
constant changes in the political climate, With poor economic frameworks, such as,
many of these investigative activities may lifestyle, wages and moral standards, devel-
take months and years to actually achieve oping countries are forced to accept bribery
punishment of wrongdoers. Given the com- as a means of quick enrichment.
plex nature of these multinational, parallel The OECD faces a major challenge in
country investigations, trends have shown addressing these real political issues in order
that FCPA enforcement activities are often to find a common working ground and to
settled with a quick plea bargain. bring developing countries into line with
the intent of its core objectives. In the near
Penalty for bribery future, OECD will have a major role to play
Even though the hefty penalties imposed in bringing about regulatory changes against
in recent cases seems to indicate the sever- global bribery.
ity of FCPA violation, lack of judicial author- With adequate member support among
ity in the cross-border white collar crime national world leaders, substantial finance
jurisdiction are the main challenges FCPA and resources, the OECD anti-bribery global
enforcement authorities face in sophisticated framework initiative will enhance the impor-
business transactions. In clear and compel- tance of the FCPA statute and promote com-
ling cases, enforcement officials must have petitive advantage in the business market.
the authority to enforce forfeiture of the Strong corporate ethics and compliance
assets as a penalty for acts of bribery. Having frameworks are the minimum requirement
cross-border foreign government officials for a sound FCPA compliance programme.
and in-country law enforcement personnel, Without true commitment and support from
as well as proactive support in information senior management teams, compliance
sharing, will certainly expedite FCPA inves- monitoring controlling tools’ systems will
tigative processes. fail to detect and apply corrective measures
in a reasonable manner. Taking a blindfold
Long way to go approach by senior executives and board
Even though the OECD Conversion initia- members to FCPA regulation, as seen in the
tive in global bribery regulation has shown KBR and Siemens cases, will lead to further
many in-country bribery policy changes, FCPA prosecutions and contribute to the
recent trends demonstrate the OECD’s development of negative reputation along
lack of authority in imposing strong-arm with unnecessary and harmful publicity.
practices, clear enforcement standards and It is the fiduciary duty of corporate

officials to maintain the corporate culture, compliance programme will promote cor-
clear and consistent compliance policies and porate governance and a proper “code of
procedures in line with the statute and regu- conduct”by offering innovative products and
lations. Policies and procedures may need services in a competitive global market.
fine tuning periodically based on changes to When it comes to the“business of nexus”
the regulations, government actions and in- quid pro quo, having clear and consistent
country laws. Implementing a global compli- global FCPA compliance policies and pro-
ance team that works closely with regional cedures is absolutely critical in third party
compliance teams in monitoring and con- vendor business dealing. Recent trends
trols as necessary will lead to a stronger, have shown that third party due diligence in
more robust compliance framework. vendor management, contract negotiations,
domestic and foreign agents, and distribu-
Team accountability tors’ relationship monitoring in the merger
With the support of in-house international and acquisitions environment, remains
counsel and external counsel, global com- a challenging compliance task. The “tone
pliance teams should be held accountable on the top” and the middle management
in initiating, monitoring and maintaining organisation culture will need to promote
FCPA compliance and ethics programmes. zero tolerance towards bribery in day-to-day
As the trends are moving in the direction business dealings.
of increased governmental FCPA enforce- Having a “right to audit” clause in
ment activities, compliance teams should third party contracts will strengthen and
undertake necessary due diligence to audit empower the due diligence process and
and fine tune the compliance programme facilitate the ability to enforce observance
to mitigate potential risk. Through periodic of contractual obligations according to the
internal investigations and testing of internal FCPA compliance policies and procedures.
controls, compliance teams should identify Sub-contracting and private party business
“red flags” and regulatory compliance gaps relationships must not be approved without
through risk assessment and take appropri- proper endorsement from corporate compli-
ate actions by ensuring that country focused ance officials.
investigation is sensitive to the culture. Regional sales management and mar-
keting teams must adhere to the FCPA
Entrepreneurial spirit compliance policy and procedures; this will
Having a robust global compliance frame- be facilitated by the application of manda-
work to promote free, honest and com- tory FCPA training. Having an international,
petitive behaviour in the global market will independent in-house and an external
provide support necessary to regain the auditing team to monitor and report irregu-
essence of the true American entrepreneurial lar activities to the compliance offices for
business spirit. With dedicated, fully-funded further investigation and mitigation will pro-
and empowered compliance resources, mote a risk aversive compliance culture in a
and strong management voices, the FCPA cost effective manner.

Knowing your customer and third party violation is effective in resolving compliance
vendors in business dealings will certainly issues in an expeditious way. Working in
help in monitoring and controlling corrup- conjunction with agencies to mitigate com-
tion in accordance with FCPA regulations. pliance gaps has enhanced credibility with
In addition, having diagnostic tools, facilities regulators.
and protection for“whistleblowers”and web In addition, the cost-benefit in plea
interface tools will also help identify compli- agreement outweighs the legal costs and
ance issues and enable resolution or the abil- reputation risk. In recommendation, vol-
ity to discipline wrongdoers in a reasonable untary disclosure in FCPA violation is the
manner according to the compliance policy best strategy in both the short and long run.
and procedures. Identifying and reporting conspiracy ele-
ments to FCPA enforcement officials will
Sustainable relationships promote a strong accountable compliance
Even though some of these advanced tools organisation.
and techniques face challenges in new busi- The trends have illustrated that operating
ness dealings, specifically in emerging mar- in high risk countries, specifically in emerg-
kets, they have proven to be a good resource ing markets, is a major challenge to the com-
for sound risk management. There is suf- pliance and ethics programme. Knowing the
ficient proof to suggest that the existence of local anti-bribery statute, jurisdictions issues
a right compliance toolset, sound business and market barriers will aid in planning con-
acumen-ship and risk aversive investigative tingencies in high risk countries as a market
techniques will aid in building sustainable entry. Implementing the FCPA compliance
business relationships. Training employees training in a timely fashion and ensuring
and vendors on FCPA regulation as a part good governance to monitor will help in
of the compliance programme will enhance operating in these countries.
the quality of detecting, avoiding and man-
aging conflicts of interest in key business Consistent compliance
transactions. Proactive due diligence and Providing consistent compliance commu-
monitoring have shown to be very effective nications and setting clear policy rules and
ways to enable compliance with FCPA regu- guidelines will aid the promotion of the code
lations and to gain credibility and account- of conduct. Fine tuning the compliance pro-
ability with regulators. gramme in accordance with local anti-brib-
ery laws, managing the overall programme
Enhanced credibility from a global perspective will provide better
Using the DoJ’s FCPA opinion procedure ability to control and monitor.
effectively and in a timely manner, specifi- Finally, coming to the“grease or facilitat-
cally in merger and acquisitions dealings, will ing payment” in these countries which are
support a proactive due diligence process. considered normally as “business of nexus”,
The trends have demonstrated that plea and care should taken in such payments, spe-
deferred prosecution agreements in FCPA cifically, if payments are made to influence

foreign officials to award new or existing References
contracts. 1 See: PBS.com – Corruption in the Crosshairs (His-
Under these circumstances it needs to be tory of International anti-bribery legislation), April
emphasised that such payments are in viola- 17, 2009 SSRN: www.pbs.org/frontlineworld/stories/
tion of FCPA regulations. However, it is legal bribe/2009/04/timeline.html
if these payments are a normal in-country 2 Amendment to Int’l Anti-Bribery Act of 1988 SSRN:
practice which has no barring towards influ- library.findlaw.com/1998/Dec/1/130472.html
encing foreign officials but to expedite the 3 Organisation for Economic Co-operation and Devel-
contract performance process. In addition, opment SSRN: www.oecd.org/
care should be taken to record such pay- 4 The Foreign Corrupt Practices Act by J.Ndumbe
ments accurately and timely in the corpo- Anyu, ISBN: 978-1424157021
rate books and records. Payments should be 5 SEC v. Halliburton Co, & KBR, Inc, CA No. 4:09-
audited periodically for compliance and“red 399, SSRN: www.sec.gov/litigation/complaints/2009/
flags” reported to the appropriation compli- comp20897.pdf
ance committee for further action. 6 KBR, Inc Pleads Guilty to FCPA, DoJ Press Release
– February 11, 2009 SSRN: www.justice.gov/opa/
Moral conscience pr/2009/February/09-crm-112.html
In the end, an individual’s moral responsi- 7 USA v. Siemens, December 12, 2008, Case No.
bility in dealing with corruption is a choice, 1:08-cr-00367-RJL SSRN: www.whitecase.com/files/
not a business necessity. As long as suppli- upload/fileRepository/Alert_WhiteCollar_FMD_
ers are willing to violate FCPA regulation by Siemens_FCPA_121608_addendum_2.pdf
bribing foreign officials, buyers are available 8 Siemens Pleads Guilty to FCPA, DoJ press release
in abundance. Even though FCPA regula- – December 15, 2008 SSRN: www.justice.gov/opa/
tion applies only to the suppliers, giving and pr/2008/December/08-crm-1105.html
taking bribes is one’s personal decision. In 9 Propublica.org on KBR Exec’s Plea Widens Probe
the midst of short-term enrichment, human – September 9, 2008 SSRN: www.propublica.org/
greed dictates wisdom which in turn leads to feature/kbr-exec-plea-widens-probe-909
hefty life penalties. 10 KBR, Inc – Jack Stanley Pleads Guilty to FCPA, DoJ
The FCPA is a powerful tool that the Press Release – Sept. 3, 2008 SSRN: houston.fbi.gov/
agencies will continue to use in an effort to dojpressrel/pressrel08/ho09032008.htm
stop individuals who seek to further their 11 Congressman William J. Jefferson Jail Sentence under
own business interests through bribes paid FCPA, DoJ Press Release – November 13, 2009
to foreign officials. SSRN: www.justice.gov/opa/pr/2009/November/09-
Given the one-way path in bribery, indi- crm-1231.html
viduals may need to reconsider options and 12 USA v. Gerald Green & Patricia Green – Case No.
protect their personal brand before making CR 08-59-GW SSRN: www.mediafire.com/ ?yfwn-
hasty decisions. Having a moral conscience wddyymy
in business dealings will lead to a strong rep- 13 DoJ FCPA Opinion Procedure Release Request
utation, mutual respect and a credible legacy SSRN: www.justice.gov/criminal/fraud/fcpa/opinion/
for generations to cherish. • 2009/ 0901.html

Compliance
Public or private accounting

and the Sarbanes-Oxley Act
The AEI’s Alex J. Pollock casts a sanguine
eye over SOX and the huge and costly
bureaucracy that was spawned in its wake.
IT IS seven years since the passage of We know it succeeded in creating a finan-

the Sarbanes-Oxley Act. As it fades into cial bonanza for the partners of accounting
history, we ought to be able to gain some firms; it was the most profitable thing that
perspective on the efficacy and effects of ever happened to them. We know it suc-
the Act. For example, as Newt Gingrich ceeded in creating a vast effort around iden-
asked: “Is it consistent with the factors tifying risk, documenting, and managing risk
that make for a successful, energetic, and risk factors.
growing, entrepreneurial society?” But what was the result? In a recent
study by Ernst & Young, The Future of Risk,
There are three sets of photos in my office an E&Y partner is asked:“Is there too much
which often amuse visitors. They depict risk management going on now? Are there
three pairs of distinguished, serious gen- so many processes and complexities that the
tlemen. One pair is Senator Smoot and actual process of mitigating and assessing
Congressman Hawley, authors of the infa- risk get in each other’s way and are counter-
mous Smoot-Hawley Tariff of 1929. The sec- productive?”The partner replied:“That was a
ond pair is Senator Garn and Congressman key finding.”Yes, that’s where we are.
St Germaine, authors of the Garn-St Of course we know that despite all the
Germaine Act, which served to make the Sarbanes-Oxley risk, efforts did not mitigate
1980s savings and loan collapse much the tremendous financial bubble and bust
worse. The third pair is Senator Sarbanes that has emerged over the past few years.
and Congressman Oxley. My motto for the With that in mind, I asked two informal
three sets of paired photos is:“It seemed like advisers of mine – both of whom are very
a good idea at the time.” knowledgeable and competent managers
What did it achieve and what do we in the area of mortgage finance – what they
know about the Sarbanes-Oxley Act? thought about the outcome of the imple-
We know it succeeded in creating a vast mentation of the Sarbanes-Oxley Act. One
bureaucracy and enormous associated costs. of them, a specialist in hedging and related

accounting issues, wrote to me: “The mort- as previously mentioned. No loss was pre-
gage meltdown has proven that Sarbanes- vented so it was all a big waste of time and
Oxley had absolutely no impact on corporate money signifying nothing.”
behaviour. Any improved investor confi- Something else we know about
dence was sorely misplaced, as we can see.” Sarbanes-Oxley is that it succeeded in creat-
Then he listed a number of examples ing a huge emphasis on the notion of“inde-
of which we are all aware: New Century, pendence”. Independence sounds like a fine
GMAC, Fannie Mae, Freddie Mac, IndyMac, idea, but independence just for the sake of
Washington Mutual, Wachovia Bank, independence is, in my view, a rather dan-
Countrywide. Note these are all or were gerous notion.
public companies, all subject to the processes
and structures that Sarbanes-Oxley requires. Sobering fact
He went on to say: “Besides doing This includes independence relating to
Sarbanes-Oxley reviews, the big four boards of directors of companies, and also
accountants were busy reviewing securiti- in government-sponsored bodies, spe-
sation models. They would opine as to the cifically the Public Company Accounting
mathematical accuracy of the models but Oversight Board (PCAOB) and the Financial
not as to the assumptions. Well, you couldn’t Accounting Standards Board (FASB). I will
audit the securities you were reviewing suggest that Sarbanes-Oxley over-empha-
because of the need created by Sarbanes- sised the idea of independence and woefully
Oxley to separate consulting from auditing.” under-emphasised, or didn’t even factor in,
This is his peroration:“Where was Sarbanes- the centrality of knowledge and the applica-
Oxley? Supporters of Sarbanes-Oxley tion of knowledge to problems.
should be required to point out at least one In retrospect, it is a sobering fact that the
success story. I can’t think of one.” votes passing Sarbanes-Oxley were 99 to 0
in the Senate of the United States and 423 to
‘Big impact’ 3 in the House of Representatives. If you add
I shared that with another colleague, who these two together, that gives you 522 votes
is a talented operating manager in finance in favour from the elected representatives of
and mortgages. He wrote back:“Dave’s mis- the American people, and three opposed.
taken when he says Sarbanes-Oxley had no These votes make me think of a story from
impact. It had a big impact: keeping manag- General Motors when it was one of the
ers focused on trivial mechanics and inves- greatest companies in the world, and at the
tors focused on the bogus management time run by Alfred P. Sloan.
assessments of risk that were the volumi- At a management committee meet-
nous output of the trivial mechanics which ing one day, Sloan said: “We’re all agreed?”
are still occupying loads of managerial time.” Everybody said “yes”. Sloan: “No one is
And Dave replied:“Well, it’s hard to disa- opposed?” Everybody said “no”. Sloan: “No
gree. In this case, no one gained anything worries or dissent?” Everybody said “no”.
other than the accounting firm partners, According to the story, Sloan’s conclusion

was:“Then we’re going to table this question 1930s, 1950s, 1960s, 1970s, 1980s and, once
until we can get some wholesome disagree- again, in the 2000s. So I don’t know why we
ment and maybe we’ll know what we are should be surprised by their travails or wish
doing.” Similarly, perhaps we should worry to feel too much“faith”in auditors.
whenever the Congress is so uniformly in
favour of something, especially in the wake ‘Enron of the day’
of a political panic. “Here are some specifics of their history:
What was the Congress trying to achieve After the stock market bubble of the 1920s,
with the Sarbanes-Oxley Act? Here is what accountants were charged with producing
Senator Sarbanes said in his address to the deceptive and misleading financial state-
Senate when the bill was about to be passed: ments. In 1938, there was a massive upheaval
“It is becoming increasingly clear that some- – the Enron of the day – the McKesson
thing has gone wrong, seriously wrong, with & Robbins accounting scandal, “greatly
respect to our capital markets. We confront embarrassing the profession.” About this,
an increasing crisis of confidence that’s an accounting journal noted: “Like a tor-
eroding the public’s trust in those markets.” rent of cold water, the wave of publicity has
So Sarbanes-Oxley was passed to establish shocked the accountancy profession into
“confidence” and “trust” — did it achieve its breathlessness.”
objective? From the perspective of the sub- In the 1950s, the accounting profession
sequent bust and panic of 2008-09, Senator was subjected to a “barrage of criticism.”
Sarbanes’idea of what the Act would achieve In 1967: “Now all at once there are more
needs no further comment. than 50 lawsuits pending against the major
accounting firms which handle 80 per cent
A matter of faith? of the US auditing business of listed compa-
Further as to the purpose of Sarbanes-Oxley, nies, charging irregularities and negligence.
at that time Senator Enzi said: “My hope is With equal suddenness, a barrage of public
that this new oversight structure will renew criticism has landed on the profession.”The
the faith that the public has in auditors and later 1960s were called“a period of“unprec-
in the financial statements that they help to edented stress”for accounting.
prepare.” Then in 1970 came what was until then
Personally, I don’t feel too much “faith” the largest bankruptcy in history, the Penn
in auditors or accounting, nor do I wish to Central Railroad. We might call that today a
have such faith. I think most auditors are “systemically important railroad.” Its failure
honest, hardworking people who make mis- and the subsequent panic in the commercial
takes like everybody else makes mistakes. paper market naturally called into question
Inevitably, the mistakes are sometimes very the effectiveness of the auditors. By the later
large. Accounting mistakes and scandals are 1970s, highly publicised bankruptcies were
nothing new. The profession of auditing and creating calls for government intervention in
accounting has often been in serious trouble the accounting profession. In the 1980s, the
over the decades. They were in trouble in the major accounting firms were entangled in

the savings and loan collapse and were the independence. A very successful retired CEO
object of numerous Congressional hearings. of a Fortune 100 company said: “Yes, from
It is hard to find any extended period the point of view of the CEO, the ideal board
in which accounting has not found itself is 100 per cent independent directors except
in some kind of hot water. The answer has for the CEO.”
always been, “more rules” and “independ-
ence”– and yet the problems continue. Authority vs expertise
Let us turn to the notion of “inde- He continued: “That’s the board I’d like
pendence” relative to boards of directors. to have! I’d be the only one who actually
Of course, there was a very large push in knows anything and I’d be able to do what-
Sarbanes-Oxley for independence. I sug- ever I want.”This brings me to a quote from
gest we need to think about the difference, Senator Gramm. Senator Gramm voted for
or perhaps the balance, between independ- Sarbanes-Oxley, but he had this to say dur-
ence and knowledge. Naturally, we want ing the discussion:
people to be independently minded; how- “For the record, I submit that in the
ever, if you have a very independent mind, approach of this bill, we are probably going
but you don’t know much about the topic, too far in putting people in positions where
what good is your independence? they’re going to have massive unchecked
authority when they have no real expertise
Part-time directors in the subject area.” I think that was a fair
More than 130 years ago, Walter Bagehot in comment.
Lombard Street wrote A Description of the Now let us turn to government-spon-
Money Market; this book, which I consider sored bodies. Over the years at AEI financial
to be the greatest ever written on banking, conferences, you will have heard a lot about
pointed out the problems with boards. The government-sponsored enterprises like
fundamental problem is that directors are, Fannie Mae and Freddie Mac. We also need
by definition, part-timers with the company to address government-sponsored bodies
and management is full time. like the PCAOB or the FASB. When you
Ask yourself this question:“Who knows apply the notion of independence to such
more? Somebody who works on some- bodies in an unbalanced way, as Sarbanes-
thing one day every two months, or some- Oxley did, you create organisations subject
body who works on something 10 hours a to few or no checks and balances.
day every day? Bagehot posed this problem: It was a key point of Sarbanes-Oxley, for
How can the board ever know as much as example, to create an independent funding
management? The only way they could is if source for the FASB, which is essentially a
they were themselves full time, in which case tax levied on all public companies, so they
they would cease to be the board. wouldn’t have to worry about whether peo-
I discussed this issue some time ago at ple think they are worth it. The same kind
an AEI conference; the problem of manage- of funding tax was set up for the PCAOB.
ment and boards and knowledge versus It seems to me that the fundamental

Madisonian precept (managerial responsi- accounting, and made it irrelevant. When
bility) we all ought to live by is that nobody the accountants were checked and balanced
should be fully independent. Everybody in this dual fashion, by Congress and by the
should be subject to checks and balances. stress tests, last spring, financial markets
Here is a good example of what hap- started to recover. The fact that the market
pens with such mistaken independence: recovery closely followed these events may
so-called “fair value” or “mark to market” not indicate causality, but it may. In any case,
accounting. the capital markets recovered.
There is no doubt whatsoever that this
kind of accounting in a panic makes the Act ‘deeply flawed’
panic worse and drives the financial system The FASB has since counter-attacked, want-
down. This would not be a surprise to any- ing to expand fair value accounting even
body who has ever thought about it. In 1999, further. If they succeed, it will make us even
for example, Paul Volker said: “Marking to more vulnerable to future panics. I repeat
market can be a great recipe for accelerating my conclusion that nobody should be fully
crises.”He was right and we have just expe- independent. Everybody should be subject
rienced it in the panic of 2008-09. to checks and balances. Therefore, a funda-
In my view, fair value accounting is con- mental assumption or ideal of Sarbanes-
ceptually flawed and not a very good theory. Oxley is deeply flawed.
But even if you like the theory, you cannot Let me come to the PCAOB and its dubi-
deny that it drove the panic closer and closer ous constitutional standing. Is this a private
to the edge of the cliff. When collapse was or a government body? It is neither. It was set
threatening, Congress finally did intervene up as a hybrid to avoid two sets of disciplines.
and forced the FASB to overrule itself. The market discipline of being fully private
was avoided, so also was the discipline of
Hand-wringing criticism being a government body, the processes of
This was subject to some handwringing crit- appointments and appropriations, the appa-
icism: “Oh dear, you overruled the experts,” ratus of being part of the government.
but anybody who really believes in democ- This avoidance of both disciplines was
racy and in checks and balances ought to see fully intentional on the part of the creators
this as a very good step. The elected repre- of Sarbanes-Oxley. As mentioned, PCAOB
sentatives of the people had to defend the is supported by what is functionally a tax on
people from the theoretical accountants. public companies, and it is obviously a regu-
The second thing that helped overrule latory body. But (like FASB) it claims that it is
fair value accounting was that the Federal “private”.
Reserve and the Treasury Department My view is that PCAOB should have
invented public“stress tests”for large banks. I to decide; it shall be public, a part of the
think this was a magnificent piece of political government with all that implies, or it shall
theatre. A key point of the stress tests is they be private with all that implies — it cannot
completely ignored and bypassed fair value be both. •

Accounting standards
‘Innumerate bankers, systemic

idiocy & accounting standards’
The FSA’s Lord Adair Turner takes issue
with some senior bankers’ views on book-
keeping standards across the industry.
IN an article in the Financial Times on that future loan losses might well be higher.
December 15, 2009, Martin Taylor, former However, accounting standards are designed
Chief Executive of Barclays Bank, argued to reflect today’s already observable facts –
that the core cause of the financial crisis and to limit the role of judgment as to future
was that ‘the system was brought down possible events.
because bankers could not count’ and Whether that should be the case is now
‘because there was no measure of cash subject to intense debate, with two very dif-
flow to tell them that they were idiots’ in ferent points of view.
their assessments of income. Among bank prudential regulators and
central banks there is a belief that existing
The article was reported as an attack on bank accounting standards were among the
innumerate bankers; in fact it was an attack factors contributing to the crisis, inducing
on accounting standards and on the way in procyclicality in credit provision and pric-
which they are applied. Indeed, there have ing. In addition, there is a demand that bank
always been bankers concerned about exist- accounting standards must reflect the con-
ing accounting approaches. Ahead of the cerns of prudential regulators. This is accom-
crisis, there were both bankers and some panied by the belief that banks are different,
boards of banks worried about how low and therefore accounting standards need to
their commercial loan loss provisions had to recognise and accommodate this.
be to comply with accounting standards.
They were low because few commer- If truth be told . . .
cial customers were behind with payments, However, among many securities analysts
so that there were very few observable and investors and among some account-
facts to suggest potential loan impairment. ing standards setters, the belief remains that
Following the most recent boom period, accounts exist for investors and not for regu-
with warning signs beginning to flash across lators, that they must tell the‘truth’as it exists
the world economy, judgment suggested at one particular point in time, and that any

influence of prudential regulators on bank economy into recession. Bank failures can
accounting standards could be a Trojan horse be a key cause of economic recession as
for a wider politicisation. opposed to a consequence of the failure of
This tension exists even within the regu- companies in other sectors. Two principle
latory community. Around the table of the reasons are put forward, the first general
Financial Stability Board (FSB), the pruden- to all financial markets and to all financial
tial regulators and central banks are par- firms which act as principals rather than
ties that are most convinced that banks are intermediaries; the second specific to banks
different and that the setters of accounting and bank-like institutions as a sub-set of the
standards must listen to us. Conversely, the financial services industry.
pure securities regulators tend to be more
sympathetic to the ‘accounts are for inves- Future value
tors’ philosophy. Indeed the tension exists Financial instruments link the present to the
within the accounting standards-setting future; they have value in markets which
bodies, thereby contributing to the compli- are inherently intertemporal. Bananas are
cating of progress towards the convergence worth what they sell for today: their mar-
of international accounting standards. The ket clears today, balancing today’s suppliers
International Accounting Standards Board and today’s buyers. But a loan or an equity
(IASB), under the leadership of David contract has value today determined by
Tweedie, has been sympathetic to the idea events still to happen in the future and by a
that it must be involved in close dialogue changing set of other opportunities to trade
with the prudential regulators. The Financial future for present value via other financial
Accounting Standards Board (FASB) has instruments.
been more wedded to the ‘accounts are for That complexity means that the prob-
investors only’philosophy, and to the philos- lems of market imperfection are more severe
ophy that in their accounting, banks should in the market for financial contracts than in
be treated no differently from anybody else. other markets. There are far greater asym-
metries of information between buyers and
Simultaneous failure sellers, and a greater influence of imperfect
So are banks really that different and a principal/agent relationships. This means
special case in ways relevant to accounting that perceptions of value can be highly
standards? If so, in what ways, and what volatile. Indeed, it introduces not just risk
should we do about it? but in the terms in which Frank Knight and
Obviously in one crucial way banks are Keynes1
different from – say – retailers, hoteliers, used it; inherent uncertainty as to the
manufacturers, mining companies, airlines, value of, say, an equity claim on the future. At
and we have seen that difference illustrated any instant, there may be a price at which an
dramatically over the past two years. Bank equity will sell in small quantity, but that price
system failures – the simultaneous failure of can change radically and rapidly in the face
many banks – can plunge the whole world of self-fulfilling changes in perception. And

it will be a quite different price if many peo- contraction in, say, airline capacity or internet
ple simultaneously influence one another in entrepreneurship. It is therefore a combina-
their decision to sell. tion and interaction of three factors which
Inherent uncertainty over how to value make banks different:
long-term and contingent assets and lia- • Inherent uncertainty of the present value
bilities introduces specific problems and of future financial claims;
complexities into the regulation and the • The maturity transformation function;
accounting of all financial institutions, both • The fundamental role which credit
for insurance companies as much as banks. extension plays as a driver of macroeco-
But banks in two key respects are also cru- nomic volatility.
cially different even from other financial
institutions in both their riskiness and their Complex accounts
importance. Insurance companies embody the first of
First, because of the maturity transfor- these features, but not all three. They are
mation function they perform, lending over faced with complex and difficult-to-interpret
the longer term than their liabilities. It is an accounts: they need to be regulated for rea-
important function of considerable social sons of customer protection but the collective
value: it results in a term structure of interest action of insurance companies together is
rates more favourable to long-term invest- not a key driver of macroeconomic instability.
ment than would otherwise pertain; and it For these reasons we have prudential
enables householders to enjoy the financial regulation of financial firms, in particular of
planning benefits and assurance of owing banks. For these reasons prudential regula-
long-term liabilities (typically mortgages) tion of banks (unlike that of insurance com-
but owning short-term assets (deposits). It panies) requires a close co-ordination with
is an extremely risky activity and one where the ‘lender of last resort’ functions of central
the risks are inherently collective rather than banks, and in the future will need to entail
individual2. a joint central bank/prudential regulator
approach to macro-prudential through-
Crucial driver the-cycle regulation focused not just on the
Second, the fact that banks extend credit to vulnerability of individual institutions, but on
the real economy, and that volatility in the the total system as a whole3.
extension of credit to the real economy (in This need for a systemic macro-pru-
both quantity and price) is one of the most dential approach lies behind the regulatory
crucial drivers of macroeconomic volatil- policies now being developed by the interna-
ity. Banks are different because swings in tional Financial Stability Board (FSB) and the
credit supply – irrationally exuberant sup- Basel Committee on Banking Supervision
ply and over capacity in the upswing and (BCBS). These include:
then sudden withdrawal in the downswing • Higher capital and liquidity require-
– matter far more to the macro economy ments overall, designed not merely to
than irrationally exuberant over supply and make individual institutions sound, but

to improve the resilience of the overall On the banking book side, the current IASB
system. accounting treatment requires banks to rec-
• Crucially, counter-cyclical capital require- ognise the implications for potential loan
ments to build up capital buffers in good losses of events which have already occurred,
years so that they are available to absorb such as failures to make interest or principal
losses during recessions. payments.
Such policies are quite different from
those which we apply in other sectors of the Dramatic variations
economy. In non-financial sectors we do not However, this also requires them only to
have prudential regulation at all; in insur- recognise such known events, not to antici-
ance, we have prudential regulation focused pate possible or probable future events. This
on the sustainability of the individual institu- necessarily implies that loan loss provisions
tion, but not focused on the macroeconomic will vary dramatically through the economic
impact of all insurance companies together. cycle, and means that in good years income
Therefore, the key question is not will be declared which does not reflect the
whether banks are different; they are and we average future loan losses likely to arise from
are already designing prudential regulations loans being put on the books.
to better reflect that fact. Instead the ques- As a result, this accounting treatment
tion for today is whether this difference has can contribute to a cycle of self-reinforcing
implications for bank accounting or whether responses which tends to exacerbate the vol-
it should be reflected solely in prudential atility of credit extension and of the economic
regulation. cycle, both on the way up and the way down.
In the upswing (figure 1), the incurred
Loss implications loss model produces low figures for loan
Two aspects of bank accounting in loss, boosting measured bank profits and
particular could be relevant to the macro- flattering lending margins through three
prudential and macroeconomic factors that transmission mechanisms that can stimulate
make banks different. First, the treatment the procyclical effect of an increased quantity
of loan losses within the banking book, the and lower price of credit. These include:
way in which we capture, or fail to capture, • high bank profits bolstering capital ratios
present or future potential loan losses aris- and thus increasing lending capacity;
ing from credit default. Second, the valu- • high apparent margins on lending gen-
ation approach in the trading book (and erating competition for lending volume,
other items which are mark-to-market), and declining loan spreads; and
the recognition of unrealised gains or losses • high banker bonuses, paid out on the
in general, but in particular in more illiquid basis of high measured profits, to rein-
securities. force banker confidence and propelling
In both these areas, there is a strong the desire for greater achievement in
case that the present accounting treatment order to earn equivalent bonuses in the
contributes to the problem of procyclicality. subsequent year.

Seen together, this can drive further credit effects are even stronger and more disrup-
extension at fine spreads, initially improv- tive than in the case of the banking book, as
ing economic prospects and firm finances, a result of the particularly procyclical tenden-
and further reducing apparent indicators of cies of securitised credit extension.
potential loan loss. However, with the exces- When credit is extended in a securi-
sive lending that this will tend to generate tised form (figure 3), with the market price
and inevitably produce a set-back (figure 2), of credit clearly visible from trading in credit
and with each of these factors operating in securities, there is an inherent risk that credit
reverse in the downswing: supply and pricing can be subject to self-
• bank capital and lending capacity is reinforcing herd effects.
depleted; and
• lending at existing prices is apparently ‘Animal spirits’
suddenly less profitable, driving reduced The originators of and investors in credit
willingness to lend and increased lend- treating the market level of credit or credit
ing spreads. default swap (CDS) spreads as indicators
Meanwhile, on the trading book side, of credit risk and consequently appropriate
the accounting approach requires banks to credit pricing. In an upswing this feeds a ris-
value assets at ‘fair value’4. Wherever possi- ing price of credit securities, falling spreads,
ble this means a ‘mark-to-market’ approach increased origination and a self-reinforcing
– the assets valued at what they could be willingness to invest in credit securities; or
sold for in a market on the day on which the indeed to lend on balance sheet.
accounts are struck. That cycle in turn can be reinforced, how-
ever, by the use of fair value approaches to
Factual approximation the valuation of assets in the trading books
When this is not possible, management and of banks and to the calculation of profit and
auditors are essentially led to infer what the loss. Rising values generate apparently high
market price would be if it existed, through profits and swell the capital basis, which
the use of indirect information inputs such can support either more trading activity or
as reference to other relevant prices, or to increased on-balance sheet lending. And
models which use other relevant prices as those effects may be reinforced by behav-
inputs. ioural and confidence effects, to use Keynes’
The rationale of this approach is that it words, the ‘animal spirits’ of bankers’ paid
reflects a set of facts – the facts, or the near- high bonuses on unrealised and potentially
est approximation of the facts, of the price illusory profits.
for which the assets could be sold, if sold at Figure 4 illustrates a set of interlocking
the balance sheet date. In some cases this cycles which can then switch dramatically
approach is unavoidable; in some ways this into reverse once confidence is lost. This
is valuable, as I’ll return to this shortly. It points to:
clearly creates dangers of procyclicality both • falling security prices exacerbated by illi-
on the way up and the way down, but the quidity and lack of confidence;

• bank balance sheets impaired by trading unrealistically low market values in illiquid
losses which may well reflect an over- markets, and demanded greater freedom
shoot of rational equilibrium values; and to shift assets from a fair value to a historic
• rising credit and CDS spreads feed- cost/hold to maturity/incurred loss account-
ing through to dramatically increased ing basis. These concerns would have had
assumptions on the fair price of credit, greater credibility if the same bankers had
whether extended in a securitised or on- complained about the potential adverse
balance sheet form. consequences of the over-valuation of assets
in conditions of the irrational exuberance of
Harmful procyclicality 2006 and early 2007.
Therefore, I believe it is clear that the current Any changes which make it easier for
accounting treatment in both banking and banks to shift assets between categories in
trading books can contribute to a harmful the face of changing circumstances will feed
procyclicality in profits and in credit extension concerns that problems are being disguised
in both its securitised and unsecuritised form. or hidden. In late 2008, uncertainty about the
Therefore, the issue is not whether there are value of ‘toxic assets’ and a lack of transpar-
problems – there are – but whether changes ency about how values had been measured
to accounting standards can help address by different banks, were major factors that
them, or whether we simply need to recog- eroded market confidence.
nise the problems and offset them through
other levers such as countercyclical and Dangerous credo
liquidity standards. It may be that there are Equally, the idea that all problems would go
problems here, exacerbated by accounting away if only there were total transparency
treatment; no feasible alternative account- and rigorous mark-to-market accounting,
ing treatment exists which would help solve extending, according to the credo of true
these problems without creating others. believers, to banking book loans as well
In trading books in particular, there are as trading book securities is, I think, quite
many instruments for which there is no fea- wrong and dangerous. Belief in this credo is
sible alternative to a fair value approach. It is sometimes based on a fallacy of composition,
almost impossible for derivative contracts to a failure to distinguish between the impact
be dealt with in any other fashion. Concepts of a policy on the competitive advantage of
of historic cost, nominal value or incurred loss one bank relative to others, and the systemic
cannot help us gauge the economic substance impact of that policy applied universally. For
of the risks inherent in a derivative contract. instance it is asserted and may well be the
There is certainly a case for being a bit case, that banks which applied a very strong
cynical about some of the criticisms of fair daily mark-to-market philosophy in their
value which broke out in the period of the internal risk management were better placed
market downturn, but only in that period. than others to navigate the crisis, more flex-
As credit securities prices fell in 2008, ible in rapidly closing out loss-making posi-
many bankers expressed concern about tions, rather than holding on in the hope

that something positive would emerge. It is summary as regards the trading books:
quite possible for that to be true, and at the • There is no alternative to mark-to-mar-
same time for it to be true that a system of ket accounting for some instruments.
universally applied and totally transparent Mark-to-market valuation provides
mark-to-market accounting would increase information which shareholders should
the volatility of prices, and increase the vola- logically value.
tility of credit extension. What is good for one • Freedom to switch accounting
bank seeking to compete with others can be approaches to hide problems can be
harmful in its systemic effect. dangerous.
• But conversely there can be systemic
Highway to despair problems of increased volatility if mark-
The fundamental problem we face is that to-market accounting is applied widely.
there are no definitive ‘facts’ about value –
but that value in financial markets is con- Therefore, what should we do about
tingent on specific circumstances and on trading book risk and trading book and
the action of all other participants. For an related accounting? The Financial Services
individual bank selling slices of its indi- Authority (FSA) believes the answer must be
vidual portfolio in conditions where the a combination of regulatory and accounting
actions of other banks can be considered reform, each aiming to ensure that a distinc-
as independent, mark-to-market account- tive trading book approach is used only for
ing provides meaningful facts and a useful activities where it is clearly appropriate.
management discipline. If all banks tried
simultaneously to sell all or a significant Fundamental review
proportion of their assets, the facts become On the regulatory side, this entails higher
quite different. capital requirements against trading books;
A fully transparent system of across the some changes to the trading book capital
board mark-to-market accounting could regime have already been agreed by the
simply increase the speed with which self- BCBS, and will be implemented by January
reinforcing assumptions about appropriate 1, 20116. In addition, among the BCBS’s
value generate cycles of irrational exuber- most important agenda items for the year
ance and ultimately despair. Market prices ahead is a fundamental review of the trading
can be subject to self-reinforcing momen- book capital regime going back to the basic
tum and herd effects as much in highly liq- question of why and in relation to what spe-
uid, technically efficient and transparently cific activities, is it justifiable to have a differ-
accounted markets, as in inefficient and ent and lighter capital requirement against
untransparent ones. Herd and momentum an asset held for trading as against one held
effects in credit markets (whether loans to maturity? The result is likely to be much
or credit securities) will cause more harm higher capital requirements for any assets
to the macro economy than similar irra- which are, or under conditions of stress
tional movements in equity prices5. So in might become, illiquid.

Meanwhile on the accounting side, approach are meant to anticipate potential
the way forward requires a parallel look economic losses, and therefore to reflect
at the appropriate coverage of fair value analysis of the economic losses which might
approaches to the definition of profit or loss, arise for different categories of loans; look-
ensuring that fair value gains or losses affect ing forward into an uncertain future and
profit and loss (P&L) only where instru- informed by a history of the losses which
ments are liquidly traded, and are likely to be have arisen for that category in the past, in
liquidly tradable in almost all circumstances. bad times as well as in good.
In the trading book, the crucial issue is
not therefore a simple yes or no as regards Dearth of historic data
‘fair value’, or mark-to-market yes or no, In reality, however, Basel II’s implementation
but rather what should be included in trad- has often been focused on procyclical point-
ing books whether this be for regulatory or in-time estimates, in part because some
accounting purposes. banks have lacked adequate data relating to
Turning to the banking books, the prob- past historic loss experience. We need to shift
lem – as Martin Taylor defined it in his arti- to a through-the-cycle approach, and the FSA
cle – is that we have ‘spreads that take no is working with firms to achieve this end.
account of default probabilities’and therefore A second parallel approach is neces-
interest income recognised with inadequate sary to add a clearly countercyclical regula-
allowance for the loss probability is always tory capital requirement, in order to build up
inherent whenever a loan is placed on the capital buffers in good times to allow draw-
books. The fundamental issues are therefore: down in bad. That too is a key priority within
how to ensure that banks adequately antici- the redesign of the global capital adequacy
pate the probable and even the improbable system now being debated by the BCBS.
but possible future in their pricing decisions We could decide to make only these
and capital adequacy levels? Should this regulatory changes and to leave account-
anticipation also be reflected in published ing unchanged. The FSA believes that there
accounts? would be considerable merit in changing
the current accounting approach to loan
Anticipating the future loss provisioning – seeking both to address
One possible approach would be to leave some of the behavioural implications aris-
accounting as it is and concentrate entirely ing from unrealistically high declared profits,
on prudential regulation and, in particular, and indeed seeking to provide investors with
on two changes. First, ensuring that Basel II a more realistic picture of underlying profit.
is implemented in a way which does indeed The case in favour of a step in that direc-
anticipate the future, rather than reflecting tion has already been accepted by the IASB,
only the recent past in a procyclical fash- which is now consulting on a new version of
ion. In principle that is what it was always its impairment (provisioning) requirements
meant to do. Capital requirements within which would require loans on balance sheet
the advanced internal ratings-based (IRB) to bear an expected loss provision throughout

their lifespan, rather than recognising losses reality and possibility, and should not con-
solely according to the existing incurred tribute to procyclical credit extension.
loss approach. In principle, this approach Faced with that trade-off between diver-
has merit, but the devil is very much in the gent aims, the FSA’s ideal preference would
detail and, in particular, in the detail of how be to provide not one but two separate
‘expected loss’will be calculated. lines of account information on loan loss
If it is calculated by reference to current provisions.
market expectations of future losses, there is
a danger that the new approach could actu- Separate lines
ally be more procyclical than the past. In The existing line, as now based on the
extremis, if ‘expected losses’ are calculated by facts of already incurred credit impairment
reference to the market prices and spreads of events; and a separate line, based either on
traded credit securities, then an expected loss a formula, as in Spain, or on the judgments
approach to the banking books becomes a of management, challenged by regulators,
form of mark-to-market by another name, together with the details, basis and ration-
potentially increasing rather than reducing ale for that judgment extensively disclosed.
procyclicality. Two separate lines and extensive disclosure,
Conversely, if, as prudential regulators we believe would provide better information
would generally prefer, expected loss is cal- to investors than either the current incurred
culated by reference to judgments about loss line or any one ‘expected loss’ based line
future possible losses informed by past could ever provide. If instead we proceed
experience or by formulae which link pro- with one‘expected loss’line, the disclosure of
visions to broad indicators of likely future supporting information to enable investors
credit problems (such as the pace of credit to understand the assumptions made will be
growth on which the Spanish dynamic pro- important.
visioning approach is based) some investors However, at least in the US, it is often
might have concerns about these judg- reported that‘investors’are strongly opposed
ments, whether made by the management to any divergence from existing standards,
or by the regulator, are based on fact and are and indeed that they continue to be attracted
understandable and transparent. to the extension of ‘fair value’ accounting to
which FASB appears still to be devoted.
Ideal preference At first sight, this attachment to fair value
So in the detailed design of the expected loss accounting appears strange. It is not clear
approach, the IASB may still face the inher- why it was in the interest of investors to be
ent trade-off between the divergent and told in spring 2007 that the credit securities
incompatible demands placed on accounts, held by the US or UK banking system were
investor concerns that they should reflect worth hugely more than they appeared to be
currently verifiable facts, and the prudential worth just a year later. Examined in another
regulators’ concern that they should inform way, the logic of the ‘investor’ perspective, or
the market about underlying economic at least the perspective of the agents who

make decisions on behalf of investors (i.e. behaviour which makes the measured
hedge funds, pension fund managers, etc) mark-to-market value cease to be true.
is clearer. Because the fund managers acting In formal economic terms, there are mul-
for end investors (if not the investors them- tiple and unstable equilibria, and the extent
selves) may be logically more interested in to which the equilibria are unstable is itself
precise and non-judgmental information as influenced by the nature of information
to the relative economic position of differ- flows about market values.
ent firms, than in judgmental information;
which, while capturing important aspects of Fundamental challenge
aggregate economic reality, is likely to create Similarly, and turning to the banking books:
more opportunities for cloudiness – non- It was true that at the end of 2006 and
transparency – in inter-firm comparison. even 2007 that the number of business bor-
This clearly illustrates that the interests of rowers behind with their payments in many
investors (or at least of fund managers) and banks’ commercial loan portfolios was very
of prudential regulators (and of sound mac- low, and that is a fact that investors might
roeconomic management) may diverge. We legitimately want to note, providing infor-
need to find ways of serving both interests. mation both about the idiosyncratic position
Indeed, once again it illustrates the fun- of each bank relative to other banks, and
damental problem with which we are strug- about the point in the cycle.
gling in accounting for financial services It is also true that when a bank puts on
companies in general but for banks or near loans during periods of rapid economic and
banks in particular: which is, under the con- credit growth and general market confidence,
ditions of inherent uncertainty that governs the measured loan losses then observed will
financial contracts – contracts which link the have a systematic tendency to understate the
present to the future – there is no one‘truth’, average subsequent resulting loss.
no one set of ‘facts’ relevant to all decisions The fundamental challenge of bank
and decision makers, but several truths and accounting is therefore to provide good
several facts. information in an environment where the
idea that there is one measure of value, one
Double-edged sword ‘economic reality’, is a chimera, a sub-set
It is true that the value at which one indi- of the wider intellectual delusion that has
vidual firm can liquidate part of its portfolio attempted to construct economic theory and
at a particular point in time is best given by policy on the assumption that markets are
the mark-to-market value. It is also true that always rationally equilibrating and that mar-
if all firms try to liquidate a large proportion ket prices are by definition‘correct’.
of their portfolio simultaneously, the mark- And that does make banks different –
to-market value will not be obtainable. not of course in absolute terms but to such
A transparent system of mark-to-market a degree that different considerations must
accounting, with fluctuating and transparent influence the development of bank account-
prices, may tend to induce the very collective ing standards than are taken into account

in other sectors of the economy. Clearly, for Treatise on Probability (1921) and The General
other companies as well as banks, asset val- Theory (1936)
ues can vary between normal and distressed 2 Note that one consequence of this function
times: if all retailers went bankrupt simulta- and the activities which go with it – funding with
neously the liquidation value of their stocks short term deposits and interbank loans and
would be quite different from that observed holding liquid assets which can be sold to meet
in the accounts. In reality, retailers do not unexpected outflows – is that the measurement
all get into trouble simultaneously; and no of “cash flow” is close to meaningless for banks.
other sector of the economy is remotely As Martin Taylor says, when banks have question-
comparable with banking in its capacity to able measures of accounting income “there is no
be a driver of economic volatility rather than measure of cash flow to tell them that they are
a victim of it. idiots.” But that is not because they have per-
There is no other sector about which versely failed to use obviously available cash flow
Martin Taylor would have reasonably argued measures (for example those required under
that accounting played an important con- International Accounting Standard 7: Statement
tributory role in provoking general sectoral of Cash Flows), but rather that these cash flow
collapse and macroeconomic recession. measures are inherently less useful in the bank-
ing sector than in non-financial sectors of the
Special relationship economy.
Banks are different because they mat- 3 See Bank of England: The Role of Macro-pru-
ter more, because they can do more harm. dential Policy:A discussion Paper (November 21,
That’s why we regulate and supervise their 2009)
business but do not regulate the business of 4 International accounting standards (IAS 39)
retailers, hoteliers or manufacturers. That’s require use of fair value measurement for items
why there is a special relationship between held for trading for all derivatives, and for “avail-
the banking system and central banks as able for sale” assets. In certain specified circum-
lenders of last resort. That’s why we worry stances, preparers of accounts may elect to
a lot about ‘too big to fail’ considerations. measure other positions at fair value under the
And that’s why prudential regulators, central “fair value option”.
banks and economic policymakers have a 5 See The Turner Review:A regulatory response to
vital interest in the decisions of accounting the global banking crisis (FSA, March 2009), pages
standard setters on bank accounting stand- 42-44 for the argument that irrational herd and
ards, which does not apply between regu- momentum effects (to which all liquid traded
lators and accounting bodies in any other markets are inherently susceptible) are likely to
sector of the economy. • cause more macroeconomic harm in securitised
credit markets than in equity markets.
References 6 Basel Committee on Banking Supervision:
1 The classic statement of the distinction between Guidelines for computing capital for incremental
risk and uncertainty is Frank Knight Risk, Uncer- risk in the trading book and proposed revisions
tainty and Profit (1921). See also J.M. Keynes to the Basel II market risk framework.

Foreign exchange
Lessons for the forex market

from the global financial crisis
Blackrock’s Michael Melvin and Warwick
University’s Mark P. Taylor argue the case
for enhanced market stress indicators.
The timing of the subprime crisis that thus date the beginning of the crisis in the
became the global crisis is well known. foreign exchange market as August 2007.
Its impact on the foreign exchange mar- An efficient way to visualise the various
kets has been much less discussed. This stages of the crisis in the currency market
column fills that void. Its findings sug- is provided by the returns to the so-called
gest that foreign exchange portfolio man- “carry trade,” a popular foreign exchange
agers could have protected their portfolio investment strategy of taking long positions
by an appropriate risk control strategy in high-interest rate currencies financed by
using market stress indicators. short positions in low-interest rate curren-
cies. Figure 1 (overleaf) displays a standard
The crisis in the foreign exchange (FX) mar- carry trade index over the crisis period.
ket came relatively late. In the early summer
of 2007, it was apparent that fixed income Flight to quality
markets were under considerable stress. Beginning in August 2007, the first wave of
Then, in July 2007 the dominoes began to fall the subprime crisis hit the foreign exchange
as supposedly market-neutral equity port- market as losses in equity and fixed income
folios suffered huge losses and it was com- portfolios spilled over as portfolio managers
mon to hear talk of a five (or larger) standard deleveraged and liquidated winning posi-
deviation event, reflecting the failure of tions, including their currency positions.
traditional financial risk analysis to capture November 2007 saw credit problems
systemic effects. increase as firms found it increasingly dif-
Foreign exchange market participants ficult to issue commercial paper, and there
watched these other markets with grow- was a flight to quality in which yields on US
ing trepidation. Their fears were realised on Treasury securities fell substantially. Investors
16 August 2007 when a major unwind of shed risk from their portfolios, including for-
the carry trade occurred and many currency eign exchange investments.
market investors suffered huge losses. We Risk appetite fell again in March 2008 as

Figure 1. Deutsche Bank Carry index
rumours of Bear Stearns’ imminent demise exposures more carefully than ever and some
began to circulate. The orderly rescue and institutions, considered more at risk than
sale of Bear Stearns to JP Morgan Chase others, found their client base shrinking.
restored some stability to the market. The
market came to believe that there is a “too Risk, volatility and transaction costs
big to fail” doctrine, so that counterparty The failure of Lehman added a new dimen-
risks were perceived as manageable going sion to perceptions of risk. Post-Lehman
forward. Then, in September 2008, this exchange rates experienced unprecedented
confidence-building exercise was undone as levels of volatility and FX transaction costs
Lehman Brothers was allowed to fail, as pol- rose dramatically.
icymakers began to worry about the moral When market makers provide liquidity
hazard implications of bank rescues. to the market, they assume inventory posi-
Lehman Brothers’ failure imposed huge tions in currencies as a result of their trades.
losses on many of their counterparties who The greater volatility, the greater risk they
were unable to collect on obligations owed face from holding positions. As a result, the
them. Post-Lehman, there was a dramatic bid-ask spread rises to compensate them for
fear across the market as to where losses this risk.
hid and who might be next to go under. In the fall of 2008, FX spreads wid-
Institutions were monitoring counterparty ened dramatically (Table 1, below). In the

pre-crisis period, the spread on a two-way one instance, a UK bank paid no bonuses for
price quoted by a market-maker to a hedge 2008. This government reaction to the crisis
fund might be in the range of 4 “pips,” e.g. is not surprising, but it is doubtful that those
an offer to buy dollars at 1.1525 Swiss francs setting the rules fully understand the impli-
each or to sell dollars at 1.1529 Swiss francs. cations of the changes they are forcing on
During the post-Lehman crisis period, the the financial industry.
spread widened to at least 16 pips. The losses experienced by financial insti-
tutions did not come from foreign exchange
Forward delivery spreads trades, imposed compensation restrictions
In the worst of times, spreads on particular treat the foreign exchange function the same
currencies were at least 400 per cent wider as other areas of the bank. We expect bank
than normal times. In addition, there were employees to respond in a predictable man-
times in the fall of 2008 when it was difficult ner to a changed incentive structure. Since
to trade at all in normal sizes. compensation is severely limited compared
Even more dramatic than the spot to the past, the risk-return tradeoff has
spreads was the widening that occurred changed in a manner that is probably con-
in spreads for forward delivery. Table 1 also sistent with public policy; less incentive to
contains data on indicative spreads for three- take risk results in less risk taking.
month swap (i.e. forward minus spot) quo-
tations. In the pre-crisis period, swap spreads Good two-way prices
on the US$-Swiss franc would be around 0.4 For example, in the foreign exchange mar-
pips; post-Lehman, they were about 15 pips. ket, market-making dealers are expected to
The cost imposed by the financial crisis provide liquidity to their counterparties and
has resulted in a legislative and regulatory then manage the risk of their positions while
reaction to rein in risk-taking and specula- earning a profit for their banks. Competition
tive behaviour. One effort has been attempt- across banks resulted in tight spreads and a
ing to reduce compensation at banks that willingness to provide good two-way prices
have accepted government assistance. In for large trade size. This willingness to bear
Table 1. FX bid-ask spreads for $50 million, in pips
Pre-crisis 2007 Period Post-Lehman crisis Period
Spot 3-mo swap Spot 3-mo swap
EUR-USD 1 0.2 5 10
GBP-USD 3 0.3 12 12
USD-JPY 3 0.2 12 10
USD-CHF 4 0.4 16 15
AUD-USD 4 0.4 20 20
USD-CAD 4 0.3 20 30
NZD-USD 8 0.5 40 10

risk on the “sell-side” was beneficial to the (2008). The index is a composite variable
“buy-side” bank clients. In fact, given the built using market-based, publicly available
large spreads reported in Table 1 and the indicators in order to capture four essen-
large volume of trading that occurred in tial characteristics of a financial crisis: large
2008, bank profits from foreign exchange shifts in asset prices, an abrupt increase in
were very large. risk and uncertainty, abrupt shifts in liquid-
ity, and a measurable decline in banking
Predictable implication system health indicators.
In the aftermath of the crisis, dealers are In order to ascertain whether an extreme
charging wider spreads and dealing in value of the financial stress index has been
smaller amounts than in the past. This will breached, we subtract off a moving-average
lower the bank’s risk exposure but impose mean and divide through by a moving-
greater costs on banks’ clientele: non-bank average standard deviation. The result then
financial institutions, corporate customers, gives a measure of the how many standard
governments, central banks, international deviations the index is away from its time-
travellers, and others who benefit from varying mean. As seen in Figure 2 (opposite
liquidity and risk-management services pro- page), the global financial stress index crosses
vided by banks. the threshold of one standard deviation
A predictable implication of the public above the mean for most of the major cri-
policy response to the financial crisis is to ses of the past twenty years or so, including
lower liquidity and raise the risks and costs the 1987 stock market crash, the Nikkei/junk
associated with non-bank currency trades. bond collapse of the late 1980s, the 1990
The“buy-side”faces greater costs associated Scandinavian banking crisis, and the 1998
with currency trading along with greater vol- Russian default/LTCM crisis.
atility of exchange rates. It should be more
difficult for non-banks to transfer their cur- Brief lull in index
rency risks to a bank than in the past, while The 1992 European exchange rate mecha-
the non-bank entities face greater risk in the nism crisis is less evident at the global level.
foreign exchange market than they used to. Most interestingly, however, the global
It is not clear that there is a net gain to society financial stress index shows a very marked
from these changes. effect during the recent crisis. Mirroring the
One practical issue that arises concern- carry unwind in August 2007, there is a brief
ing the crisis in the FX market is whether lull in the index as it drops below one stand-
FX portfolio managers could have protected ard deviation from its mean before leaping
their portfolio by an appropriate risk con- up again in November 2007 to nearly 1.5
trol strategy. In order to illustrate such a standard deviations from the mean.
strategy without recourse to proprietary The global financial stress index
methods, we constructed a global financial then breaches the two-standard devia-
stress index that is similar in many respects tion threshold in January 2008 and again
to the index recently proposed by the IMF in March 2008 (coinciding with the near

Figure 2. Global financial stress index
collapse of Bear Stearns). With the single In this regard, we see that the financial
exception of a brief lull in May 2008, when stress index and similar market stress indica-
index falls to about 0.7 standard deviations tors may have practical potential to add value
above the mean, it remains more than one to foreign exchange investments.2 •
standard deviation above the mean for the
rest of the sample, spiking up in October to Footnotes
more than four standard deviations from 1 We look at the same group of 17 developed countries
the mean following the Lehman ebacle in as in the IMF study but, in contrast to the IMF analy-
September. sis, we built a ‘global’ financial stress index based on an
We simulated the returns an investor average of the individual country indices. See Melvin &
could have earned from investing naively in Taylor (2009);
the Deutsche Bank Carry Return Index and 2 This is likely to be true even after allowing for transac-
the returns from investing in the index in tion costs and implementation lags – see M&T (2009).
normal periods and closing out the position
in stressful periods when the FSI exceeds a References
value of 1. Over the entire 2000-2008 period IMF (2008), “Financial Stress and Economic Downturns,”
studied, the naïve carry strategy yields an World Economic Outlook: Chapter 4, 129-158.
information ratio of -0.3 (the annualised Melvin, Michael and Mark P.Taylor (2009),“The Crisis in the
return divided by the annualised standard Foreign Exchange Market,” CEPR Discussion Paper 7472,
deviation of returns) while the risk-control- September (forthcoming in the Journal of International
led carry strategy yields a ratio of 0.69. Over Money and Finance special issue on the Global Financial
the more recent 2005-2008 period, the naïve Crisis, December 2009).
information ratio is -0.66 while the risk- New York Fed (2009).”Timelines of Policy Responses to
controlled information ratio is 0.31. the Global Financial Crisis.”

Trade finance
Exports and financial shocks:

new evidence from Japan
New York Fed’s Mary Amiti and Columbia
University’s David Weinstein show how
bank health impacts global trade.
Can the drying up of trade finance help standard gravity and macro models of trade
explain the recent collapse in exports would have predicted given the changes
relative to output? Using firm-level in supply, demand, and relative prices (see
data, this article examines the effect that Chinn 2009, Campbell et al 2009, Levchenko,
trade finance had on exports during the Lewis, and Tesar 2009a, OECD 2009).
Japanese financial crisis of the 1990s. It
suggests that the direct effect of declining Why the collapse in trade?
bank health on exports caused at least a Several authors have argued that trade
third of the decline in Japan’s exports at finance may have been partially responsible
the time. for the remarkable fall in trade (Auboin 2009
and OECD 2009). However, most empirical
One of the most striking features of the most work relating to trade finance has been ham-
recent global financial crisis is the collapse pered by the lack of information regarding the
in international trade – a fact highlighted by institutions providing the finance and what
Richard Baldwin in a recent Vox ebook, The was happening to domestic sales at the same
Great Trade Collapse. time [e.g. Bricogne et al (2009), Levchenko,
Figure 1 (overleaf) plots the ratio of real Lewis, and Tesar 2009b, Mora and Powers
world exports to real gross domestic prod- 2009 and Chor and Manova 2009].
uct (GDP) for a sample of the world’s largest Hence, the mixed findings of these stud-
economies.This illustration shows the decline ies which are in addition, hard to interpret
in world exports was much greater than because a clear link cannot be identified
the decline in world GDP. Between the first between changes in financial conditions
quarter of 2008 and the first quarter of 2009, and changes in exports and the inability to
the real value of GDP fell 4.6 per cent while address the question of whether financial
exports plunged 17 per cent – a decline of shocks affect exports more than domestic
US$761 billion in nominal terms. Moreover, sales as is suggested in Figure 1 above. The
this decline in exports was much larger than role that trade finance played has come as

Figure 1. Quarterly movements in the ratio of world exports to GDP, 1995-2009
Source: This figure was constructed using national sources: Australia, Australian Bureau of Statistics; Belgium, the
Banque Nationale de Belgique; Canada, Statistics Canada; France, National Institute of Statistics and Economic
Studies; Germany, Deutsche Bundesbank; Hong Kong, Hong Kong Census and Statistics Department; Italy,
Istituto Nazionale di Statistica; Japan,Cabinet Office; Netherlands, Centraal Bureau voor de Statistiek; Norway,
Statistik Sentralbyra;South Korea, Bank of Korea; Spain, Instituto Nacional de Estadistica; Sweden, Statistiska
Centralbyran; Switzerland, State Secretariat for Economic Affairs; Taiwan, Directorate General of Budget,
Accounting and Statistics; United Kingdom, Office of National Statistics; and United States, Bureau of Economic
Analysis. The set of countries accounted for 66% of world GDP and 68% of world exports in 2008.
a surprise to most academic economists, as have failed to predict the dramatic collapse
trade finance is almost completely ignored in world exports is due to their simplistic
by the academic literature. Most interna- modelling of the role of the financial sector
tional models assume international payment in international trade. It is suggested that in
settlement markets function perfectly. order to understand how trade responds to
In a new paper (Amiti and Weinstein financial crises, it is necessary incorporate
2009) we argue that a potentially important ‘financial accelerators’ as used by Bernanke,
reason why most macro and trade models Gertler, and Gilchrist (1999) that specify

why export flows are likely to be hard hit by as in any of these situations banks will not
financial shocks. pay the exporter.
To understand the central role played by Around 40 per cent of all trade finance
finance in international trade, we need to contracts utilise ‘letters of credit’ (LoC). This
begin with what textbooks on international requires the importer to ask its issuing bank
financial management refer to as “the fun- for a LoC that in effect guarantees payment
damental problem with international trade”. for the imports. Using the LoC as collateral,
How do firms guarantee payments across the exporter will often obtain a working cap-
international borders? (See, for example, ital loan from its negotiating bank to cover
Bekaert and Hodrik 2007.) the goods production costs.
International trade differs from domestic
trade in two fundamental ways: Banker’s acceptance
1) International trade is typically riskier Assuming that all of the documents are in
than domestic trade. While firms often order, the issuing bank will issue a banker’s
know how to work domestic legal sys- acceptance to the negotiating bank guaran-
tems for dealing with payment defaults teeing payment at a specified future point
and delays, frequently it much more in time. Although the working capital loan
difficult for firms to collect payments in is repaid by the exporter, the negotiating
foreign countries even if foreign legal bank needs to raise money to cover the cost
systems are fully functional. of payment to the exporter, in addition to
2) The added shipping times associated with the funds it will need to raise for the initial
international trade often mean that inter- working capital loan. This is often achieved
national transactions take two months by selling the issuing bank’s bankers accept-
longer to conclude than domestic trans- ance to other investors.
actions. This imposes additional working Over the past several decades ‘open
capital requirements on exporters. account’ transactions have become increas-
ingly common. In these transactions, import-
Working capital loans ers do not use banks to guarantee payments
As a result of these added risk and work- to exporters. In order to handle these high
ing capital needs, exporters typically turn risk transactions, exporters often turn to
to banks and other financial firms to han- non-bank financials like the CIT Group,
dle payments. Exporters benefit from these which provide working capital loans, export
arrangements because financial firms typi- insurance, and export factoring (buying trade
cally assume all of the importer’s default risk credits from the exporter at a discount).
and also provide working capital loans. For example, a 2007 survey of sup-
The importer also benefits because this pliers using open account transactions
eliminates the need for cash-in-advance (Scotiabank, 2007) found that 38 per cent of
payment terms, and the importer can avoid respondents used financial institutions for
payment issues associated with non-ship- post-shipment financing, 30 per cent used
ment, late shipment, or damaged shipments them for pre-shipment financing, while 49

per cent used them for buyer default insur- the wake of the 2008 Lehman Brothers bank-
ance, 24 per cent used institutions to obtain ruptcy may have made banks exceedingly
political risk insurance, and 22 per cent risk averse about lending to each other; this
used them as export factors. The fact that all break down in the interbank lending is likely
documentary credit transactions and at least to have had a significant impact on exporters.
half of all open account transactions require We examine the impact on exports
financial institutions to provide capital or resulting from the Japanese financial crisis
insurance suggests a strong potential for a of the 1990s; the Japanese case is an ideal
financial accelerator in trade. laboratory for understanding these forces for
a two main reasons:
Starved of credit 1) As was the case of the financial crisis
A financial crisis can create a number of that came to a head in 2008; the crisis in
problems in this payment process. If an Japan was also caused by twin real estate
exporter’s negotiating bank cannot easily and stock bubbles that metastasised into
raise capital, the bank may not be able to interbank loan market defaults.
make working capital loans or discount the 2) Because Japanese data enables us to
exporter’s trade credits. This may leave the match exporters with their negotiating
exporter starved of credit and unable to ship banks, we can assess directly how much
on time. Similarly the bankruptcy or finan- a decline in the health of an exporter’s
cial difficulties that major non-bank financial bank affects the exports of a firm relative
institutions like CIT and AIG faced meant to its domestic sales.
that many exporters using open account
transactions were left scrambling for insur- Sensitivity to exports
ance support and financing. Our results suggest that exports are much
Similarly, if an importer’s issuing bank more sensitive to the health of negotiating
runs into trouble, foreign negotiating banks banks than domestic sales. The relation-
may not accept their LoC which undermines ship between bank health and the change
both the negotiating bank’s willingness to in exports is not only statistically signifi-
provide working capital and payment guar- cant but also quantitatively important.
antees to the exporter. Of the 10.5 per cent decline in Japanese
While all the parties in these transactions exports that occurred following the bank-
may be able to locate new guarantors this ing crisis of 1997, we find that the direct
is likely to take time. Finding new banks to effect of declining negotiating bank health
take on credit risk is likely to be particularly on exports was caused approximately a
difficult in the midst of a financial crisis when third of the decline.
there is enormous uncertainty about the This is probably underestimated because
exposure of many, if not all, financial institu- declining bank health may have negatively
tions to toxic assets. affected Japanese exporters through other
All of this suggests that the defaults in the channels in addition to that of trade finance.
interbank lending markets that occurred in Our study raises a number of important

implications vis-a-vis the recent financial Baldwin, Richard (2009), (Ed). The Great Trade Collapse:
crisis. Although Japan’s recession and bank- Causes, Consequences and Prospects, VoxEU.org ebook,
ing crisis was severe at the same time it was 27 November. Available: [http://www.voxeu.org/index.
largely localised. However, this time around php?q=node/4297]
the financial crisis was global in nature and Bekaert, Geert and Robert Hodrick (2008), International
featured banks in many countries. Financial Management Ch 18. New Jersey: Prentice Hall.
In the US, the unwillingness of markets Bernanke, Benjamin S, Mark Gertler, and Simon Gilchrist
to lend over the short-term to banks was (1999), “The Financial Accelerator in a Quantitative Busi-
clear from the rising interbank loan spreads ness Cycle Framework”, in J.B. Taylor and M. Woodford
from a typical 50 basis points over treasury (ed.), Handbook of Macroeconomics, edition 1, vol. 1,
rates up to 450 basis points following the Chapter 21: 1341-93, Amsterdam; New York and Oxford:
Lehman bankruptcy. All of these indicators Elsevier Science, North-Holland.
point to a seizing up of short-term credit Bricongne, Jean-Charles, Lionel Fontagné, Guillaume Gaul-
markets. It would therefore be hard to see ier, Daria Taglioni, and Vincent Vicard (2009) “Firms and the
how this could not have had a profound global crisis: French exports in the turmoil,” Bank of France.
impact on the ability of firms to export. Campbell, Douglas L, David Jacks, Christopher M. Meissner,
There is good reason to believe that the and Dennis Novy (2009),“Explaining Two Trade Busts: Out-
recent crisis may have had a greater impact put vs. Trade Costs in the Great Depression and Today”,
on exporters than the Japanese one. The VoxEU.org, 19 September.
global nature of the crisis may mean that Chinn, Menzie (2009), “What Does the Collapse of US
both exporters’ and importers’ banks suf- Imports and Exports Signify?” econbrowser.com
fered capital losses, making it even harder Chor, Davin and Kalina Manova (2009) “On the Cliff and
for exporters to finance their trade. This all Back? Credit Conditions and International Trade during the
suggests that the impact of the recent glo- Global Financial Crisis,” Stanford University.
bal crisis on international trade may be even Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar
greater than that of the Japanese crises in (2009a). “The Collapse of International Trade during the
the 1990s. • 2008–2009 Crisis: In Search of the Smoking Gun.” Univer-
The views expressed in this paper are those sity of Michigan, mimeo.
of the authors and do not necessarily reflect Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar
those of the Federal Reserve Bank of New York (2009b). “The collapse of US trade: in search of the smok-
or the Federal Reserve System. ing gun,” VoxEU.org, 27 November.
Mora, Jesse and William Powers (2009). “Did trade credit
References problems deepen the great trade collapse?” VoxEU.org,
Amiti, Mary and David E. Weinstein (2009), “Exports and ebook, 27 November. Available: [http://www.voxeu.org/
Financial Shocks.” CEPR DP 7590. index.php?q=node/4297]
Auboin, Marc (2009), “Restoring Trade Finance: What the Organisation of Economic Co-operation and Develop-
G20 Can Do.” in The Collapse of Global Trade, Murky Pro- ment (2009), OECD Economic Outlook 1 (85).
tectionism, and the Crisis: Recommendations for the G20, Scotiabank (2007).“2007 AFP Trade Finance Survey: Report
ed. Richard Baldwin and Simon Evenett, London: Centre for of Survey Results”, Association for Financial Professionals,
Economic Policy Research. October.

Market risk
A case of mistaken identity: the

illusion of ‘too big to fail’
Intelligence Capital’s Avinash Persaud
argues global policymakers need to focus
more on market risk rather than TBTF.
Policymakers and commentators approach to banking regulation is necessary,

have recently argued for downsizing and the next, saying“nobody is going to tell
banks that are ‘too big to fail.’ This arti- us how to regulate our banks”. Beneath the
cle argues that the logic is based on an veil of global unity, different regional per-
illusion. In 2006 a list of institutions con- spectives and national actions are emerging.
sidered ‘too big to fail’ would not have This is most clear in the area of international
included Northern Rock, Bear Sterns, or banking regulation.
even Lehman Brothers. Instead, regula-
tors should aim to make the financial sys- Damage limitation
tem less sensitive to error in the markets’ In Europe, the thrust has been on how to
estimate of risk. regulate financial markets in order to miti-
gate future crises. It should be emphasised
A new global governance was forged in the that credit mistakes are made during the
white heat of the financial crisis.The G7 gave boom, not during the crash. Better regulation
way to the G20 (Eichengreen 2009). Leaders during the boom years (and perhaps better
representing 80 per cent of the world’s pop- monetary policy, too) could limit the extent
ulation met and were resolute in calling for a of the bust.
global policy response to the crisis. Moreover, in a crash, markets are not
Governments opened the fiscal very discerning and it is hard to strike the
sluice gates, interest rates were slashed, balance of who to save and who to leave to
the International Monetary Fund (IMF) the wolves. Consequently, ‘Europeans’ are
was given additional resources, and the focused on how to limit the crashes by intro-
Organisation for Economic Co-operation ducing macro-prudential regulations such
and Development (OECD) finally got tough as counter-cyclical charges and minimum
with European tax havens. But as the ashes liquidity buffers.
cooled, senior officials are quoted one day in In the US, perhaps reflecting a greater
the international press saying that a global belief in markets and a stronger mistrust of

regulation, the emphasis has been on find- regulation may not be such a poor second
ing market-friendly ways to contain the spill- best. The record of policymakers with regard
over of bank failure. US policy debates are to the international regulation of banks is
occupied with concerns that banks should hardly a source for optimism. One global
not be ‘too big to fail’; that private investors, mistake is far worse than a few smaller ones,
not taxpayers, should hold ‘contingent capi- and small developing countries in particular
tal’which carry implicit or explicit conversion need to be wary of international banking
into equity in a crash, and that improvements rules forged in developed countries with a
must be made to the functioning of ‘overview to expanding developed country banks
the-counter’ markets through greater use of into the emerging world.
centralised trading, clearing and settlement.
These proposals are less about modifying Playing to the gallery
capital requirements and more about prohi- One other point of intersection between
bition and taxation and are micro-prudential these regional perspectives concerns big
in nature. Banks would not be allowed to do banks. This has less to do with a conver-
‘risky’ things (the ‘Volcker plan’) and large gence of regulatory thinking on bank size
balance sheets will be taxed to repay the bail- or function and more to do with the com-
out funds (the‘Obama Levy’). mon need to play to the political gallery and
In the former crisis countries of Asia, raise taxes somewhere. Robin Hood, previ-
where banking regulation followed new ously banished from the Kingdom by Prime
international banking rules more closely, Minister Thatcher and President Reagan, has
the view is more sanguine. Officials from returned.
Indonesia, Thailand, Malaysia, Philippines This desire to raise taxes from bankers sits
and Australia argue that because the econo- well with the idea that policy should offset
mies of Asia largely escaped the crisis, it must the incentive for banks to become systemi-
actually be about poor supervision by their cally more important. I have long argued this
European and American peers. They argue point (Persaud 2008), but I have also come to
that we should tinker less with regulation realise that the notion that we should con-
and instead deepen supervisory capacity. centrate our efforts on making sure banks
are not ‘too big to fail’ is partly based on an
It was them, not us illusion.
The principal point of convergence between Bank balance sheets bloated by lever-
these perspectives is that the crisis was age are systemically dangerous, and regu-
caused by ‘the others’ and ‘they’ had bet- latory or fiscal policy should address this
ter get their house in order. But regional through liquidity buffers and leverage ratios.
perspectives and national action should be But given how contagious crises are, it is
seen as inevitable as long as national tax- likely that what is ‘too big to fail’ is actually
payers provide the bailouts. A European small. Any list of institutions that were ‘too
Union (EU) bailout of Greece will further big to fail’ conjured up in 2006 would not
integration, not kill it. Elsewhere, more local have included Northern Rock, Bradford &

Bingley, IKB Deutsche Industriebank (IKB), old-fashioned world of credit and concen-
Bear Sterns or even Lehman Brothers. Banks tration limits and lending rules of thumb.
lend to banks. While some are more illiq- The systemic effect of having one large bank
uid than others, they are intrinsically illiquid engaged in rapid lending growth is no dif-
institutions. It does not take a large failure ferent than having several small banks do so.
to lead to panic. High-yielding deposits can It may even be easier to resolve a crisis with
fly out of the website almost as quickly as one large bank.
money market funds can withdraw. In a cri- It is argued that the underestimate of
sis, almost everyone is‘too big to fail’. risk by bankers is encouraged by the further
Moreover, we can have as large a boom belief that if it all goes ‘belly up’ their institu-
and subsequent crash, with the same eco- tions are too big to fail and their jobs would
nomic misery, in a world of only small banks. be safe. But if that latter belief dominated
Some will recall the Secondary Banking bankers’ thinking, they may not worry about
Crisis of 1973-1975 in the UK; some 30 rela- their jobs but they would still worry about
tively small financial institutions had to be their savings.
supported by the Bank of England follow-
ing the preceding property boom. The 1973- More fools than knaves
1975 crisis rivals, and on some measures They would not wrap themselves up in the
exceeds, the impact on the UK of the current equity of their institutions and the lever-
financial crisis. aged products they are selling. But they did.
It was one of the reasons that developed The revealed preference of bank and banker
country regulators began to take a more behaviour is that they did not lend more
benign view of large banks snapping up because they thought they could get away
smaller ones. The fashionable argument of from selling risk to others, or because they
the day was that small, competitive, finan- knew there would have to be some sort of
cial institutions were inefficient and had lit- bail out, but because they thought it was safe.
tle ‘franchise value’ and so they would under They were more fools than knaves.
invest in their own longevity – by having less The main driver of excessive lending
conservative lending practices – than larger, and leverage is a mistaken view of risks, by
more profitable banks. everyone and not just big banks. The riski-
est institutions were not the largest. Some
Brave new world very large institutions, such as J.P. Morgan
Crashes follow booms. Booms are fuelled and HSBC, proved safer than others and did
by some new dawn – normally the arrival not seek or require state funding, while those
of new technology – that makes bankers that failed were relatively small, e.g. IKB, Bear
feel that the world is a brighter place, risks Sterns, etc. There is an all too narrow divid-
have decreased, and that they are therefore ing line between this argument and the one
justified in lending and leveraging more.This that got us into this mess.
behaviour is even more acute in the modern Big banks like the idea that regula-
age of ‘risk-sensitive’ regulation than in the tion should care less about size of banks

and more about their riskiness, and so they capital requirements and perhaps some dis-
championed the ‘risk-sensitive’ approach to cretion, but not too much. Market-efficiency
bank regulation, not least because they had zealots will complain that the market can-
the bigger risk models and databases, so not make predictable mistakes, but there are
risk-sensitive regulation was more onerous many reasons why the market fails to correct
for their smaller competitors. its systemic error, the least rigorous being
that booms are always founded on the fal-
Bigger booms, deeper busts lacy of why ‘this time it is different’, one that
A better argument for curbing bank size is takes in regulators and bankers. Recall the
the excessive influence of big banks on pol- essays in central bank stability reports on
icy. The problem is that if booms are fuelled how credit derivatives were bringing new
by an underestimation of risks, and regula- stability to the financial sector?
tion is made more sensitive to the estima- The second way to reduce the sensitiv-
tion of risks, then the booms will be bigger ity of the financial system to the errors of
and the busts deeper. This is the fallacy of estimating risk, is to limit the flow of risks
the ‘risk-sensitive’ approach to risk manage- to institutions with a structural capacity for
ment, regulation and auditing. This is a fairly holding that risk, and not a statistical capac-
fundamental point, but I have discussed it ity. In this way when the risk modellers get
before and would like to highlight here how it wrong we are in less trouble. Credit risk is
the solution to this issue relates to current best hedged through diversification across
proposals. uncorrelated credits. Liquidity risk is best
What we are looking for is regulation hedged through diversification across time.
that makes the financial system less sensitive
to the error in the markets’ estimate of risk, not Capacity for risk
more so. Market risk is best hedged through a com-
There are two ways to do this. The first bination of diversification across assets
is to observe that this error is strongly cor- and time (having time to decide when to
related to the boom-bust cycle. Booms sell). In the past, risks of similar statistical
have similar characteristics – strong growth magnitudes were considered fungible and
in bank balance sheets and credit, a rise in simply flowed to whoever was prepared to
leverage, etc. The appearance of these would pay for it.
imply an increased probability of the mar- But while banks with short-term fund-
ket underestimating risk and so regulators ing and many branches originating differ-
should raise minimum capital requirements ent loans have a deep capacity for holding
when they spot these trends. credit risks, they have a limited capacity for
holding market risks and little capacity for
‘This time it’s different’ holding liquidity risk. Insurance companies
Counter-cyclical capital requirements fit in and pension funds on the other hand have
with this idea. A range of indicators would limited capacity for credit risk, but more for
have to be used to calibrate the rise in the market and liquidity risks. The capacity for

risk is related to the maturity of funding and the Volcker proposal to fragment financial
not what an institution is called. institutions, though fragmentation should be
This idea resonates to some degree with along the lines of risk-capacity and not legal
the former Chairman of the Federal Reserve entities or names. We should also be careful,
Paul Volcker’s idea of banks severing their however tempting it may be, to expect too
exposure to proprietary trading (market much from bashing big banks. •
risks), hedge funds, (market risks) and pri-
vate equity (liquidity risks). But we must be Editor’s note
wary of arbitrary distinctions – some hedge The editor wishes to thank VoxEU – www.
funds behave like banks and some banks voxeu.org – and the UK-based Intelligence
like insurance companies. Capital Ltd for allowing the Journal of Risk
& Regulation North Asia to publish a revised
Beware bank-bashing version of this paper.
Although the response to the crisis is becom-
ing more of a national issue and less global, References
current proposals to reform banking regula- Eichengreen, Barry (2009), “The G20 and the crisis”,
tion have some promise.This is especially the VoxEU.org, March 2.
case in the area of counter-cyclical measures Persaud, Avinash (2008), “Why bank risk models failed”,
being discussed by the Basel Committee and VoxEU.org,April 4.

North Asia
J ournal of reg
ulation & risk
north asia
Reprint Service l change

impacts
Complia
nce
Articles & Papers
Issues in resolving
Resecuritisation
systemically important
in banking: major
Volume I, Issue III,
financial institution
s
Autumn Winter 2009-2010
Dr Eric S. Rosengren
financia liance and risk

challenges ahead
A framework for
Global
funding liquidity Dr Fang Du
in times of financial
comp Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
nt – from bad to worst
manageme ent
Derivatives: from
disaster to re-regulati Stephan Schoess,
products pot on
head of details a
Black swans, market Professor Lynn A. Stout
EastNet’s David Dekker,
crises and risk: the
rkets. human perspectiv
ncial ma Measuring & managing e
nce,
complia al reaction in fina
risk for innovative Joseph Rizzi
financial instrumen
Red star spangled ts
che mic banner: root causes
of the financial crisis
Dr Stuart M. Turnbull
ngst oth-The ‘family’ risk: Andreas Kern & Christian

anies amo a cause for concern
among Asian investors Fahrholz
of comp services.
just be one able to offer these abou Global financial
t change impacts
s will will be r speak Thei- compliance and David Smith
the first sign ers that ld rathe risk
we saw d we shou mon scramble is on to tackle bribery Opinion
banks, or that
David Dekker
a year ago the financial worl s These days and corruption
About in utions than , a nameWho exactly is subject to the
formation credit crisi cial instit Penelope Tham & Gerald
of a trans last months the
cial worl
d at finan financial service
providers ities.
future activ Financial
Foreign Corrupt
Practices Act? Deregulation Li
and in
the
the finan ge that is tored their current and we have mov
ed markets remuneration
reform: one step
Tham Yuet-Ming , non-regul
has trans
formed
. the chan than cove
rs ly
how rapid n on the Ofbank
s
‘Black Swans’, stress tests
forward
Umesh Kumar & Kevin
and ‘desup ation
osive pace in scope Look at actio ation) to
& optimised risk Marr
an expl
is much
broader
occurring expected. bank
s that
were
from phys
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and hour
s of oper Challengin
banking.
g the value of enterprise
management
David Samuels ervisio n’
fail or fall s (location Internet Rockybut
risk management
Professor
causes of the William Black exam
nally to term then
origi too big by ents e, road ahead for global Tim Pagett & Ranjit Jaswal
d to be taken over ronic paym still in charg to a accountancy convergenc
considere
failing or being more finan- elect n the banks were igm is shifti ThengAsian regulatory
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Cube Goeth
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financial d, resulting in by as
Alan Ewins and Angus
regarded e we (phy out Ross
cially soun how banks are world wher each other with es such as THE autho States.
in ) pay technologi r of this
digm shift r banks. porations paper is a
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ng cal failure
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ing large mers, los- of the unsun collar’ failure tion
Since bank y to service custo impact providers s and organisatio
ns Savings & of private marke and a wholesale
the abilit ng the ork Loans debac g heroes of the and t discipline
trust and determini risk Netw future the bank and othe
r pay- Professor
Black nowa le of the 1980s, Crime
other forms of fraud
mer and ongoing the NACHA
of credit risk.
ing a custo be part of the as In SWIFT, providers of his time days spend s Enforcemen The Financial
ld n, as well such as network researching s much t Network
of it, shou of the organisatio become A to B markets have why financ released a (FinCE
ent ng and new ment networks send money from traf- a tendency ial Activi study this
week on Suspic N)
managem ess of existi ng to ork functional. to become ty Reports
g the riskin using/buyi allow you you for the netw Reno dys- lated (SARs ious
ges that s similari- ‘control fraud wned for his theory financial institu ) that federally regu-
Contact
monitorin customers e
ucts and the are more chan and will charg rate. This bring y University
’, Prof. Black on with tions (some
prod there are energ lectures at the Federa times) file
ucts. But world that you gene as telecom, of Missouri the (FBI) l Bureau of
these prod s in the banking fic that stries such financial He is the autho and Kansa when they Investigation
enge known it. with indu anies. The r of ‘The Best Way s City. fraud. find eviden
and chall as we have not be the ties cable comp g an important a Bank is ce of mortg
g banking e, liers and rgoin to Own One: to Rob age
threatenin s will, in the futur our funds, supp is clearly unde Executives
and Politi
How Corpo
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e world
The bank by which to mov ; they 135 S&L Indus cians Loote mic warni
les portfolios try.’ A prom d the The ng
default vehic balances and tor on the inent comm FBI began
Christopher Rogers
our causes of enta- mortg warning of
maintain crisis, Prof. the curren age fraud in an “epidemic”
h Asia Black is a t financial their congre of
Risk Nort way the US vocal critic mony ssional testi-
lation & governmen of the ago. in September 2004 –
of Regu banking crisis t has handl It also warne over five years
Journal and rewar ed the not d that if the
that have ded institu dealt with epidemic were
clearl tions sis. it would cause
duties to inves y failed in their fiduci Nothi a financial
tors. ary respon ng remotely adequate cri-
d to the epidem was done to
General Secretary
enforcemen ic by regula
The following t, or private tors, law
commentary sector
essarily repres
ent the view does not nec- cipline.” Instead, the epidem “market dis-
Regulation of the Journa hyper-inflate ic produced
and Risk – l of that d a bubble and
North Asia. produced a in US housin
“The new crisis so severe g prices
numbers on
rals for mortg criminal refer- caused the collapse that it
age fraud in
the US are system of the global nearly
just in many and led to unpreceden financial
Journal of of the world ted bailouts
Regulation ’s largest banks of
& Risk North .
Asia
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