text:
This action might not be possible to undo. Are you sure you want to continue?
E di te d by : M a th i a s D ew a tr ip o nt , Xav i e r F re i x as a n d R i c ha rd Po r te s
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
cepr.org Website: www.org © Centre for Economic Policy Research 2009 .Centre for Economic Policy Research (CEPR) Centre for Economic Policy Research 2nd Floor 53-56 Great Sutton Street London EC1V 0DG UK Tel: +44 (0)20 7183 8801 Fax: +44 (0)20 7183 8820 Email: cepr@cepr.
Xavier Freixas and Richard Portes .Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Edited by: Mathias Dewatripont.
CEPR research may include views on policy. but the Executive Committee of the Centre does not give prior review to its publications. CEPR is an entrepreneur. 1727026). Chair of the Board President Chief Executive Officer Research Director Policy Director Guillermo de la Dehesa Richard Portes Stephen Yeo Mathias Dewatripont Richard Baldwin . Established in 1983. consumers and sponsors of research. developing research initiatives with the producers. The opinions expressed in this report are those of the authors and not those of the Centre for Economic Policy Research. 287287) and a company limited by guarantee and registered in England (No. The Centre is pluralist and non-partisan. CEPR is a registered charity (No.Centre for Economic Policy Research (CEPR) The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates. bringing economic research to bear on the analysis of medium. and the Centre takes no institutional policy positions. based primarily in European universities. The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is a European economics research organization with uniquely wide-ranging scope and activities.and long-run policy questions.
and as Chief Economist and Special Adviser to the President at the European Bank for Reconstruction and Development. the EBRD. He has held academic appointments at Princeton University. economic development and transition economies. in Economics v . University of Oxford and in 2008 Max Schmidheiny Visiting Professor for Entrepreneurship and Risk at the University of St. EDF. BP. fiscal policy. by the London School of Economics (LSE). a Research Fellow of CEPR and the Executive Director of the European Corporate Governance Institute (ECGI). he has served as an Advisor to Goldman Sachs International. The World Bank. and behavioral trading. Alcatel. Markus K. In 2003. social security. an associate editor of the American Economic Review. He has published widely on subjects such as open economy macroeconomics. the OECD and the World Bank. He is also a research associate at CEPR. Since 2005. He was awarded his Ph. His research spans economics and finance. He is a member of the Belgian Corporate Governance Commission and has given expert briefings to the Group of Economic Analysis of the President of the European Commission. the European Parliament. he was Visiting Professor at the Saïd Business School. Brunnermeier is the Edwards S. He obtained his PhD in Economics from Yale in 1975.D. and as Co-Director of the CEPR International Macroeconomics Programme. NBER and CESifo. Journal of European Economic Association. the University of Bristol. among others. Willem Buiter is Professor of European Political Economy at the European Institute of the London School of Economics and Political Science and a CEPR Research Fellow. a Resident Fellow at ECARES at ULB. strategic considerations. Sanford Professor at Princeton University. His research also explains why liquidity dries up when it is needed most and has important implications for risk management. He is a member of the Department of Economics and affiliated with Princeton's Bendheim Center for Finance and the International Economics Section. and the European Commission.D. and an academic consultant to the Federal Reserve Bank of New York. the board of Andra AP Fonden. He has been Research Director of CEPR as well as part-time Visiting Professor at MIT since 1998. Securities Regulators. The Inter-American Development Bank. Journal of Finance. He has served as a member of the Monetary Policy Committee of the Bank of England. He is primarily interested in studying financial crises and significant mispricings due to institutional frictions. Journal of Financial Intermediation and was previously on the editorial board of the Review of Financial Studies. where he was also affiliated with its Financial Markets Group. Yale University and the University of Cambridge and has been a consultant and advisor to the International Monetary Fund. monetary and exchange rate theory. Mathias Dewatripont is Professor of Economics at the Université Libre de Bruxelles where he is Vice-President of the Solvay Brussels School of Economics and Management and a researcher at ECARES. He is a Sloan Research Fellow. Gallen.About the Contributors Marco Becht is a Professor of Finance and Economics at Université Libre de Bruxelles.He holds a Ph.
He is an author of many books including The Japanese Economy. The vi . His research contributions deal with the issues of payment systems risk. banking regulation and systemic risk. He is Associate Editor of Journal of Financial Intermediation. Econometrica.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 from Harvard University and was awarded the Francqui Prize in 1998 and the Yrjö Jahnsson medal in 2003.D. the Interamerican Development Bank. He has published some 50 articles and edited two books in the areas of monetary economics. Senior Advisor in the Research Department at the IMF. Review of Financial Studies. from Harvard University. He has served as Head of Secretariat to the Committee on the Global Financial System at the BIS. and at the INSEAD. as Executive Director (Research) at the Hong Kong Monetary Authority and Director of the Hong Kong Institute for Monetary Research. He is also Chairman of the Risk Based Regulation Program of the Global Association of Risk Professionals (GARP). He has published a number of papers in the main economic and finance journals (Journal of Financial Economics.M. Takatoshi Ito is Professor in the Graduate School of Economics at the University of Tokyo. Journal of Political Economy. His research covers the theory of incentives and organizations. Ito served as President of the Japanese Economic Association. the European Central Bank. Review of Finance. He received his Ph. Deputy Vice Minister for International Affairs at the Japanese Ministry of Finance and as a member of the Council of Economic and Fiscal Policy (2006-8). He is the author (with Jean Tirole) of The Prudential Regulation of Banks. received tenure at Brandeis University. and has taught at Harvard. contagion and the lender of last resort. He is an External Member of the Monetary Policy Committee of the Bank of Mauritius. Journal of Banking and Finance and Journal of Financial Services Research. and a CEPR Research Fellow. Xavier Freixas (Ph D.…) and has been a consultant for the European Investment Bank. international finance and financial stability. He received his doctorate from the University of Münster and has worked at the University of Mannheim. the New York Fed. Stefan Gerlach is Professor of Monetary Economics at the Institute for Monetary and Financial Stability at the University of Frankfurt and a CEPR Research Fellow. and on reputation and market structure. His research focuses on risk management. Much of his current research focuses on the role of asset prices in monetary policy. He has served as Managing Editor of The Review of Economic Studies and as was President of European Economic Association. He is a member of European Commission DG-Competition's Economic Advisory Group on Competition Policy and of European Commission President J. the University of Minnesota and Hitotsubashi University. and University of Minnesota (as a visiting scholar). MEFF and the European Investment Bank. Hendrik Hakenes is Professor of Financial Economics at the University of Hannover. the Max Planck Institute in Bonn. and has held visiting positions at Harvard and Brown Universities. He received his doctorate from the Graduate Institute of International Studies in Geneva in 1983. the World Bank. with applications to banking and corporate finance as well as to transition economics. Barroso's Group of Economic Policy Analysis. Toulouse 1978) is Professor at the Universitat Pompeu Fabra in Barcelona (Spain) and Research Fellow of CEPR.
About the Contributors
Political Economy of the Japanese Monetary Policy and Financial Policy and Central Banking in Japan, as well as more than 50 academic journal articles on international finance and the Japanese economy. Philip R. Lane is Professor of International Macroeconomics at Trinity College Dublin. In addition, he is a managing editor of the journal Economic Policy and the founder of The Irish Economy blog. He is a research fellow of the Centre for Economic Policy Research (CEPR) and a member of the steering group for its Macroeconomics of Global Interdependence (MGI) working group. His research interests include financial globalisation, the macroeconomics of exchange rates and capital flows, macroeconomic policy design, European Monetary Union, and the Irish economy. He also serves on the editorial boards of the International Journal of Central Banking, Empirica, Open Economies Review and Moneda y Credito. He is also a member of the scientific advisory committee of CEPII. In 2001, he was the inaugural recipient of the German Bernacer Award in Monetary Economics. He is also a member of the Royal Irish Academy, the Bellagio Group and the EURO-50 group and is a former member of the Handelsblatt ECB Shadow Council. He has consulted for the International Monetary Fund, World Bank, European Commission, European Central Bank and a number of national central banks.
Marco Pagano is Professor of Economics at University of Naples Federico II, President of the Einaudi Institute for Economics and Finance (EIEF), and a CEPR Research Fellow. He holds a Ph.D. from MIT and has taught at Bocconi University and the University of Salerno. He is joint managing editor of the Review of Finance and chairs the Scientific Committee of EuroMTS and is an advisor to the Unicredit Group. He has advised the Italian Treasury on the reform of security markets, and has been a member of the Treasury's privatisation committee, the European Parliament's advisory panel on financial services, and has served as Co-Director of the CEPR Financial Economics Programme. His research is in the fields of corporate finance, banking and stock market microstructure. He has also done research in macroeconomics, especially on its interactions with financial markets. His publications have appeared in journals such as American Economic Review, Review of Economic Studies, Quarterly Journal of Economics, Journal of Finance, Review of Financial Studies, RAND Journal of Economics, Journal of the European Economic Association, European Economic Review, and Economic Journal.
Richard Portes, Professor of Economics at London Business School, is Founder and President of the Centre for Economic Policy Research (CEPR), Directeur d'Etudes at the Ecole des Hautes Etudes en Sciences Sociales and Senior Editor and Co-Chairman of the Board of Economic Policy. He is a Fellow of the Econometric Society and of the British Academy. He is a member of the Group of Economic Policy Advisers to the President of the European Commission, of the Steering Committee of the Euro50 Group, and of the Bellagio Group on the International Economy. He was SecretaryGeneral of the Royal Economic Society 1992–2008. Professor Portes was a Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton, Harvard, and Birkbeck College (University of London). He has been Distinguished Global Visiting Professor at the Haas Business School, University of California,
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia Business School. His current research interests include international macroeconomics, international finance, European bond markets and European integration. He has written extensively on globalisation, sovereign borrowing and debt, European monetary issues, European financial markets, international capital flows, centrally planned economies and transition, macroeconomic disequilibrium, and European integration. Rafael Repullo is Professor of Economics and Director of the Centre for Monetary and Financial Studies (CEMFI) in Madrid. He is also Executive Vice-President of the Econometric Society, Member of the Executive Committee of the European Economic Association, Fellow of the Econometric Society and of the European Economic Association, and CEPR Research Fellow. He holds a PhD in Economics from the London School of Economics. He has been a Houblon-Norman Fellow at the Bank of England, and has held visiting appointments at the European Central Bank, the Federal Reserve Board, the Federal Reserve Bank of Minneapolis, the Federal Reserve Bank of New York, the London School of Economics, and the Universities of Columbia, Pennsylvania, Princeton, and Tel Aviv. He has served as Co-Director of the CEPR Financial Economics Programme. His recent research is in the areas of banking and finance. He is currently Co-Editor of the International Journal of Central Banking.
Jean-Charles Rochet is Professor of Mathematics and Economics at Toulouse School of Economics. He holds a Ph.D. from Paris University and has been visiting professor in several universities and schools such as the London School of Economics and Political Science. His books include (with Xavier Freixas) Microeconomics of Banking; (with Guillaume Plantin) When Insurers Go Bust (Princeton) and Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation.
Jesús Saurina is Director of the Financial Stability Department at the Banco de España. He is a member of the Banking Supervision Committee of the ECB/Eurosystem. He is a PhD in Economics from the Universidad Complutense de Madrid and is a portgraduate from CEMFI (Madrid). He was an Associate Professor at the Carlos III University in Madrid. His research interests are banking and finance, regulation, and financial stability. He has published recently in the Review of Financial Studies (credit lines), the Journal of Financial Economics (collateral), the Journal of Money, Credit and Banking, the Journal of Financial Intermediation (capital buffers), the Journal of Banking and Finance, the Journal of Financial Services Research (Basel II impact on SMEs lending and procyclicality in mortgages), Economics Letters (risk premium and market power), Review of Industrial Organization, European Accounting Review (earnings and capital management), the European Economic Review (financial deregulation and risk taking) and the International Journal of Central Banking (dynamic provisions).
Isabel Schnabel is Professor of Financial Economics at Johannes Gutenberg University Mainz and a CEPR Research Affiliate. She received her doctorate from the University of Mannheim and has served as Senior Research Fellow at the Max Planck Institute for Research on Collective Goods in Bonn. She has been a visiting scholar at the International Monetary Fund (IMF), the London School of Economics, and Harvard University. Her research focuses on financial crises, bank regulation, and the history
About the Contributors
of financial crises and institutions. Schnabel currently serves as Scientific Advisor to the German Federal Financial Supervisory Authority (BaFin) and as editor of Economics of Transition. Carlos Trucharte is a senior economist of the Financial Stability Department in the Directorate General for Banking Regulation at the Banco de España. He holds an MSc. from the London School of Economics (Operational Research, OR) and a postgraduate degree from CEMFI (Madrid).
Paolo F. Volpin is Associate Professor of Finance and the JP Morgan Chase Research Fellow at London Business School. He holds a Ph.D. in Economics from Harvard University. His field of research is Corporate Finance. Currently, his interests focus on international corporate finance, corporate governance and political economy of corporate finance. His work has been published in the Journal of Financial Economics and the Oxford Review of Economic Policy.
main policy proposals and summary Global Imbalancess Richard Portes The Global Crisis and Capital Flows to Emerging Markets Philip Lane The Risk of Deflation Stefan Gerlach Zero Interest Rate Policies and Quantitative Easing Takatoshi Ito Fiscal Sustainability Willem Buiter Financial Crises: Mechanisms. Prevention and Management Markus Brunnermeier Mitigating the Procyclicality of Basel II Rafael Repullo.Contents About the Contributors Acknowledgements Introduction. Jesús Saurina and Carlos Trucharte The Regulation of Credit Derivative Markets Hendrik Hakenes and Isabel Schnabel Credit Ratings Failures: Causes and Policy Options Marco Pagano and Paolo Volpin The Treatment of Distressed Banks Mathias Dewatripont and Jean Charles Rochet Corporate Governance and the Credit Crisis Marco Becht v xii 1 19 27 49 67 79 91 105 113 129 149 165 xi .
We hope the proposals and the underlying analysis will be useful in preparations for the London Summit on 2 April. We are grateful to Stephen Pickford at HM Treasury and Charles Bean at the Bank of England who supported this workshop with enthusiasm. with additional support to CEPR from the European Union's programme of "Support for bodies active at the European level in the field of active European citizenship. careful use of the theory and empirics as the basis for policy recommendations. first. the temptations for each individual country to free ride increase and the need for coordination becomes more evident. It requires. the Reinventing Bretton Woods Committee or CEPR (which takes no institutional policy positions). HM Treasury.Acknowledgements As the financial crisis deepens. Economics and Global Governance: The European Dimensions" (PEGGED). funded by the European Commission's Seventh Research Framework Programme. the Bank of England. The London Summit on 2 April should play a key role in generating such a coordinated response. a rigorous analysis of the key features of the financial crisis using the latest empirical evidence. CEPR was delighted to join the Reinventing Bretton Woods Committee in organizing a seminar with the G20 Deputies on 31 January. implementable results that can restore confidence and lead the way to recovery. but delivering this analysis is a formidable challenge. by offering concrete. For this reason." The views expressed in these papers are those of the authors and not those of the European Commission. and to Anil Shamdasani for publishing this e-book so quickly. and second. Sound economic analysis is essential in designing this response. We are grateful as well to Nadine Clarke and Nav Sandhu at CEPR for the smooth preparations for the meeting. hosted by HM Treasury and the Bank of England. at which preliminary versions of the papers in this e-book were presented. Stephen Yeo of CEPR oversaw all these activities and assisted us in editing. It was a pleasure to work with Marc Uzan of RBWC in planning the workshop and with Nicholas Joicey and his staff at the Treasury in organizing it. Support for the preparation of the papers and for the meeting itself was provided under the auspices of the collaborative project "Politics. Xavier Freixas Mathias Dewatripont Richard Portes .
We hope the proposals and the underlying analysis will be useful in preparations for the London Summit on 2 April. and using the theory and empirics as the basis for policy recommendations.Introduction. covers the macroeconomic as well as the microprudential aspects of the crisis. based on a careful interpretation of the latest empirical evidence. Université Libre de Bruxelles and CEPR. 1 . Delivering this research is a challenge: it requires a rigorous analysis of the main features of the financial crisis. The standard textbook analysis of a systemic crisis involves two pillars: macroeconomic fragility and contagion. ECARES. Universitat Pompeu Fabra and CEPR. They were first presented at a seminar with the G20 Deputies on 31 January. the current crisis is no different from previous ones. The G20 process offers the prospect of concrete. and hosted by HM Treasury and the Bank of England. main policy proposals and summary Mathias Dewatripont. (iii) facilitate estimating the cost and benefits of each policy proposal. The systemic crisis is a global crisis. so that these can anchor the discussions and make it easier to reach a consensus. There is no decoupling. We face a systemic crisis. From that perspective. Xavier Freixas and Richard Portes Solvay Brussels School of Economics and Management. Introduction and policy proposals As the financial crisis deepens. It will help to (i) eliminate policy options that are appealing yet inefficient or costly to tax-payers. sound theory and careful empirics will be at the core of the debate on the present collapse of financial markets and its macroeconomic causes and consequences. organised by the Centre for Economic Policy Research and the Reinventing Bretton Woods Committee. and poor countries. These essays and our proposals are designed to be an input into the G20 process. The London Summit will play a key role in generating such a coordinated response. It involves the advanced countries. emerging market countries. (ii) identify the most efficient solutions. and solutions must involve reciprocal commitments and actions. This is why this book. as the title indicates. Even if particular policy recommendations are not adopted. at least. London Business School and CEPR 1. Sound economic analysis is essential in designing the response. The striking difference comes from the specifics of the macroeconomic fragility and the channels of contagion which are to some extent unprecedented. the temptations for each individual country to free ride increase and the need for coordination becomes more evident. implementable results that can restore confidence and lead the way to recovery.
While it was thought that these innovations were beneficial because they transferred banking risk to nonbanking institutions. 2 . such as the interbank market for maturities beyond one day. This sudden change has been so remarkable that the best representation of the crisis is a model with two possible equilibria. and the lack of adequate countercyclical prudential regulation. the passive attitude of the regulators was bound to lead to disaster. contributed to amplify the impact of the breakdown? On the macro side. despite generous liquidity injections by central banks all over the world. to what extent have mechanisms intended to improve financial efficiency. Global imbalances . lax monetary policy led to the building of bubbles in a period of low interest rates and macroeconomic stability. one close to the perfect market paradigm and the other akin to Akerlof's adverse selection market for lemons. As information becomes more and more scarce.further contributed to the growth of international liquidity. the buildup of huge portfolios of credit default swaps (CDS) in a small number of institutions that suddenly became vulnerable with the onset of the crisis.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 1. Switching regimes One of the most striking characteristics of the current crisis has been the complete freezing of liquidity in key markets. to financial markets. two main questions are to be answered: First. however. characterized by an absence of trade. the search for yield. sufficiently capitalized or with a lower social cost of bankruptcy than banks. coupled with poor corporate governance and the failure of shareholders to act to protect their investments.1. Three key factors combined to trigger the regime switch: liquidity shortages that occurred. the lack of a proper system for dealing quickly with insolvent banks. and pressures on financial intermediation. the increased risk of the collateral on which the securities were based. The switch from one regime to another challenges all our views on economic and regulatory policy.large current account surpluses and deficits . we have to acknowledge now that in practice they imported systemic risk from non-banking institutions and securities markets to the heart of the banking system. The sudden transformation from markets that were perfectly transparent to complete opacity can be attributed to the complexity of instruments. This was supposed to lead to a more efficient allocation of risks. and the collapse of credit ratings awarded to structured securities as a basis for valuing and trading these securities. the switch to the market collapse and the (Akerlof) no-trade equilibrium was inevitable. That would only happen. what macroeconomic features led to the dramatic regime switch from boom to total collapse? Second. On the micro side. if these risks were transferred to agents with well-diversified portfolios. financial innovations such as securitization and credit default swaps have redefined the boundaries of the banking system. Once those risks concentrated in undiversified portfolios of large non-banking institutions such as AIG or Lehman Bros. the failure of credit rating institutions to perform properly. either as innovations or as new regulatory measures. There were other causes too: the procyclical bias of Basel II regulation. and the tendency of bank compensation systems to encourage excessive risk taking by employees. Banking regulators stood by as financial innovations were transferred outside their reach. To understand how this switch in regime has come about.
flexible.e.. Since the crisis is all-encompassing. along three possible lines: more central bank swap lines. • International coordination of cooperatively designed fiscal stimuli is necessary to allow the internalisation of the effective demand externalities of a fiscal stimulus through the trade balance and the real exchange rate. 'reserve pooling'. with a zero interest rate policy (ZIRP) and quantitative easing. fast-disbursing facility that would come with little or no conditionality to countries that are adversely affected by global shocks. Large loans to the IMF by major reserve holders offer one way of funding this insurance until Fund quotas are raised. Promote regional cooperation in the design of common institutional standards for financial market development and work to lift barriers to cross-border asset trade within regions. before it takes hold. 2. Establishing an inflation target may help to avoid expectations of deflation. we stress above all the short-run policy imperative. we list these proposals. starting with the global perspective and continuing all the way to the individual bank. 2009)1. But in keeping with the conception and the title of this book. Financial intermediation and the structure supporting it must be restored to near-normal conditions to stop the accelerating decline. Addressing global imbalances and capital flows • Create credible insurance mechanisms for countries that forego further reserve accumulation and stimulate domestic expansion. 3 . • Accelerate the development of emerging market country financial systems. which would be a beggar-thy-neighbour policy. with particular emphasis on local currency bond markets and on foreign currency hedging instruments. i. The contributions are summarized below. together with IMF emphasis on a large. Here the two are deeply complementary.Introduction. A country with large trade surpluses with positive GDP growth should refrain from intervention to prevent appreciation. These are for the most part either 'micro' or 'macro' proposals. • A global ZIRP would raise a particular problem: not all countries can benefit from the stimulus of exchange-rate depreciation. 1 The references for the papers mentioned in this Introduction appear at the end of each of the relevant chapters. its ability to generate larger future primary government surpluses. and an expansion of IMF resources. Let us stress here several proposals that deserve special attention in our view (in addition to the set of recommendations discussed in Markus Brunnermeier's chapter. as they must be. 1. Fiscal stimuli should follow the 'fiscal spare capacity' of each country. Neither monetary nor fiscal policies will work unless and until the blockages in the supply of credit are resolved. which summarizes the Geneva Report of Brunnermeier et al. main policy proposals and summary 1. Addressing the crisis This book analyzes a wide array of reform proposals the G20 should consider in order to address the crisis.2. The challenges of macroeconomic policy in the crisis • Meet any threat of deflation promptly.
4. force greater disclosure of information about the underlying pool of securities. But typically financial crises follow on booms and asset price bubbles.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 3. The global imbalances interacted with the flaws in financial markets and instruments to generate the specific features of the crisis. Summary of the contributions 2. Greed.in particular. or at least that the link between CRAs and the issuer is severed. Market reforms • Require without further delay a centralized clearing counterparty for CDS trades. positive and negative. 2.traded and consider prohibiting CDS that do not insure a holder of the underlying asset (naked CDS). Also. financial innovation. The dispersion of current account balances. increased great- 4 . This would involve USstyle 'prompt corrective action'. Consider an openaccess. so that a CRA's rating does not affect its future business with a given client.were the major underlying cause of the crisis. and they have played roles in past crises. Even the sophisticated financial markets of the United States and United Kingdom could not cope with the pressures. Macroprudential regulation • Mitigate procyclicality by adjusting the Basel II capital requirements using a simple multiplier that depends on the deviation of the rate of growth of GDP with respect to its long-run average. Consider going further to require that CDS be exchange. giving the (independent and well-staffed) supervisory agency powers to limit the freedom of bank managers (possibly remove them) and shareholders (possibly expropriate them) before the bank is technically insolvent. the macroeconomic environment created the conditions for the crisis. eliminating the NRSRO designation and the extensive 'hard wiring' of the CRAs in the regulatory system. for structured instruments. 5. Controlling financial institutions • Establish a harmonized special bankruptcy regime for banks. and in this case too. • Require that credit rating agencies (CRAs) be paid if possible by investors rather than by issuers. deficiencies in regulation are not new. Prohibit indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. The specific feature of this crisis is that major saving-investment imbalances and consequent huge cross-border financial flows put great stress on the financial intermediation process. non-prescriptive approach by regulators. • Consider the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities.1 Global Imbalances Richard Portes argues that global macroeconomic imbalances . incentive problems. large current account deficits and surpluses .
but so will their fiscal deficits. 2. Portes proposes direct limits on the borrowing and leverage of financial institutions. Rather. the surplus countries have been accumulating reserves since the Asian crisis of 1997-98 as a precaution against any further 'sudden stops' in capital flows. Portes therefore argues that the key to reducing the global imbalances is to create credible insurance mechanisms for countries that forego further reserve accumulation and stimulate domestic expansion. as well as their willingness to accept a fall or even a reversal of their current account surpluses. Large loans to the IMF by major reserve holders offer one way of funding this insurance until Fund quotas are raised. and the current crisis will only further encourage such behaviour. Loose monetary policies together with the large reserves accumulated by surplus countries brought excessive global liquidity. they ignore the role of global imbalances in feeding financial market excesses. 'reserve pooling'. and several Asian emerging market countries as well as some commodity exporters have had large surpluses.Introduction. and an expansion of IMF resources. So this proposal is directly linked to global imbalances. because the institutions cannot expand their balance sheets much by relying exclusively on domestic capital markets (that would drive up interest rates). In the medium term. together with IMF emphasis on a large. Most of these imbalances continue. fast-disbursing facility that would come with little or no conditionality to countries that are adversely affected by global shocks. and Australia have had large current account deficits. Japan. Advanced countries could require that their financial institutions accept liabilities abroad only in the currency of the borrower. The UK. Germany. 'savings glut'. or at least suggesting they were a sustainable equilibrium . that led to the 'search for yield' and rise in leverage. Together with low interest rates. Alternatively. There are three possible avenues: more central bank swap lines. reducing the global imbalances will require a rise in domestic demand in the surplus countries. The global imbalances played a significant role in the fall in all major financial market volatilities that began in 2004. But the emerging market countries are unlikely to put their trust in the IMF until its governance and their representation in it are radically changed (see Philip Lane's chapter). Even more important than their flaws. Household savings will doubtless rise in the US and UK. borrowing countries could make foreign currency obligations incurred by domestic firms and households unenforceable in their courts. That is not specifically external assets. Financial regulation and global imbalances intersect directly in leveraging.2 Capital Flows to Emerging Markets Philip Lane shows that the external balance sheets of emerging market economies are 5 . This is not primarily an exchange-rate issue. main policy proposals and summary ly over the past decade. Portes recommends a proposal due to Anne Krueger (2000). Any increase in balance sheets of systemically important financial institutions (balance sheets of intermediaries) should not exceed the fiscal capacities of host governments. Portes rejects the various arguments justifying the global imbalances.'Bretton Woods II'. Gross capital flows have risen even more than the net flows implied by the current accounts. flexible. This is not just a US-China story. Spain. Policies ought also to control currency mismatches. but such a constraint would naturally limit the increase of external assets. 'global asset shortage'.
Regional capital flows may be more stable. and financial protectionism . Lane points out that the risk profile of emerging market countries has improved greatly in the past decade: net liabilities are down.pressure on banks to lend domestically rather than abroad . Financial integration is still incomplete. complemented by the development of the currency derivatives markets. however: these economies are sufficiently integrated into the global financial system to be exposed to severe financial shocks. Moreover. The external environment has indeed suddenly become much harsher. The problems are most acute for entities that relied on short-term external funding to acquire longer-term illiquid domestic or foreign assets. They have partly overcome 'original sin' (inability to borrow abroad in their own currencies) through foreign direct investment and foreign investment in portfolio equity. Exports and commodity prices have collapsed. as well as allowing the international financial institutions to make local-currency loans to clients in those markets. and they have exploited alternatives to foreign debt finance. in view of the underlying linkages between neighbouring economies and the lower level of bilateral exchange rate volatility. Lane argues that the recent increase in the cost of external capital should motivate greater efforts to develop domestic financial systems. both by enabling effective monetary expansion and through direct deployment of reserves. The rise in risk aversion has brought a general widening in spreads and a moderation in the search for yield that reduces the appeal of investment in emerging markets. in order to allow investors to separately trade currency risk and credit risk. it is desirable that regional groups intensify efforts to cooperate in the design of common 6 . but they are treated differently by the global system in comparison to the financial environment that faces the most advanced economies. Deleveraging by the financial institutions of advanced countries has brought a pullback from foreign markets. Lane sees much scope for regional levels of financial integration.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 far different today than during the international financial crises of the 1980s and 1990s. The high level of reserves accumulated in recent years improves the capacity to manage balance sheet problems. Although there is scope for domestic expansion (monetary and fiscal stimulus) in many emerging market countries. But the still limited role for local-currency debt in external financing means that the emerging markets remain highly exposed to international financial crises. reserves are up. Accordingly. He complements Portes in arguing that self-insurance (through reserve accumulation) is collectively inefficient and incomplete. The improved domestic mobilisation of domestic savings reduces the importance of external capital as a funding source.is a further threat. so that international financial disturbances will have less impact on them in the future. The international financial institutions could do more to issue securities in the currencies of the emerging market economies. a deeper financial system increases the span of investment opportunities available to foreign investors. That leads him to propose domestic and international reforms to improve the stability of capital flows to emerging market economies. however. they need above all to safeguard medium-run fiscal sustainability. thereby expanding the depth and liquidity of the domestic-currency bond markets. Lane puts particular emphasis on the development of local-currency debt markets.
Furthermore. It is incumbent on the advanced countries to accept this redistribution. 7 . 2. Thus a contractionary shock of a given size will be more difficult to handle if it pushes the economy into deflation than if the rate of inflation remains positive. Even if the threat materializes. of slowing aggregate demand. To that end. A more serious concern arises because central banks cannot reduce nominal interest rates below zero.Introduction. Gerlach is not too concerned about downward nominal wage rigidities. main policy proposals and summary institutional standards for financial market development and work to lift barriers to cross-border asset trade. In particular. and not a cause. Deflation is a fall of the economy-wide price level that is sufficiently persistent to trigger expectations that prices will continue to decline for some non-negligible period of time. which can be changed in a counter-cyclical manner to support employment. the real interest rate is equal to minus the rate of inflation. The strength of two-way international transmission mechanisms between advanced and developing countries means that this reform debate has to involve representatives of the emerging economies in a central role. This may reflect particularly large and persistent declines in the demand for goods and services. Stefan Gerlach argues that the risk should not be exaggerated: so far. positive rate of inflation. nominal wages may be rigid downward and there is a risk that policy-controlled interest rates reach zero. which reduces the effectiveness of the interest rate channel of monetary policy. economic agents do not expect deflation. real unit labour costs can still decline even if real wages are rising. As deflation takes hold and turns increasingly severe. real interest rates rise. the importance of downward nominal wage stickiness may decline if the economy enters deflation. appropriate monetary and fiscal policies can deal with it. with the obvious potential for the consolidation of representation by member countries of the European Union. downward nominal wage rigidity is not a structural feature of the economy but rather a consequence of having experienced a long period of positive inflation. and that is one reason why it is unlikely. deflation is merely an indicator. as well as IMF quota increases and the potential importance of the Fund's new Short-Term Liquidity Facility. Monetary and fiscal policy measures that raise demand will stimulate economic activity just as they would at a low. But deflation can induce non-linearities in the functioning of the economy. reducing aggregate demand and exacerbating the downward pressure on prices. In regard to the broader G20 agenda. Unit labour costs depend also on indirect taxes and social charges. Irving Fisher's (1933) debt deflation theory has come into fashion. If the nominal interest rate is zero. Indeed. If productivity growth is positive.3 The Risk of Deflation There is some risk that the rapid decline in inflation in many countries in recent months could turn into deflation with highly adverse real economic developments. a major shift in the distribution of voting power at the IMF would be clearly beneficial. He also endorses regional currency swap arrangements and reserve pooling. Lane argues that it is in the interests of the emerging market economies to support international reforms that improve stability in the major financial centres and at the global level. If so.
and quantitative easing can step in at the zero interest bound. Most of them fall into a category of QE. measures to support the financial system. he points out the obstacles to getting monetary policy right. The monetary authorities have other options. Deflation impairs economic activity both by raising real interest rates and by increasing the burden of debt fixed in nominal terms. The papers by Takatoshi Ito and Willem Buiter give detailed support to these conclusions. an expansion of the central bank balance sheet by purchasing risk assets that the central bank normally would not buy. broadly defined . (3) what assets to buy. QE). in order to help maintain mild inflation expectations.that is. then fiscal policy measures to shore up the banking system and to expand aggregate demand may be necessary. The prime example of the dangers and policy errors is Japan in the 1990s. Like Gerlach. Gerlach suggests that central banks that do not yet have inflation targets should adopt such a target now. leading to valuation gains for bond holders and an improvement of their balance sheets. Situations in which fiscal policy is ineffective are not likely to be of much practical relevance. If deflation does take hold. and a fall in other interest rates that use them as reference rates.4 Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) Takatoshi Ito emphasizes the importance of avoiding deflation. If the exchange rate is fixed. 2. The Bank of Japan tried one version of QE from 2001 to 2006. and. There are many proposed variants of unconventional monetary policies. Emerging market countries should be conscious of this deflation risk. If concerns about credit risk limit the willingness of banks to extend credit even when all interest rates have reached zero. the central bank can provide credit directly to borrowers. Inflation expectations are currently positive. despite aggressive monetary policies. when it is associated with financial instability.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Gerlach dismisses the argument that central banks should avoid cutting interest rates to zero since they then have no policy lever left to use if inflation falls further. QE variants differ with respect to (1) what is the primary purpose. But guided by the Japanese experience. central banks can reduce their yields. They are more likely to have fixed exchange rate regimes than advanced economies. The economics of stopping a deflation is clear and calls for aggressive easing of monetary and fiscal policy. the entire burden of adjustment to a shock will fall on the nominal price level. Gerlach does have a particular word of caution for emerging market countries. and (4) how to influence inflation expectations. and he elaborates on appropriate monetary policies (in particular. (2) what would be the target instrument and communication strategy. Additional policy easing is less likely to be needed if rates are cut aggressively at an early stage of the easing process. The US Federal 8 . Ito stresses the importance of maintaining positive inflation expectations. Ito considers what the central bank could do beyond ZIRP to stimulate the economy. Past episodes of deflation are therefore best seen as reflecting policy mistakes or an inability to forge a political consensus about how policy should be conducted. despite the falls in commodity prices. By purchasing long-term government bonds.
rather than (a Japanese-type) QE. All countries. and the Bank of Japan again goes into ZIRP/QE. Based on that experience and the ongoing experience of the Fed. This is uncharted territory in international macroeconomics and finance. however. Arriving at ZIRP should not be delayed until the inflation rate reaches zero. 2. This may be particularly tricky in the euro area. without excessive concern for maintaining a risk-free balance sheet. followed by several European central banks. but room for sustainable fiscal deficits is quite different across countries. are remarkable and commendable. some positive and some negative. main policy proposals and summary Reserve. Ito makes the following very clear policy recommendations. 4. 1. would not be available. 9 . The authorities should make unmistakably clear their do-everything attitude to avoid a prolonged deflation. namely. Under a global ZIRP environment. The authorities should not hesitate to expand the central bank's balance sheet by buying whatever risk assets would most effectively restore financial stability. with a promise to raise a less-distortionary tax in the medium run. the exchange rate depreciation. If deflation sets in. the effectiveness of QE in one country would be diminished. is now trying another version. if possible. 5. since intervention to prevent appreciation would be equivalent to a beggar-thyneighbour policy. a country with large trade surpluses with positive GDP growth should refrain from large scale intervention. The fiscal authority must be willing to fill any holes in the central bank's balance sheet without using this as a lever to reduce the bank's independence. Who should that be? Countries with large trade surpluses are obvious candidates. Coordination among central banks may become important for this reason. transparent message. we will enter an environment of global ZIRP and QE.ends up with ZIRP and QE. 3. since one channel of stimulus from ZIRP. The higher the debt ratio is. If the ECB sooner rather than later . Trust between the central bank and the fiscal authority is important to induce the central bank to take bold actions in QE or CE. The ZIRP/QE experiences of the Bank of Japan from 1999 to 2006 offer important lessons. In this respect. Globally-coordinated fiscal stimulus is desirable. With adoption of ZIRP by several major central banks. Many variants of QE should be considered and attempted. current fiscal spending associated with structural reforms removing inefficiencies and with subsidies to green innovations. Thus. the FRB actions to purchase wide range of securities. may be prudent fiscal policy in the circumstances. Even in high-debt countries. Ito joins Gerlach in saying that inflation targeting may be helpful as a clear. and with some expectation of what is coming in Europe. which it says is "credit easing" (CE). where a single central bank faces 16 separate fiscal authorities. some currencies have to appreciate vis-à-vis others. but not all of them can do so simultaneously. want to depreciate to help encourage exports and discourage imports under a deflationary environment.Introduction. the authorities should commit to err on the side of late rather than early for the timing of exit from ZIRP and to an easier-than-usual monetary policy thereafter. the more constrained is the country in implementing fiscal stimulus.
QE through purchases of government securities is an especially important source of revenue for the sovereign whenever short-term interest rates are well below long-term interest rates. which should seek to boost domestic demand and reduce their trade surpluses. When done competently. (iii) an increase in short-term unemployment benefit financed by a reduction in long-term unemployment benefit (short-term and temporarily unemployed workers are more likely to be liquidity-constrained).. while minimizing moral hazard. Examples include: (i) an increase in social security retirement pensions financed fully by higher social security contributions by workers and employers (pensioners have a higher marginal propensity to consume). Close cooperation between the monetary and fiscal authorities is necessary to achieve the right timing and magnitude of monetization of public debt and deficits. 5.g..g. International coordination of cooperatively designed fiscal stimuli is likely to be necessary to allow the internalisation of the effective demand externalities of a fiscal stimulus through the trade balance and the real exchange rate. according to its ability to generate (and to commit itself credibly to generate) larger future primary government surpluses. credit. With Portes and Lane. 6. A temporary increase in public consumption or investment will always boost aggregate demand. 1. but not outstanding stocks of loans. 2. Buiter argues that international fiscal stimuli must be cooperatively designed according to the 'fiscal spare capacity' of each country. and the reversal of this monetization when the economy recovers. which we paraphrase here. or securities. 10 .financed tax cuts. He conveniently summarises his analysis and recommendations in nine propositions. 4. If there are liquidityconstrained households. But the stimulus must be mindful of sustainability constraints. Countries with unsustainable external deficits (e.5 Fiscal sustainability Willem Buiter argues that a fiscal stimulus is a key weapon in the policy arsenal used to address an undesirable weakening of aggregate demand. 8. even a permanent balanced-budget increase in public spending on goods and services will boost aggregate demand. even if the budget is kept balanced. With Ito. the United States) should seek to boost their trade balances and de-emphasize domestic demand relative to countries with unsustainable external surpluses (e. the fiscal authorities should guarantee or insure flows of new lending and credit. 3. 7. including securitisation. Even operationally independent central banks must recognise that their profits or (equivalently) their monetary issuance are an important source of fiscal revenue. China). (ii) an increase in student grants financed fully through a levy on financial wealth (students are likely to be liquidity-constrained). To get the maximum impact in stimulating aggregate demand.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 2. Buiter is concerned that very large fiscal deficits and public debt issuance by rich countries will risk crowding out sovereign and private sector borrowers from emerging markets and developing countries. Balanced-budget redistribution between households with different marginal propensities to spend out of current income can boost demand as effectively as deficit. these coordinated actions will not threaten the price stability mandate of the central bank. that is.
toxic asset purchases. Notice that liquidity spirals create an important procyclical mechanism that makes Basel II capital requirement procyclicality even more severe. Jesus Saurina and Carlos Trucharte compare various ways to reform the Basel II capital requirements in order to handle procyclicality. 2. Rafael Repullo. but this will lead to a further decrease in the price of the asset. 9.6 Liquidity Crisis Markus Brunnermeier offers an overall view of the crisis. Quantitative easing or credit easing is therefore likely to be complementary to fiscal policy in economies badly affected by a credit squeeze. fear demands for liquidity from SIVs to which they have granted credit lines) as well as from depositors. So liquidity spirals and margin/haircut spirals reinforce one another and lead to fire sale prices for securities. (2009). When the price of an asset falls. main policy proposals and summary Longer-term risk-free global real interest rates are likely to rise. the increase in haircuts during a crisis implies that with the same assets the amount of liquidity available is lower. Because production takes time. Brunnermeier summarizes the policy conclusions from the Geneva Report.7 Mitigating Procyclicality In their chapter. marking to market requires the bank to take the loss immediately. In addition. These represent rational behaviour on the part of individual financial institutions (they may. There is indeed broad agreement by now that one has to 'index' current capital requirements to take into account macroeconomic variables and thereby avoid the destabilizing effects of prudential regulation. As the effects of liquidity shortages are clearly the main cause of contagion in the present crisis. How to do it is a key policy question. distinguishing crisis prevention (with recommendations like the introduction of macro-prudential regulation or liquidity regulation among other topics) from crisis management (with analyses of nationalization. for example. This contagion mechanism combines marking to market and forced sales to obtain liquidity. To improve its capital ratio the bank may be forced to sell some assets. The main vector of contagion has been the liquidity shortage: this is one of the most striking features of the current crisis. forcing even more asset sales. working capital is essential. In his chapter. decreasing its equity and thus increasing its leverage beyond the target level. second. Brunnermeier emphasises two features of this channel of contagion: first. and runs (possibly triggered by higher margins and haircuts) may develop. asset guarantees or mortgage subsidies). its origins. 2. fire sales by one institution affect all other institutions and.Introduction. contagion is not confined to the banking sector but propagates to the entire financial sector. we should not forget that other mechanisms may act to compound it: banks may hoard liquidity making the liquidity shortage more acute. 11 . but individual rationality may lead to huge negative externalities for the banking system as a whole. This issue is discussed in the Geneva Report written by Brunermeier at al. Policies to provide credit to the non-financial enterprise sector may therefore be a precondition for expansionary fiscal policy to have any material effect on production and employment. possible mechanisms for its resolution and ways of preventing such crises in the future.
2. held in reasonable proportions within diversified portfolios and in institutions able to absorb losses. 1. This complexity makes it impossible for a market participant to assess risk. for example. the requirements would be increased in expansions (or decreased in recessions) by 7. The empirical model provides an estimate of the point-in-time (PIT) probabilities of default (PDs) of the loans in the portfolio of commercial and industrial loans of the Spanish banks. such as the rates of growth of GDP.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 The chapter by Repullo et al. Concentration of counterparty risk: some financial institutions such as Lehman Bros or AIG were able to build up enormous risk positions. is a step forward in this direction. namely how to introduce "macro-prudential" regulation into the Basel II philosophy. This chapter thus offers an interesting pragmatic solution to a key policy issue.2% for a one standard deviation change in GDP growth. as an institution may hedge one counterparty risk with another CDS. This was clearly not the case. Since such macro-prudential regulation will have to be based on the macroeconomic specifics of each country (the business cycle in Spain. 12 . Also. The results show that the best procedure is to use a simple multiplier of the Basel II requirements that depends on the deviation of the rate of growth of the GDP with respect to its long-run average. the legal status of the netted positions in case of default of one of the counterparties is unclear. by using a through-the-cycle (TTC) adjustment in the PDs. namely: (i) smoothing the inputs of the Basel II formula. 2. or (ii) smoothing the output by using an adjustment of the Basel II final capital requirements computed from the PIT PDs (using macroeconomic variables. hidden from the eyes of regulators and their own shareholders. Uncertainty and asymmetric information: the development of an active market for CDS has led to a complicated chain of linked exposures. Specifically. not to mention the US). being different from that in Germany. They use data from the Credit Register of the Bank of Spain to analyze the effect of the leading alternative procedures that have been proposed to mitigate the procyclical effects of the Basel II capital requirements. In practice. it shows the way to go: identifying reasonably robust linkages between the state of the economy and the degree of solvency of banks. in order to provide buffers that will limit the procyclical effect of prudential regulation. the main function of the credit derivative market was to allow institutions to engage in regulatory arbitrage. They can then compute the corresponding Basel II capital requirements per unit of loans and estimate the credit risk profile of the Spanish banks over the sample period using the metric of Basel II.8 Credit Derivatives In their chapter Hendrik Hakenes and Isabel Schnabel identify three key channels through which the credit default swaps (CDS) market has contributed to the crisis. As the authors put it. Then they consider the effect of the two main procedures to mitigate the cyclical behavior of these requirements. Efficient transfer of risk requires that they be transferred in a diversified way. of aggregate lending. The resulting uncertainty about banks' positions in the credit derivative market contributed to the disturbances in interbank markets. or the returns of the stock market).
9 The Information Content of Credit Ratings Marco Pagano and Paolo Volpin address the issue of why credit ratings have not been sufficiently accurate in the market for structured products. Banning naked CDS would prohibit such speculation and limit the purpose of CDS to hedging. Inflation in credit ratings might have been exacerbated by (i) the use of ratings by regulators.to a complete unwinding of the CDS market. since their clients are the issuers. 2. particularly the opportunity costs of standardization and of holding eligible collateral. Although this was apparent at the level of each individual institution. The collapse of a major dealer could potentially lead to severe domino effects. and the existence of a centralized clearing counterparty. In general. as mentioned by Brunnermeier and Pedersen (2009). that speculation may yield useful information. which confers an intrinsic value to ratings over and above their true ability to measure risk." 3. The function of CDS is to reduce risk. they prefer improvements in the infrastructure of CDS markets. however. The CDS market contributed to the increase in "connectivity" of global financial markets. the opacity of CDS markets seems to have contributed to disruptions in interbank markets. Switching to organized markets will have costs.may create undesirable incentives. and . whose number may have increased with the popu- 13 . In addition. The authors carefully consider the three elements characteristic of organized markets: Transparency over exposures and netting. This has led issuers to fine tune their packaging strategies so as to put together securitized assets that are just on the lower bound of the range of eligible AAA securities.Introduction. a measure partially promoted by the regulatory authorities themselves. The authors maintain. CDS allow investors to short debt without any restrictions. The origin of the problem lies in conflicts of interest within the credit rating agencies (CRAs). collateral and margin calls. but is simply betting that a firm or sovereign will default (or speculating on a rise in the market's estimate of the likelihood of default) . The centralized clearing counterparty would have to be subject to an implicit government guarantee. The authors point out that 'naked' CDS .in which the purchaser does not own the underlying asset. neither market discipline nor the regulator could control the extent of risk. A natural policy recommendation here is to force all trades to go through an organized market. main policy proposals and summary "instead of providing useful information. Collusion between CRAs and issuers have led CRAs to disclose information on their models to their issuers. Because of the opacity of the credit derivative markets. the overall impact of CDS has been to increase systemic risk. They argue that rating inflation and coarse information disclosure are the main reasons why trading on the basis of credit ratings has collapsed. standardization. margin requirements give rise to new risks. who are directly interested in obtaining good ratings. the most important being funding liquidity risk.in an extreme scenario . This would clearly occur if the buyer could influence the market assessment of credit risk or if widening CDS spreads themselves affected the health of the bond issuer. (ii) the presence of naïve investors. Transparency over exposures would allow market discipline (and regulatory authorities in some cases) to penalize the excessive concentration of exposures.
The question is then why information coarseness could be in the interest of CRAs. if feasible. however. that their effectiveness in addressing the failures exposed by the current crisis is likely to be low. would shift onto issuers and investors the burden of determining the pieces of information that are most relevant to evaluate the risk of each security. as there is a potential market for resale. an open-access. In addition. In contrast. instead of further increasing. but the idea of harmonized capital ratios is a sound one. Information coarseness leads to market opacity. 2. the tangle of regulations in this area. information coarseness provides more opportunities for rating inflation. Notice that here information is coarse not only because of the low number of tranches. 2008). It will also be essential to prevent indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. as increased competition among the CRAs will lead them to provide issuers with more favourable ratings. to require that CRAs be paid by investors rather than by issuers (or at least constrain the way they are paid by issuers) and force greater disclosure of information about the underlying pool of securities. makes monitoring more costly and fosters adverse selection. in choosing the degree of rating transparency. This is why the authors suggest a second best policy related to the Cuomo plan. Thus. issuers effectively face a trade-off between primary and secondary market liquidity. The authors believe. requiring that users pay for ratings leads to a number of well known complications. not Loss Given Default (LGD) are provided. as this could limit the development of a secondary market. but also because only probabilities of default (PDs). where "Credit rating companies should be paid an upfront fee irrespective of the rating issued and credit shopping (and paid advice by rating agencies to issuers) should be banned. and would not run the risk of obsolescence. The analysis of the typical prospectus for structured debt reveals that the quality of the information available to investors through the prospectus is quite limited. In addition. a third major Nationally Recognised Statistical Rating Organisation (NRSRO). This is an instance in which less regulation might also be safer and better regulation.10 The Treatment of Distressed Banks Mathias Dewatripont and Jean-Charles Rochet start from the observation that the current regulatory system is inconsistent because it has not attempted to harmonize the treatment of distressed banks." These more limited reforms may still be consistent with the current regulatory delegation of vast powers to a select group of CRAs.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 larization of finance in recent years. The policy recommendations are. 14 . This stands in contrast with the efforts to harmonize capital ratios under Basel I and II. non-prescriptive approach by regulators. It would also reduce. This harmonization has several significant flaws that must be addressed. the models used by CRAs are based on assumptions of default correlation that are clearly underestimates in a downturn (Bemmelech and Dlugosz. Still. eliminating the NRSRO designation and the extensive 'hard wiring' of the CRAs in the regulatory system. The answer provided by Pagano and Volpin (2008) is that limiting transparency at the issue stage shifts the adverse selection problem onto the secondary market. first. and ironically (iii) the increase in competition associated with the entry of Fitch.
The signals triggering intervention should be crude indicators of the risk of potential problems. while consolidated supervision . Dealing with individual banks. undercapitalized banks may lack the incentives to be well managed. in order to provide simple signals of the various dimensions of banking risks (including liquidity and transformation risks. main policy proposals and summary which should be extended to the treatment of distressed banks. But the current system has clearly erred in the opposite direction. Without such centralization.allows for cost savings and simpler coordination. Once in a crisis. These would be used simultaneously to determine whether supervisory corrective action is needed. risks of large losses. or procyclical deposit insurance premia. there is always a potential cost of such rules in terms of loss of flexibility. Simplicity reduces manipulability and enhances transparency and credibility. Of course. because of 'political economy' considerations: whether in good or bad times. they recommend moving towards a centralized supervisor and a centralized deposit insurer. 15 . …). This implies a coordinated mechanism (involving the central bank. so Dewatripont and Rochet recommend explicit ex-ante provisions. exposure to macroeconomic shocks. such as the EU. capital insurance (privately or publicly provided). they recommend relying on a battery of plain indicators. Regarding the structure of regulation. Dewatripont and Rochet consider international cooperation in crisis management. rather than for low capital requirements. they argue that a harmonized special bankruptcy regime should be established for banks. There is therefore a cost in leaving the treatment of distressed banks vaguely specified or unspecified and therefore at the discretion of supervisors. however. as we see with current regulation. Finally. supervisors always face pressure from lobbies and from politicians that undermine the proper functioning and stability of the financial system. it may reduce accountability. such as higher capital ratios in good times. Dewatripont and Rochet offer a number of recommendations to move closer to a rule-based system that maintains some flexibility. Banking crises do happen. Avoiding this requires 'automatic stabilizers' in the regulatory system. even if it is costly. it is important to foster best practices in establishing credible Memoranda of Understanding for cross-border banking crisis management between authorities that detail in particular the respective rights and obligations with respect to intervention thresholds and deposit insurance. Rather than a single. That can be countered by reducing discretion in terms of intervention by the supervisors (as in the US). This would involve US-style 'prompt corrective action': giving to the (independent and well-staffed) supervisory agency powers to limit the freedom of bank managers (and possibly remove them) and shareholders (and possibly expropriate them) before the bank is technically insolvent. they stress that.bundling ex-ante monitoring and ex-post intervention . one should therefore also seriously consider partial centralization of supervision and deposit insurance at the global level. as in Basel II. Regulatory authorities need to be protected ex ante through a system of transparent rules. Dewatripont and Rochet argue for a limited number of simple indicators rather than highly sophisticated systems. the supervisor and the finance ministry) for declaring a crisis formally and triggering the release of public funds. complex capital requirement. This is a central issue. For economic areas which are meant to be highly integrated. One should go for 'real' recapitalization. dynamic provisioning.Introduction. If one wants to keep integrating the world banking market. Maintaining adequate capitalization in bad times may have procyclical effects.
Corporate governance at the firm level was never designed to internalize contributions to systemic risk. Many non-bank institutions on the periphery of prudential regulation have contributed to the leveraging of the world economy. These individuals must be given appropriate pecuniary and non-pecuniary rewards to make themselves available and to succeed. Banks with weak governance have collapsed in one country. misaligned or perverse incentives. These developments pose new challenges for prudential regulation. There are robust banks and distressed banks with similar corporate governance arrangements. Shareholders and boards encouraged executives to expand and leverage. There have been problems at widely held banks. Banks have collapsed in countries with weak shareholder rights and in countries with strong shareholder rights. weaknesses in internal controls. Moreover. followed a simple pattern. The incentive contracts for executives must be analyzed at all levels. Private equity firms drove up leverage in the corporate sector.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 2. however. In many cases there was no agency problem at the firm level. This would explain why some banks within the same countries failed and others did not. either directly or by purchasing shares in institutions that did. Governance at the firm level did not take into account the systemic stability implications of selling or purchasing certain financial services. Central gatekeepers like credit rating agencies and analysts did not raise the red flag. empire building. for the reasons mentioned in Pagano and Volpin chapter. conflicts of interest. These corporate governance failures have not. First. which has traditionally focused on banks. This leads Becht to make several specific recommendations. however. Equally there is no simple pattern across countries. Becht notes. The failure to incorporate systemic risk into the corporate governance and incentive contracts of individual institutions amplified these problems. with the consent of the buyout targets' shareholders and of their own investors.. incompetence and fraud. This diversity of experiences suggests that corporate governance failures have combined with regulatory failures in complex ways. Pension funds and asset managers of all sorts purchased what turned out to be "toxic assets". especially once they are recapitalized. In many cases governance did not provide a failsafe means of offsetting regulatory failure. Marco Becht stresses that the current crisis has brought to light classic examples of board failure on strategy and oversight. The banks should follow the example of Union Bank of Switzerland (UBS) and conduct a detailed investigation of the sources of their writedowns and propose measures for their future avoidance to shareholders and regulators. on the corporate governance and prudential supervision of individual institutions: Banks need to recruit individuals of outstanding competence and integrity to run them. It would also explain why some countries have avoided major bank failures while others could not. at banks with a large shareholder and at banks controlled by the state. but banks with equally weak governance did not collapse in other countries. nationalized or re-privatized.11 Corporate Governance In the final chapter. At the micro level it appeared that risk could be insured and lending expanded profitably. it is likely that systemic failure would have occurred even with perfect governance at the level of individual institutions. and perverse incentive schemes must be banned. the need to investigate the governance of regulators and the incentives they can provide for their staff 16 .
The fund would have no controlling stakes but would act as a focal point for other institutional investors with significant influence. corporate governance failure at state-controlled banks in some G20 countries has undermined the credibility of government intervention in the banking sector. main policy proposals and summary in parallel with the governance of financial institutions. Similarly. The fund could also provide the capital insurance recommended by Kashyap. The corporate governance of state-owned or nationalized banks deserves special attention. 17 . Becht makes an original proposal: the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities.Introduction. Rajan and Stein (2008). In order to build financial stability incentives into corporate governance structures.
and Global Governance: The European Dimension"). I then consider forward-looking concerns and policies to deal with them. 19 . reserve pooling. This would indirectly constrain global imbalances. focusing on creating conditions for them to borrow internationally in their own currencies. or to the international institutions. I also acknowledge support for this work from the European Commission DG Research Framework Programme grant to the CEPR project PEGGED ("Politics. and an expansion of IMF resources with significant changes in how they may be used. Author's note: I am grateful to Hélène Rey for suggestions. I conclude by proposing several major policy initiatives. This too is an essential condition for comfort in accepting capital inflows and current account deficits. • Limit the balance sheets (leverage) of systemically important financial institutions so as not to exceed the fiscal capacities of their host governments. crisis. possibly by requiring that advanced country financial institutions accept obligations only in the currency of the borrower. Economics. as well as to Rakesh Mohan and Stephen Pickford for comments. and economic policy I propose here an interpretation of the crisis and its policy implications.Global Imbalances Richard Portes London Business School and CEPR 1. so here I simply set out the argument. I maintain that global macroeconomic imbalances are the underlying cause of the crisis. • Directly control currency mismatches. but the responsibility for the final version is entirely mine. There is now an extensive literature. and the data are easily available. • Give high priority to developing the domestic financial markets of developing countries. responsibilities for dealing with it lie with all countries and are reciprocal. to the group as a whole. They will require action by both the developed country members of the G20 and the developing and emerging market G20 countries. through central bank swap lines. Only this could induce them to forego further accumulation of precautionary reserves and accept a switch from current account surpluses to deficits. Implementation may fall to individual countries. Global imbalances. But regardless of the origins of the crisis. The key proposals regarding global imbalances include: • Provide emerging market countries with credible insurance against sudden stops. with only a few references and no tables or graphs.
nor were the banks holding such instruments in off-balance-sheet vehicles. 2. Australia) and many Asian emerging market countries and (until recently) commodity exporters with large surpluses. Global imbalances as the source of the crisis 2. but even there. the emerging market/developing country current account in surplus by $ 900 bn. it was not a disaster. 2. The Russian default of August 1998 and the LTCM near-death experience of September 1998 caused great instability in the financial markets. high leverage in financial institutions. which even the sophisticated American and British financial systems could not handle responsibly. It was transmitted to Brazil. In the major US banks. Fear was pervasive by the end of September. the US current account and emerging market plus developing country current account were each about zero. the US current account was in deficit by $ 600 bn.3. however egregious and important these may be.2. The underlying problem in international finance over the past decade has been global imbalances. The dollar fell by almost 15% relative to the yen in three days in October. the search for yield. while those with slow productivity growth attract capital inflows (Gourinchas and Jeanne. I pass by the debate whether the global imbalances and associated financial sector weaknesses could have been remedied gradually. 20 .1. They brought low interest rates. as well as Japan and Germany. not greed. I suggest that the global imbalances that built up in the past decade permitted and indeed stimulated the dysfunctional aspects of financial markets and instruments that are now troubling us. Spain. The macroeconomic imbalances did interact with the financial sector problems. In 1996. But this 'crisis' had virtually no effects on the real economy. and in early October even the US Treasury market became illiquid briefly. but the phenomenon of global imbalances is much broader. The major differences with the past six months are that there were no big global macroeconomic imbalances then (except perhaps for the weakness of the yen). leverage was actually greater in 1998Q3 than in 2007Q3. There are several other major advanced countries with large deficits (UK. I simply argue here that global imbalances led to financial sector distortions. from developing countries and emerging markets to advanced countries. And counterintuitively. poor incentive structures. and financial engineering had not yet developed the range of complex structured products we saw in 2005-07. or weak financial regulation. Both surplus and deficit advanced countries invest mainly in other advanced countries. and avoiding the next crisis of this kind requires addressing them. and an excessive volume of financial intermediation. had Lehman Brothers not failed (as I believe). It is important to distinguish two separate features of the global imbalances: (a) The much greater dispersion of current accounts (absolute values). without a crash. 2008). This puts a burden on financial systems to intermediate the large gross flows. In 2008. There was a major spike in volatilities for almost all financial assets. Much of the policy discussion has focused on the US deficit and the Chinese surplus. (b) Capital flowing the 'wrong way'.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 2. and deleveraging in 1998Q4 went further than it has gone so far since autumn 2007. developing countries with fast productivity growth show capital outflows.
They were constrained to buy US 21 . They were willing to invest the resulting foreign exchange reserves in the United States. and policy-makers in the developed countries and international agencies encouraged this.5. They saw the imbalances as a sustainable equilibrium. bond and equity markets. with effects from Iceland and Turkey to the yen. 'Excess' reserves safeguard against both 'sudden stop' and flight by domestic savers (when no capital outflow controls). is the only one that has not happened! There is no dollar crisis (yet). but the interpretation of imbalances and their policy implications are totally different. the rise in volatilities had killed the carry trade. 2. together with lower and more stable inflation and low interest rates. This shortage was a particular problem for the countries with excess savings and undeveloped financial markets. But before then. The Bretton Woods II story was also too focused on China. nor on the implications of global imbalances for financial intermediation in advanced countries. Global imbalances played a significant role in the fall of volatilities: they contributed strongly to a sharp rise in the volume of financial transactions and to a major increase in global liquidity. before autumn 2007 much attention focused on volatilities in advanced country foreign exchange. low volatilities. in particular China. The latter turns out to be most important. it put excessive emphasis on exchange-rate policy. led to the 'search for yield' that brought many of the financial excesses. the classic 'sudden stop' crisis (for the US). But this analysis misunderstood the rationale for trade surpluses: those surpluses were intended to build up precautionary reserves to deal with 'sudden stops' in capital flows. analysis seldom focused on the consequences of low real interest rates and the 'search for yield'. (2007) posit a global 'shortage of reliable and tradeable assets'.Global Imbalances This pattern and the data are well known (see Ferguson et al. The effect may be the same. despite a 'flight to quality' into US Treasuries. although the volatility spikes were not extreme relative to historical experience until 15 September 2008. Two main stories appeared.4. asking why they had been so low from mid-2004 onwards and considering the risks that rise in volatilities would pose. But until the crisis. both of which brought lower volatilities. In fact. The first was the 'Bretton Woods II' argument (Dooley et al. the main concern seemed to be the potential rapid unravelling of imbalances and the associated risk of abrupt dollar depreciation. Ch 3). intended to absorb surplus labour coming out of agriculture. The major exchange rate move so far is large yen appreciation. 2. however. were deliberately maintaining undervalued exchange rates as part of an export-led growth strategy – in the Chinese case. collateralisable assets. In regard to financial intermediation. with perhaps a new bubble there. The rise in volatilities since August 2007 has in turn been a significant part of the financial turmoil. and the dollar has appreciated significantly relative to the euro since its low. a reversal of capital flows. 2007. 2003) that several major developing and emerging market countries. and this 'vendor finance' could continue for a decade or more.. Caballero et al. and it included odd views about foreign exchange reserves serving as 'collateral' for FDI coming from the US (so the US could expropriate those reserves in the case of foreign expropriation of FDI). to justify the pattern of capital flows that we have called imbalances. Moreover. With the notable exception of the Bank for International Settlements.
it is now abundantly clear that not only the Asian countries have difficulties with financial intermediation. with a wide range of quality. a consequence of the global imbalances. Neither story addresses the key questions about global imbalances going forward. Nor did the process channel emerging market savings into emerging market investment projects – instead. when ex post real interest rates on sovereign borrowing were negative 1-2%. 22 . (b) No one now believes in the exceptional quality of US private sector financial assets or intermediaries. Recently central banks (except for the Peoples Bank of China) have apparently stopped buying Treasuries. fall in investment. But interest rates were not in fact exceptionally low – compare the 1970s. the pattern was not benign. if commodity prices stay low and Asian surpluses fall? I address these shortrun questions below. It was much remarked. 2. Moreover. a lot covered the US current account deficit. that when US short rates went up. But the capital inflow to the US continues. the rest went mainly through the US to advanced country markets. along with the current account deficit. but rather mainly from foreign central banks (supposedly themselves intermediating on behalf of their savers). and the LM curve shifted to the right (so both downwards). Both of these interpretations of global imbalances – which do not really regard them as imbalances in the sense of disequilibria – ignore the stresses that the massive capital inflows created for financial intermediation in the US and other advanced countries. The inflows did not finance US investment. Both versions gave a rationale for an equilibrium transfer of capital from the excess savings countries to the low-savings advanced countries.6. In the light of the crisis and policy responses to it. are the prime suspects as the cause of low real interest rates and consequently the search for yield. however. what foreign investors. in particular the 'savings glut' (see below). after 2000. Output was maintained at low interest rates. especially the US. (2007) stressed the asymmetry in financial market development. together with loose monetary policies in the US and some other advanced countries. can the US deficit continue – or will a collapse in trade go with rise in US savings. by domestic or foreign investors? Indeed. That was partly because of the increase in foreign central banks' demand for Treasuries and US agency securities. partly because of the monetary effects of reserve accumulation. and a major recession? The rise in US government deficits goes in the opposite direction – but how will that be financed.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 assets. Indeed. But this interpretation does not fit the patterns of capital flows. but the foreign private sector is now doing so. Global imbalances. Mendoza et al. long rates did not (the 'Greenspan conundrum'). Global liquidity rose sharply. the IS curve shifted to the left. Globally. (a) Surplus country savings went into all advanced country financial assets. (c) US gross capital outflows are very high – primarily to other advanced countries (d) Gross flows to the US did not come primarily from the private sector (before 2008). because of the unparalleled breadth and depth of US financial markets and the abundance of appropriate financial instruments. but rather consumption and government deficits.
A savings glut in one region must have as a counterpart excess domestic demand in another. domestic as well as foreign? In fact. Exchange rate adjustment may be necessary but certainly not sufficient to reduce them. So yes. But 'financial excesses' are as old as financial markets. insofar as elimination of capital controls and the advances of financial innovation permitted (financed) current account imbalances. much of it war-related. but we should not imagine that will suffice unless we deal with the global imbalances. A well-known interpretation.Global Imbalances The difference with the 1970s is financial deregulation. On the other hand. We focus on net savings. from corporates as much as households. 2. since investment actually rose substantially in China. preventing excessive leveraging in future should help to reduce the global imbalances (see below). 3. it is unlikely that this could continue. I also look at flows. US net foreign debt did not rise in the period 2002-2007. there was excessive leveraging.e.5 above. On the other hand. So is that the problem? Yes. and 23 . Fiscal stimulus in the advanced countries (both US and Europe) will generate a very large increase in net government debt issuance – a major asset supply shock. but deleveraging alone will not bring conditions sufficient for recovery. although preliminary data suggest it did rise substantially in 2008 (Milesi-Ferretti. 2. at least at the long end of the yield curve. 2009). Just because they became based on securities rocket science and ratings agency failures does not make the various manifestations of 'greed' new. From the beginning of the decade. is the 'savings glut' story (Bernanke 2005). US net savings fell – there was both a credit-fuelled rise in household consumption and a fall in government saving due to tax cuts and rising expenditure. savings minus investment. it is not helpful to represent the former as prior. we do need better regulation. There are major unresolved macroeconomic issues. Then we can envisage an increase in savings and possibly some fall in private investment. related to those in Sec. But even this is not straightforward. Of course US net savings equals rest of world net investment. the latter issue being the 'sustainability' of debt burdens. rest of world net investment did fall (with both investment down and savings up). however. Although I shall not discuss sustainability (see Buiter's essay in this book). Once we emerge from global recession. and unless one can demonstrate a causal relationship. But this is oversimplified and asymmetrical. though it fell elsewhere in Asia. Concerns looking forward 3. But the stocks of domestic debt will now rise substantially in the advanced countries. i. Chinese savings rose even more. which create problems for financial intermediation. which could permit reducing current account deficits.1. Yes. Who will absorb this debt? If it is to be domestic financial markets. then interest rates must rise. I shall consider how this relates to global imbalances. Current account imbalances are real imbalances.. The US could grow without saving because of Asian finance (partly due to the international currency status of the dollar).7. Is the problem flows or stocks. because of valuation effects. In the medium run this is desirable: households should reduce their indebtedness.
And will we eventually see the oft-foretold dollar crisis (as in Krugman 2007)? The safe haven effect will not last. Depreciation creates a potential inflationary pressure. The key desiderata are clear. in limited measure: real rates fall. 24 . of their current account surpluses (see below). and foreign central banks are unlikely to step in (partly because their surpluses are falling). Alternatively. Policies 4. 3. while long rates rise. as part of quantitative easing. short-run private inflows will turn around. • Limit both global imbalances and financial fragility. First. where will international liquidity come from? This is not in fact a problem: the issuer of the main international currency (world banker) need not run current account deficits. and sterling all fall in that scenario.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 dealing with global imbalances requires raising savings in the advanced countries with current account deficits.1. the domestic central banks could buy the government debt. however. and we have 'twin deficits'. a reduction in the global imbalances. If real interest rates must rise. but rather necessary? This breaks down into two questions. the euro.3. where will the 'replacement' demand come from? The answer is clear: it must be from a rise in domestic demand in the surplus countries. perhaps a reversal. To assess these scenarios. and it is harder to grow out of a debt crisis in a global recession. 3. 4. that is. the burden of debt is somewhat eroded. and if there is a zero interest rate policy. The experience of the 1930s and of Japan in the 1990s may be relevant. Second. as it could lead to Fisherian debt deflation.4. Could that provoke emerging market country defaults? Interest rates are low.2. Many G20 policy-makers fear that capital will be pulled out of emerging markets into the government bond markets of developed countries running large fiscal deficits. It can instead just borrow short and lend long. This might be welcome. This leads us to ask whether the rest of the world can do without US deficits. The markets indeed fear that the US might want to devalue or inflate its way out of crisis. So the dollar. and the depreciations facilitate current account adjustment. But inducing foreign investors to absorb this debt will require some combination of higher interest rates and exchange-rate depreciation. then there may be deflationary pressures as well as a sharp steepening of the yield curve. but commodity prices are down. Is the major global imbalance not destabilising. see the essays by Gerlach and Ito in this volume. 3. So this is a real possibility still. Or foreign central banks and sovereign wealth funds buy the government debt. as the UK did under the gold standard (while running large current account surpluses). The deflationary impulse would be dangerous. achievable only if they are willing to expand and accept a fall.
Where financial regulation and global imbalances intersect directly: Limit borrowing and leverage of financial institutions. This does suppose that there will be periods of significant inflows.5. After all. • Get capital flowing from advanced countries to emerging market and poor countries. So this proposal is directly linked to global imbalances. BoJ. The IMF looked carefully at the issues in 2006-07. That is. borrowing countries could make foreign currency obligations incurred by domestic firms and households unenforceable in their courts. So reduce emerging market surpluses. Alternatively. on outflows in recession. • But limit crises.e. 2006). That is not specifically external assets. capital controls are often porous.2. that the international financial system and institutions will insure them against sudden stops. One proposal made several years ago by Anne Krueger (2000) should be resurrected. limit the increase in balance sheets of systemically important financial institutions (balance sheets of intermediaries) to below the increase in the fiscal capacities of host governments. which kept interest rates low and permitted leveraging up. perhaps. There are cogent arguments for countercyclical capital controls – on inflows in boom. but they still have some effect. and among the emerging market countries themselves (as in the Chiang Mai initiative – but these would have to be on much larger scale and more automatic) (b) more ambitious 'reserve pooling' arrangements – would it be possible to go beyond swaps on a large scale? There are serious political obstacles here. and there are other 'insurance' proposals that avoid the pitfalls of the illfated contingent credit line. But then we must assure the emerging market countries that they can safely accept current account deficits – i. With recent experience in mind. 4. ECB. but with some imagination and commitment. but such a constraint would naturally limit the increase of external assets. that will require some conviction and serious insurance schemes. is that the international financial system should provide credible insurance to countries that forego further reserve accumulation. Control currency mismatches.Global Imbalances • Avoid reversing financial development and financial integration. even go to deficits. because the institutions cannot expand their balance sheets much by relying exclusively on domestic capital markets (that would drive up interest rates).. The institutions could not have expanded leverage without borrowing from abroad. Advanced countries could require that their financial institutions accept liabilities abroad only in the currency of the borrower. 4. • Avoid financial repression. 4. 4. (c) the IMF – we have proposed a 'lender of first resort' scheme (Cohen and Portes. As recent Chinese experience suggests. the emerging market countries might reasonably think now that they need even more precautionary reserves! The three avenues for this are: (a) central bank swap lines – with the Fed. Most important.3.4. they might be overcome. 25 .
. 2004. P. 'Conflicting demands on the International Monetary Fund'. Mendoza. 6149. Ferguson. need substantial domestic investors – pension funds. (2007). Cohen. CEPR Discussion Paper no. et al. G. 'Will there be a dollar crisis?'.6. 'Financial integration. 307-313. American Economic Review Papers and Proceedings. and global imbalances'. Nor could an agreement be implemented – 'reference rates'... CEPR Discussion Paper no. International Financial Stability. Dooley. however.7. 'grids' are all unreliable and unenforceable without effective capital controls (although occasional intervention might be useful). 'A lender of first resort'.-M. Capital Flows to Developing Countries: The Allocation Puzzle. and O. We cannot specify equilibrium exchange rates so as to get an agreed basis for policy (the IMF has three different models which typically give a fairly wide range of answers). this has proved to be possible (cf. and R.. 26 .-O. For the longer run.org. 'The Revised Bretton Woods System.-O. insurance companies. March 2006. so we should not want to limit that except in circumstances where it might have the potential to be seriously destabilising. 4. it will just be ignored or discredited. D. E. et al. An addendum: in some policy discussions and comment. If that is what IMF surveillance focuses on. 'An equilibrium model of 'global imbalances' and low interest rates'. (2000). References Caballero. (2009). there has been emphasis on exchange rates. These countries also need to be able to borrow in their own currencies – despite the 'original sin' view. Gourinchas (2008).Macroeconomic Stability and Financial Regulation: Key Issues for the G20 4. American Economic Review. (2007). and P. A useful policy in this domain would be to encourage smaller currencies to go into currency unions with large ones (euroisation could have made a great difference for Iceland). Krueger. Krugman. Folkerts-Landau. 'A $2 trillion question'. Jeanne (2008). Farhi. Revised version as IMF Working Paper WP/06/66. R. D. Garber (2004). financial deepness. 4615.. the emerging market countries do need much greater financial development and effective domestic financial intermediation. as part and parcel of global imbalances. R. Brazil). and P. E. A.' International Journal of Finance and Economics. But although exchange rate stability is desirable. we are not going to get it among the key currencies. Milesi-Ferretti. P. CEPR and ICMB. Portes (2006). asset managers. both swings and misalignments. July. Gourinchas. M.VoxEU. This partly comes from international financial integration. (2007). Economic Policy. Domestic bond markets.
In turn.The Global Crisis and Capital Flows to Emerging Markets Philip Lane IIIS. In truth. especially in the aftermath of the LTCM collapse. Ousméne Mandeng and Stephen Pickford. especially the session discussants Rakesh Mohan. both types of factor are at play during any given episode but their relative weights vary substantially over time and across countries. During the 1980s. while the latter refer to the fundamentals in the host economies that affect the expected return and volatility on investment. there were also many positive pull factors. Similarly. the resumption of capital flows to emerging market economies in the early 1990s was in part facilitated by the low dollar interest rate associated with the US recession. The past decade has seen a transformation in the external financial profile of the Author's note: I am grateful for useful comments from the conference participants.1 The three major crises emerging market financial crises during 1994-1998 also exhibited different mixes of push and pull factors. Christiane Hellmanzeik and Peter McQuade provided helpful research assistance. Agustin Benetrix. the initial negative push factor of the increase in dollar interest rates during 1981-1982 helped to trigger the Latin American sovereign debt crisis. However. its transmission around the world was driven by negative push factors. negative pull factors (macroeconomic instability. the proximate cause of the 1998 crisis was the negative pull factor of the Russian default. The former refers to factors relating to conditions in the major financial centres which affect the propensity of global investors to allocate funds towards the emerging markets asset class. the main factors related to concerns about the scale of the current account deficit and domestic political uncertainty. inward-looking policies) prolonged the lost decade. However. due to the attainment of macroeconomic stabilisation and the adoption of more liberal and reformed policy packages. 1 See Calvo et al (1996) for an account of this episode. Jeyoon Shin. banking stability and investor protection) were to the fore in the origins of the 1997-1998 Asian financial crisis. 27 . I am especially indebted to Kevin Daly for his help in sourcing data. even if these were compounded by contagion effects and fickleness on the part of international investors. Negative pull factors (fears of current account sustainability. Trinity College Dublin and CEPR Introduction The traditional approach to analysing capital flows to emerging market economies has been to distinguish between push and pull factors. However. While the sharp rise in US interest rates during 1994 doubtless contributed to the Mexican crisis. with the retrenchment of global investors.
With stronger fundamentals in other emerging market economies. while the major policy challenges are discussed in Section 6. Accordingly. The severe problems in the major financial centers represent a negative push factor. levels of reserves were improved and alternatives to foreign-currency debt financing were developed. The boom in commodity prices acted as another positive development for those emerging market economies that were positive net exporters of commodities. risk aversion has increased such that the spread between low-risk and higher-risk securities have widened. the global recession hurts the short-term growth prospects of export-orientated emerging market economies. The structure of the rest of this paper is as follows. In particular. Section 7 offers some concluding remarks. I turn to the impact of the global financial crisis in Section 5. Some conceptual issues In keeping with the distinction between push and pull factors. Moreover. In relation to positive and negative pull factors. Finally. the low interest rates in the core financial centres during 2001-2006 and the compression of spreads between low-risk and higher-risk domestic securities increased the perceived attractiveness of investing in emerging market economies in the search for yield. the emerging market economies now face a much harsher external financial environment. the scale of net foreign liabilities fell in many emerging market economies. the greater vulnerability of emerging market economies to cap- 28 . In terms of negative pull factors. investment institutions are seeking to liquidate assets. With the exception of Central and Eastern Europe. In particular. with a deeper pool of investment analysts better able to discriminate across economies with very different fundamentals. primarily adversely affecting only its close neighbour Uruguay. The positive pull factors that have operated over the past decade have been reinforced by positive push factors. Symmetrically. the academic literature has paid considerable attention to both dimensions. Similarly.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 emerging market economies. in the sense that financial crises in these core markets have led to several mechanisms by which capital is pulled back from foreign markets. while the collapse in commodity prices is a further blow to net commodity exporters. the 2001 Turkish crisis was largely contained in terms of its international impact. the willingness of global investors to remain invested in other emerging market economies also indicated that the sophistication of this asset class had improved. I outline some conceptual issues in thinking about capital flows to emerging market economies. reduce leverage ratios and satisfy redemption and margin calls. there were grounds for hope that any future crises that would be triggered by negative pull factors in specific economies might not unleash the contagion forces that played a role during earlier crises. Moreover. the 2001 Argentina crisis was not widely transmitted across this group of countries. Accordingly. emerging market economies are negatively affected by the current global financial crisis by the reversal of these positive factors. In Section 2. in order to improve liquidity. Section 3 reviews recent empirical trends in the international financial integration of emerging market economies.
negative economic events that induce currency depreciation lead to a deterioration in balance sheets. there is a significant risk of re-offending in terms of default: the historical incidence of default has been a good predictor of default probabilities in recent decades (see. Reinhart and Rogoff 2004). the gross foreign asset position has expanded. which amplifies the impact of the bad news. See Devereux et al (2006) for a recent example. governments boost public spending and cut taxes during booms. a less-advanced economy has the potential to grow very quickly if it has the right combination of good policies and good luck.The Global Crisis and Capital Flows to Emerging Markets ital flow reversals has been attributed to a number of factors.3 This destabilising pattern provides an additional reason why foreign investors may flee at the first signs of a deterioration in economic performance. Under this pattern. much of which is held in the form of liquid foreign-currency assets (official reserves. Equally. 29 . In addition. until recent years. in some cases. In part. foreign investors may react with considerable elasticity to perceived shifts in the potential economic performance of an emerging market economy: good news stories may stimulate a capital inflow windfall. by the nature of the institutional limitations that explain why countries have not already joined the group of advanced economies. Second. external liabilities typically took the form of foreign-currency debt. While the output growth of leading-edge economies such as the United States is bounded by the rate of global technological progress. there is considerable scope for an economy to experience a downward slide in its relative economic standing. the share of non-debt instruments (FDI and portfolio equity) in total foreign liabilities has climbed. it is important to emphasise that the external balance sheets of emerging market economies have been radically restructured over the last decade. private-sector 2 There are many models of this balance sheet effect. less-developed economies tend to be more volatile in terms of economic performance. amongst others. 3 There is a considerable debate as to whether this pattern can be attributed to pro-cyclical sovereign access to credit or to distortions in the political system that disable governments from operating counter-cyclical fiscal policies. This fragility has historically been compounded by the traditional external funding mechanism for developing countries. Accordingly. this can be explained in terms of the composition of industrial structure and. The reliance on foreign-currency debt has been termed original sin to connote that this may be an intrinsic feature of the capital market environment that faces emerging economies (see the contributions contained in Eichengreen and Hausmann 2005). In particular. only to be forced into fiscal contractions during downturns.2 Accordingly. First. However. While domestic-currency foreign borrowing remains extremely limited. a negative shock of the same magnitude that hits both an advanced economy and an emerging market economy has a more severe negative impact on the latter. However. while bad news may trigger a major reversal. such that capital may flow out more quickly. A further amplification mechanism is provided by the historical tendency towards procyclical fiscal policies in many emerging market economies. a greater reliance on primary commodities for export revenues. Accordingly. it is also case that it is just more difficult to make trend output projections for countries that are far from the frontier (Aguiar and Gopinath 2007).
these may be forced to sell positions in order to meet redemption calls from clients or improve liquidity. even if there are zero direct financial linkages. a common analysis channel may exist by which shifting views of equilibrium asset prices in the advanced economies are also adopted by domestic investors in emerging market economies. Turning to negative push factors. the negative wealth effect from domestic asset prices declines is now potentially much larger compared to previous crisis episodes. An international bank that must write down impaired assets in its advanced-economy operations may be compelled to call in loans to emerging-market clients simply to rebuild capital adequacy ratios. Second. the greater the degree of leverage in the portfolios of the investor institutions (Krugman 2008). Chapter 4 of the IMF's October 2008 Global Financial Stability Report reports econometric estimates that shows that equity prices in emerging markets are systemically linked to advanced-country factors such as measures of global excess liquidity.4 Third. an adverse shift in the financial markets of the advanced economies negatively affects capital flows to emerging market economies through several channels. Finally.5 Similarly. dollar swap spread) and the market risk premium (the implied volatility of the S&P 500 index [VIX]). the liquidity premium that has characterised the current global financial crisis may exert an especially powerful negative push factor on capital flows to emerging market economies. especially for those emerging markets that pursue export-orientated growth strategies that rely on the advanced economies as a primary source of demand. the credit risk premium (the level of the 10-year U. Since the size of domestic financial markets has expanded over the last decade. an increase in investor risk aversion tends to be general in nature. We describe these trends in more detail in the next section but their overall impact should be to reduce the vulnerability of emerging market economies to dislocations in international financial markets. This negatively affects the emerging market economies through the trade channel. 30 . Accordingly. These forces operate more intensely. 5 The McGuire-Tarashev study also reviews the earlier empirical contributions on this topic. 4 The econometric model of Felices and Orskaug (2008) confirms the importance of factors such as US high-yield spreads in determining the volume of capital flows to emerging market economies. with higher-risk domestic corporate debt and emerging-market instruments grouped together as investors switch into the most liquid and safest domestic assets.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 liquid assets). A similar mechanism operates in relation to bank claims. the net foreign asset position of most emerging market economies is much less negative than in the mid-1990s (with the major exception of the Central and Eastern European economies). This dynamic is compounded for highly-leveraged institutions. McGuire and Tarashev (2008) provide evidence that the level of foreign bank claims in emerging market countries is indeed influenced by funding conditions in the interbank markets of the advanced economies and by the general health of the advanced-country banking systems. Fourth.S. a decline in advanced-economy financial markets may be associated with projections of a slowdown in advanced-economy output growth. even if professional asset managers do not downwardly revise return projections for emerging markets. since declines in the value of other holdings trigger margin calls and the forced sales of otherwisesound assets. First.
Indonesia. India. the level of international financial integration remains far below that exhibited by the major advanced economies. Saudi Arabia and Turkey. Korea. We return to this issue in subsequent sections of this paper but next describe the patterns in international capital flows in the period running up to the current crisis. Figure 1. the historical evidence indicates that emerging market economies are highly vulnerable to directional shifts in international capital flows. 6 See Reinhart and Reinhart (2008) for a comprehensive empirical study of the behaviour of emerging market economies during and after capital flows `bonanza' episodes. 31 . The scale of gross positions grew rapidly over the last five years.7 As is analysed by Lane and Milesi-Ferretti (2008a). the major open question has been whether the steps taken by emerging market economies to self-insure has enabled this group to avoid the worst of the crisis. South Africa.The Global Crisis and Capital Flows to Emerging Markets In summary. Recent empirical trends Figure 1 shows the degree of international financial integration of the major emerging market economies has trended upwards over time. it is much higher in terms of gross positions than was the case during previous crisis episodes in the 1980s and 1990s. Mexico. 7 In what follows. where the IFI index is the sum of foreign assets and foreign liabilities expressed as a ratio to GDP. International Financial Integration Ratio (5 of GDP) Source: Based on updated version of dataset developed by Lane and Milesi-Ferretti (2007). the group of major emerging market economies typically comprises the following members of the G20: Argentina. Brazil. Moreover. with a tightening of credit conditions in the major financial centres leading to a pull-back from the emerging markets. However. which was mainly generated by an acceleration in gross capital flows.6 In relation to the current global crisis that began in Summer 2007. the vulnerability is compounded by fiscal pro-cyclicality during boom periods and the reversal in capital flows is often associated with substantial economic distress. China.
This has been a positive development in terms of risk profile. Mexico. Portfolio Allocations to Major Emerging Markets EMs: Portfolio Shares CPIS 10 9 8 7 6 5 4 3 2 1 2001 Equity Debt 2002 2003 2004 2005 2006 2007 year Source: Based on updated version of dataset developed by Lane and Milesi-Ferretti (2007). Brazil. China. since the foreign investor absorbs the risk of state-contingent returns on these positions. India.Japan) in selected emerging markets(Argentina. Source: Author's calculations based on IMF's Coordinated Portfolio Investment Survey.UK.EuroArea. Equity Share in Foreign Liabilities (% of total liabilities) Source: Based on updated version of dataset developed by Lane and Milesi-Ferretti (2007). In addition. Note: Portfolio holdings of major investor nations(US. SouthAfrica. the composition of the international investment position of emerging market economies underwent a major shift. Accordingly. Russia. Indonesia. Figure 3. the emerging market economies were much more integrated into the global financial system at the onset of the current global crisis. 32 . rising global asset values increased the scale of balance sheets relative to GDP. Korea). in terms of gross cross-border positions. Turkey. As was noted in the previous section.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Figure 2. Saudi Arabia. A major trend has been the growing importance of FDI and portfolio equity as a source of finance (Figure 2).
The Global Crisis and Capital Flows to Emerging Markets Figure 4. Foreign Exchange Reserves (% of GDP) Source: Based on updated version of dataset developed by Lane and Milesi-Ferretti (2007). The transformation of the external financial profile of emerging market economies also included a major reduction in net foreign liabilities (Figure 6). 33 . We can gain further insight by inspecting the scale of the portfolio holdings by advanced-economy investors that are located in the major emerging market economies. Figure 3 expresses these holdings in terms of their weight in the total international portfolios of the major investor nations. The mirror-image trend is evident for the major advanced economies. it should have reduced the vulnerability of emerging market economies to capital flow reversals. See also the recent analysis in ECB (2009). This was achieved by a sustained period of running current account surpluses (Figure 7). Figure 4 shows that the risk profile has been further improved by the rapid growth in foreign-exchange reserves. in order to offer investors protection against the risk of a double drain. The recent study by Obstfeld et al (2008) highlights financial development as a driver of external reserves. these trends have led to a striking shift in the international configuration of portfolios. 8 There is a rapidly-growing literature that seeks to explain the determinants of reserve accumulation. which have increased from 5 percent of aggregate GDP in the 1980s to over 25 percent by 2007. while these countries are much less important in international portfolio debt holdings. since the net external position has been a historical predictor of the incidence of crises. While the longterm allocative efficiency of capital running uphill may be open to question.8 Taken together.9 Figure 5 shows that the major emerging market economies have shifted from a position in 1995 in which these countries were both net debtors and net recipients of equity investments to a profile in which a much larger negative net equity position is nearly matched by a very large long position in foreign debt holdings. 9 See also the analysis in Lane and Milesi-Ferretti (2007a). which increased their long position in foreign equity while also taking on a larger short position in foreign debt. We observe the increasing importance of emerging market destinations in portfolio equity assets.
Figure 6. Euro Area. while a country with zero foreigncurrency foreign liabilities and all of its foreign assets denominated in foreign currencies would score the value 1. the depreciation of the domestic currency would actually generate a positive balance-sheet effect. Source: Author's calculations based on updated version of dataset compiled by Lane and Milesi-Ferretti (2007a). Lane and Shambaugh (2008) have developed an index of the foreign-currency exposure that is embedded in a given level of foreign assets and foreign liabilities. since the capital gain on its foreign-currency assets would exceed the capital loss on its foreign- 34 . UK. Composition of External Balance Sheets Note: Advanced G17 comprises US. For this latter group.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Figure 5.1) where a country that has only foreign-currency liabilities and zero foreign-currency assets would score the value -1. This FXAGG index has the range (-1. Japan and Canada. Table 1 shows the FXAGG index has become much less negative for most major emerging market economies and indeed is substantially positive for a number of countries. Emerging G17 is group of major emerging market economies. Aggregate Net Foreign Asset Position of G17 Emerging Market Economies (% of GDP) Source: Author's calculations based on updated version of dataset compiled by Lane and Milesi-Ferretti (2007a) The impact of these shifts in external capital structure has been to transform the aggregate foreign-currency position of emerging market economies.
02 -0.05 -0.07 0.03 0.15 -0.06 -0.01 0.08 0. Foreign Currency Exposures FXAGG KOR MEX ARG 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 -0.43 IND -0.02 0.42 -0.58 0.34 -0.23 Note: Based on dataset developed by Lane and Shambaugh (2008).24 -0.11 -0.06 0.29 0.01 -0.59 0.00 -0.30 -0.41 0.27 -0.22 -0.Af.38 -0.46 0.72 S. However. At one level.33 0.43 0.52 -0.33 0.05 0.08 -0.13 -0.32 -0.16 -0.32 -0.02 -0.25 0.17 -0.03 BRA CHN -0.21 -0.56 0.09 0.21 -0.34 TUR -0.32 -0.17 -0.64 0.55 -0.05 0.47 0.06 -0.15 0.10 0.24 -0.48 0.31 0.48 -0.01 0.58 0. 35 .09 0.33 0. this should be welfare improving to the extent that investors in the higher-income economies with more developed financial systems should be better equipped to manage risk. this general reconfiguration may be viewed as involving a major risk transfer from the emerging markets to investors in the advanced economies.19 -0.31 0.63 0.35 0.15 -0.01 -0.19 -0.13 -0.48 -0.36 -0.38 0.17 -0.46 0.Ar.48 0.20 0. Current Account Balance of G17 Emerging Market Economies (% of GDP) Source: Author's calculations based on updated version of dataset compiled by Lane and Milesi-Ferretti (2007a) Table 1.26 0.13 -0.05 -0.01 0.42 -0.16 -0.31 0.02 -0.24 -0.18 -0.19 -0.66 0.The Global Crisis and Capital Flows to Emerging Markets currency liabilities.34 -0. 0. the build up in large two-way gross positions also meant that failures in risk management and illquidity problems in the advanced economies would be transmitted quickly to counterparts in the emerging market economies.40 0.02 0.22 0.54 0.06 -0.33 -0. Figure 7.20 0.24 -0. 0.15 0.12 -0.19 0.27 0.04 -0.36 -0.20 0.38 -0.07 IDO RUS S. In turn.37 0.
albeit with the major exception of China. EMBI Total Return Index 36 . The decline in demand for emerging market bonds is evident in the sharp decline in the JP Morgan emerging market bond index during 2008. Figure 8 shows that most of the major emerging market economies have experienced substantial currency depreciation against the US dollar. Similarly.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 The impact of the global financial crisis Although the epicenter of the global financial crisis has clearly been in the financial systems of the advanced economies. even if it has rallied to some extent in the most recent period (see Figure 9). The most timely evidence is in terms of asset prices. activity indicators are now emerging that show severe declines in exports and deceleration in output growth in the last quarter of 2008. 30/6/2007 to 31/12/2008 Figure 9. the emerging markets have been substantially affected by the crisis. Currency Depreciation. Figure 8. equity returns in emerging markets have been very negative. In addition to the asset market data. as is shown in Figure 10.
For those emerging market economies that are long in foreign-currency assets. Moreover.21). 37 . For instance. Milesi-Ferretti (2009) estimates that each of the BRIC economies made on the order of $200 billion in external capital gains during 2008. the short position of emerging markets in equity instruments means that the global decline in equity values further improves the net foreign asset position of these countries. Source: Abiad et al (2008). Accordingly. the expansion in the equity share of liabilities has indeed provided some useful risk transfer during the current crisis. Financial Reforms Index Note: Index range is (0.The Global Crisis and Capital Flows to Emerging Markets It should be acknowledged that full impact of these asset value declines has been mitigated by several factors. currency depreciation per se confers a valuation gain. Figure 10. Stock Market Indices for Emerging Market Economies Stock Market Indices 600 540 480 420 360 300 240 180 120 60 0 1/1/2004 12/1/2003 1/1/2005 Argentina Brazil China India Indonesia Mexico Russia Saudi Arabia South Africa Turkey 1/1/2006 1/1/2007 1/1/2008 12/31/2008 Date Figure 11.
In particular. However. McGuire and Tarashev (2008) show that the level of claims between mid-2007 and mid-2008 exceeded that predicted by their empirical model that was estimated on data over 1992-2007. the challenges in utilising foreign-currency 38 . by helping to support net exports in the face of a decline in external demand. the evidence is that banking claims on emerging market economies initially held up quite well. Obstfeld et al (2009) find that the extent of currency depreciation has been smaller for those countries that maintained excess levels of reserves (relative to the levels predicted by their empirical model). There is little by way of publicly-available high-frequency data on the behaviour of international portfolio investors. This problem is most intense for entities that relied on short-term external funding to acquire longer-term illiquid domestic or foreign assets. However. market reports indicate that foreign equity flows to emerging markets have been negative in recent months. there is anecdotal evidence that foreign banks active in Central and Eastern Europe have withdrawn funds in order to replenish the balance sheets of parent banks. with the cost of capital remaining above pre-crisis levels. Policy issues The increase in global risk aversion and the contraction in the balance sheets of major international investment institutions means that the scale of gross capital flows to emerging market economies is set to shrink in the near term. since national authorities can more credibly resist speculators that seek to engineer self-fulfilling currency attacks. In relation to near-term policy challenges. the high level of reserves that were accumulated in recent years improves the capacity to manage balance sheet problems. Moreover.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 The fact that currency depreciation exerts a positive balance sheet effect (or at least a less negative balance sheet effect for those countries that still maintain negative foreign-currency exposure) means that currency depreciation can have a stabilising impact on the emerging market economies. This stands in contrast to the experience during the 1990s. both by enabling effective monetary expansion and through direct deployment of reserves. It is also important to appreciate that there is variation across emerging markets in terms of exposure to individual banking systems and in terms of the maturity of claims. In relation to the banking channel. However. while the volume of bond issuance by emerging markets has undergone a dramatic decline. This poses a host of near-term and medium-term policy challenges for this group of countries. Indeed. with those countries more heavily reliant on short-term funding from those countries with the weakest banking systems and/or the greatest exposure to emerging market economies facing the greatest risk of an adverse shift in funding conditions. the governments in several emerging market economies must manage deterioration in the balance sheets of key actors. it is plausible that banking claims may have declined in late 2008. To this end. the high levels of foreign-currency reserves has helped to limit freefalling currency depreciation. when sharp depreciations were associated with major contractions due to the fact that adverse balance sheet effects overwhelmed the positive trade channel impact.
10 Two major innovations stand out. However. such that the SLF has the potential to be helpful in tackling short-term liquidity difficulties. Second. Accordingly. further progress in developing fiscal processes that can protect sustainability is highly desirable (Lane 2003). the currency swaps with emerging market economies have typically been with countries that have already very high levels of reserves. the effectiveness of fiscal interventions depends on the sustainability of a country's fiscal position. To this end. there has been the establishment of currency swap arrangements among the world's major central banks and also vis-a-vis selected emerging market economies. the IMF created the new Short-Term Liquidity Facility (SLF) that is available to those member countries that have previously demonstrated strong fundamentals in terms of sound policies. the international community has also responded to the incipient funding crisis in some emerging market economies. interest rates. In addition. Indeed.term effectiveness of policy through adverse effects on financial markets. emerging Asia). but also for the short run. In addition to the domestic policy response. it is also essential that fiscal stimulus not be seen by markets as seriously calling into question medium-term fiscal sustainability. In relation to the medium-term goal of improving the structural foundations of the international financial system. While this study generally advocates the deployment of fiscal policy.The Global Crisis and Capital Flows to Emerging Markets reserves to stabilise the domestic economy in an environment in which domestic-currency and foreign-currency asset values are also falling are severe (Caballero and Krishnamurthy 2001). Accordingly. the SLF represents a potentially useful expansion in the range of instruments available to the IMF in dealing with liquidity problems. the goal is to develop mech10 See McGuire (2009) for an illuminating analysis of the global dollar shortage that was created by international banks seeking to obtain dollar funding for the very large dollar asset positions that expanded rapidly in recent years. More generally. the main function of the swaps has been to signal the commitment of the participating central banks to ensure adequate foreign-currency liquidity for the countries in question. the authors state. First. As is discussed by Obstfeld et al (2009). fiscal accomodation is only desirable for those emerging market economies that can credibly demonstrate that the fisal position is sustainable over the medium term. not only for the medium run. However. the planned scale of fiscal expansions is quite large in some regions (most prominently. the funds can be disbursed quickly and without conditionality. Accordingly. the over-riding principle is to reduce the risks faced by emerging market economies in engaging with the international financial system (Wolf 2009). This is key. 39 . and consumer spending (paragraph 27 on page 8). in managing the residual risk. as questions about debt sustainability would undercut the near. Since it relies on the track record of the applicant. access to capital markets and sustainable debt burdens. This is fully recognised in the recent IMF study on the role of fiscal policy in the current crisis (Spilimbergo et al 2008). there is scope for domestic fiscal and monetary expansion in a number of emerging market economies in order to support the domestic economy in the face of adverse external shocks. In particular. it recognises that it will not be effective in all countries.
as is emphasised by Kose et al (2008). the improved domestic mobilisation of domestic savings reduces the importance of external capital as a funding source. a considerable gap remains for several countries relative to a fully-liberalised domestic financial system (the maximum score is 21 in the IMF index). Financial development should be broadly interpreted to encompass improvements in corporate governance and the quality of the regulatory system. the accumulation of substantial liquid reserves and the running of current account surpluses. while the full impact of domestic financial reform only unfolds over the medium term. the financial integration threshold is affected by key features of the domestic economy. reaping the gains from financial globalisation involves the same types of reforms that are also generally beneficial for domestic economic performance. macroeconomic policy discipline and trade integration. including the level of domestic financial development. The goal for the emerging market economies is to pass this threshold and thereby attain a more robust form of financial integration. it exerts substantial spillover effects on the reserveissuing countries. the recent increase in the cost of external capital should induce an intensification of efforts to develop the domestic financial system. these countries are treated differently by the global system in comparison to the financial environment that faces the most advanced economies. at the same time. Empirically. It is also important to take into account that the empirical evidence indicates that financial reform policies only promote financial development in environments in which private property rights are secure from arbitrary political interference (Tressel and Detragiache 2008). this strategy has been costly in terms of foregone domestic absorption opportunities and in the potential for superior international risk sharing arrangements. In general. In general. Moreover. Importantly. Calvo et al (2008) and Kose et al (2008) find that there is a threshold effect in terms of the relation between international financial integration and financial stability. these economies are sufficiently integrated into the global financial system to be exposed to severe financial shocks. In particular. First. a deeper financial system increases the span of investable opportunities that are available to foreign investors. In particular. Domestic financial development is important for two reasons. In relation to the domestic reform efforts of the emerging market economies. Second. the quality of institutions and governance. Accordingly. 40 .Macroeconomic Stability and Financial Regulation: Key Issues for the G20 anisms that reduce the cost of insuring against such risks. the appropriate framework for thinking about medium-term reform is to recognise that the emerging market economies suffer from an incomplete level of international financial integration. We documented above that significant progress has been made in shifting the external risk profile of emerging market economies since the late 1990s. through the impact of persistent trade surpluses and the officialsector demand for liquid securities. each involves significant inefficiencies. Unlike very low income countries. While these steps have reduced the vulnerability to financial crises. While Figure 11 shows that the major emerging market economies have made major progress in financial reform. the credible announcement of a programme of financial reforms should be helpful even in the short term. Moreover. the current crisis has highlighted that volume-based indices of financial development (such as the stock of outstanding securities) are not good measures if the financial system is distorted by a poor regulatory environment. the funding model for these countries has changed through a greater reliance on equity--type liabilities. However.
the current crisis teaches us that poorly-functioning derivatives markets can lead to non-fundamental volatility in the prices of the underlying assets.11 So far. 12 This is not to under-estimate the regulatory and market design challenges in establishing a well-functioning derivatives market. it is also desirable to enable effective cross-border capital flows in local currency. the degree of social insurance for major personal risks (illness. leading to a high degree of precautionary saving by households. These international hedges meant that the aggregate foreign-currency exposure of Australia turned from negative to positive. the Australian example illustrates how foreign-currency debt can be transformed via currency derivatives into domestic-currency debt from the perspective of domestic residents. with relatively little participation by foreign investors. via welfare systems and the public funding of relevant goods and services. part of the reform agenda is to improve the adequacy of social insurance. In particular. In advanced economies. While participation by domestic residents is a major achievement in itself. However. it is important that the development of local-currency debt markets is complemented by the development of the currency derivatives market. these authors note that the requirements for a thriving local-currency bond market are very similar to those for the development of the domestic-currency banking system. Accordingly. The analysis of this survey by Becker and Fabbro (2006) shows that currency hedging allowed Australian residents to transform the risk profile of the external balance sheet. risk management is provided by a combination of public and private systems.12 11 Schmitz (2009) finds that domestic financial reforms stimulates capital inflows for a sample of emerging European economies. To this end. In relation to domestic reforms that directly affect the nature of international capital flows. foreign-currency debt of AUS$428 billion at the end of March 2005 was greatly reduced to AUS$90 billion through derivatives contracts with overseas counterparties. Burger and Warnock (2006) investigate the determinants of success in promoting local-currency debt markets and find that key drivers include the attainment of macroeconomic stability (low inflation) and strong creditor protection. A striking feature of his work is that it is banking-sector reform that is especially important in attracting inflows.The Global Crisis and Capital Flows to Emerging Markets It should also be understood that domestic risk management extends beyond the financial system to include social insurance programmes. 41 . Accordingly. in order to allow investors to separately trade currency risk and credit risk. A striking illustration is provided by Naughton (2006). local-currency debt markets have been dominated by locally-resident investors. In similar fashion. However. one key element is the development of local-currency debt markets. institutional reform extends beyond the regulation of the financial system. unemployment) is much less adequate in a number of emerging market economies. reform efforts that are targeted at improving the operation of debt financing in general can serve the dual purpose of promoting both the bond market and the banking system. the evidence from a recent national survey in Australia is quite striking. with many derivative trades simply redistributing risk across domestic residents. The role of derivatives markets in cross-border risk transfer is not well understood at the empirical level. Again. Indeed. due to lack of clarity over the appropriate distribution of dividend payments. Accordingly. who shows how the ambiguous ownership status of many enterprises in China generates an extraordinarily high level of corporate savings.
Similar factors also apply in relation to foreign direct investment. institutional reforms can do much to improve the cyclical behaviour of fiscal policy (Lane 2003). such that investors do respond to shifts in the institutional environment (Faria et al 2007). the evidence is that financial reform is associated with an increase in the equity share in liabilities. For instance. such that it cannot be manipulated by the issuer. Lane and Milesi-Ferretti 2008b). In addition. The importance of domestic institutional development extends beyond the financial sector. However. such that some shift away from foreign direct investment could be desirable in some cases. However. all else equal. This feature eliminates the moral hazard problem that generically affects state-contingent contracts. a fundamental goal for emerging market economies is to copperfasten stability in macroeconomic policies. in the other direction. Accordingly. More broadly. In a series of contributions. there is also considerable scope to improve risk sharing via other types of state-contingent instruments. However. In addition. there are restrictions in some countries that limit the capacity of foreign investors to acquire controlling stakes in certain sectors that are deemed to be strategically important. the share of equity in the foreign liabilities of emerging markets has grown strongly over the last decade. The empirical evidence is that gravity factors such as distance and cultural linkages are influential in international asset trade (Portes and Rey 2005. Caballero and a set of collaborators have advocated other types of state-contingent instruments (see Caballero and Cowan 2007 for an overview of this line of work). As indicated earlier. it is desirable that regional groups intensify 42 . a commodities exporter might issue debt with a coupon that is indexed to global commodity prices. In relation to fiscal procyclicality. the limitation of an asset-based approach is that. So far. the capacity of countries such as Chile to develop fiscal processes that help to insulate the budget from the curse of procyclicality has been impressive. In particular. there is much scope for regional levels of financial integration. the evidence provided by Kho et al 2008). since many of the risk sharing benefits of state-contingent liabilities can be replicated by an appropriate portfolio of assets. there is a strongly positive correlation between trade in goods and services and trade in assets. corporate governance and regulatory problems limit the attractiveness of emerging-market stockmarkets for many investors (see. the idea of GDP-indexed bonds has received considerable attention (see Borensztein and Mauro 2004 for a recent and comprehensive review). Accordingly. There is also scope for greater use of state-contingent instruments on the asset side of the international balance sheet. in view of the underlying linkages between neighbouring economies and the lower level of bilateral exchange rate volatility. it involves the leveraging of the international balance sheet. While there remains considerable variation across countries. emerging markets might tie yields to the high-risk spread in the US corporate debt market. for example. An extension of this is to further promote regional financial integration. we have discussed domestic reforms. The virtue of these types of instruments is that the contingent element in the return is a function of external conditions. regional capital flows may be more stable in character. On the liabilities side. it is possible that the level of subsidies and tax breaks offered to foreign direct investors is arguably excessive in a number of host countries.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 In addition to the promotion of local-currency debt markets. However. In particular. A second key element is to further promote international equity financing.
with the obvious potential for the consolidation of representation by member countries of the European Union. the World Bank's GEMLOC program seeks to build a common knowledge base concerning the operation of these markets. a major shift in the distribution of voting power at the IMF would be clearly beneficial and it is up to the advanced economies to voluntarily agree to a new agreement. such as the RMB-denominated bond issues by the Asian Development Bank and the International Finance Corporation (the so-called Panda Bonds). Accordingly. in relation to local-currency debt markets. A better-financed IMF that stood ready to provide liquidity support would enable these economies to shed some of their excess foreign-currency reserves and would be collectively more efficient. In terms of governance arrangements. The strength of two-way international transmission mechanisms between advanced and developing countries means that this reform debate has to involve representatives of the emerging economies in a central role. in view of the free riding problem and other externalities that inhibit the creation of new securities markets. The recent agreement to reallocate quotas in a limited fashion took a considerable period to be negotiated and has not yet been ratified by all member countries. For instance. 43 . At the international level. the IFIs potentially have a central role in helping to develop the types of state-contingent securities that may improve the risk profile of the external liabilities of emerging markets. the expansion of IMF resources need not wait for the completion of governance reform. That said. it is in the interests of the emerging market economies to support international reforms that improve stability in the major financial centres and at the global level. Already. In terms of the broader G20 agenda. the prospect of a more radical quota reform seems unlikely in the near term. Accordingly. In tandem with a redistribution of quotas. the principle of major IMF renewal should be a key G20 target.The Global Crisis and Capital Flows to Emerging Markets efforts to cooperate in the design of common institutional standards for financial market development and work to lift barriers to cross-border asset trade. Turning to the international dimension of reform. Japan has offered $100 billion in financing for the IMF. it is unlikely that major IMF reform can be achieved in the short term. Such issuance could be in specific currencies. 13 GEMLOC stands for Global Emerging Market Local Currency Bond Fund Program. as well as allowing the international financial institutions to make local-currency loans to clients in those markets. The current crisis has vividly illustrated how public sources of funding must be available in the event of the breakdown of financial trade among private-sector counterparties. there is considerable scope for the international community to support a more stable system of international finance for emerging market economies. Such issues have the potential to help to expand the depth and liquidity of the domestic-currency bond markets.13 The IFIs could possibly do more in terms of issuing securities in the currencies of the emerging market economies. In addition. However. securities could be issued that are indexed to a basket of emerging market currencies (see also the discussion in Wolf 2009). More generally. The international financial institutions have a clear role to play in terms of the provision of technical advice in the development of domestic financial systems. it is appropriate that the largest emerging market economies join the advanced economies in becoming substantial underwriters of the IMF's balance sheet. this reinforces the need for an expansion of the funding base for the IMF.
there is also room for a greater level of regional initiatives. While these are severe even for the most advanced economies. 17 See Lane and Milesi-Ferretti (2009) in relation to problems in the measurement of the US international investment position.17 Most obviously. In line with a risk pooling model. However. Regional groupings may also be better placed in terms of continuous surveillance of member country policies and in designing multi-dimensional forms of policy coordination.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 while other major surplus economies may also be prepared to offer extra funding. While the scope for political integration clearly varies across regions and limits the transferability of institutional models across regions. Indeed. major increases in the scale of the agreed bilateral swaps between China and Korea and between Japan and Korea were announced in December 2008. with the information deficit particularly large for lightly-regulated entities such as hedge funds. measurement problems are growing in absolute scale.16 The European experience also suggests that there may be scope for regional cooperation in the development of processes that help in ensuring the sustainability of the public finances (Lane 2008). the general principle is to obtain those benefits from regional integration that are feasible in each particular setting. See Lane (2008) on the lessons to be drawn from the European approach to economic integration. 15 See Kohlscheen and Taylor (2008) for an analysis of the Chiang Mai bilateral swap arrangements. due to the rapid growth in the volume of cross-border transactions and the pace of financial innovation.15 Moreover. offshore financial centres play a central role in the intermediation of international capital flows. contributing to the development of early-warning systems and other desiderata. The analysis of international capital flows to emerging markets would be greatly facilitated by renewed efforts to improve the collection of publicly-available highquality data on international capital flows and international investment positions. the bilateral swap arrangements among ASEAN+3 countries under the Chiang Mai Initiative demonstrate the viability of securing liquidity insurance that is additional to IMF resources. This agreement demonstrates the ability of governments to agree on forms of policy coordination even when the level of political integration is quite low. While data availability has greatly improved with initiatives such as the Coordinated Portfolio Investment Survey (CPIS). Korea) provides for short-term currency swap facilities. Better quality data would also do much to faciliate improved surveillance and analysis by the IMF and other policy organisations. measurement problems are especially acute for emerging markets and developing economies. major data holes remain. 44 .14 Most obviously. by which regional integration in trade and factor mobility reinforces the incentives to cooperate in terms of financial support. the weaker the correlation in reserves between the pair of countries. In addition to reform of the global financial institutions. the current crisis has also shown a regional capability to quickly respond to the shift in international financial conditions. 14 See Irwin et al (2008) for a model of how diversity across countries limits the capacity of the IMF to function as a credit union. The limits to the potential resources of the IMF and the heterogeneity of IMF membership means that there is scope for additional resource pooling at the regional level. 16 The Chiang Mai agreement among the ASEAN+3 (China. Japan. For example. these authors also highlight the limitations of a regional approach to risk pooling: the correlation in reserves growth is much higher within regions than across regions. these authors find that bilateral swaps among participants are larger.
Conclusions At one level. However. In particular. Accordingly. The reforms that are good for emerging markets are also the reforms that should improve global economic performance and global financial stability. See also the discussion in Lane and Schmukler (2007). the limited role of domestic-currency debt in the funding of external liabilities means that the nature of international financial integration for the emerging market economies remains quite different relative to the experience of the advanced economies. Accordingly. The self-insurance approach adopted by individual emerging market economies is also highly inefficient in terms of the collective allocation of resources within the emerging market economies and between the emerging markets and the advanced economies. there is a busy reform agenda at the domestic. the emerging market reform agenda should be an integral part of the wider G20 reform agenda. in terms of the exposure to breakdowns in the normal operation of financial markets. These steps have increased the capacity of emerging market economies to withstand international financial shocks. this should be a welcome development.The Global Crisis and Capital Flows to Emerging Markets Finally. A New Database of Financial Reforms. other potential borrowers will receive smaller net capital inflows and/or the level of global interest rates will climb. Mark and Gita Gopinath (2007).18 If this scenario plays out. Emerging Market Business Cycles: The Cycle 18 Dollar and Kraay (2006) calibrate a model that projects current account deficits for China on the order of 5 percent of its GDP for a sustained 10-15 year period. For advanced economies seeking to save due to population ageing. 45 . Aguiar. the growing share of global GDP that is generated by emerging market economies in combination with successful domestic financial development and appropriate international financial reforms may lead to this group of countries seeking to be a major net absorber of global capital flows. regional and global levels in order to develop a financial system that improves the stability of external financing for emerging market economies. the role of equity financing has greatly expanded and very large foreign-currency reserve positions have been accumulated. References Abiad. Net foreign liabilities are much lower. and Thierry Tressel (2008). Moreover. the international financial position of emerging market economies has undergone radical change since the late 1990s. it would still be a substantial call on global savings. IMF Working Paper No 08/266. Abdul. Enrica Detragiache. it is important to appreciate that a broad reform programme at the domestic and international levels could lead to a major re-configuration of the distribution of global imbalances. the expansion in the gross scale of international balance sheets means that the linkages between the emerging market economies and the advanced economies have grown tighter. While not approaching the size of the current US deficit relative to world GDP.
The Case for GDP-Indexed Bonds. Other People's Money: Debt Denomination and Financial Instability in Emerging Market Economies. 349. Andre. Journal of Monetary Economics 48. Exchange Rates and Monetary Policy for Emerging Market Economies. Calvo. Lane and Juanyi Xu (2006). Alejandro Izquierdo and Luis-Fernando Mejía (2008). 513-548. IMF Staff Papers 53. Ricardo and Kevin Cowan (2007). 69-102. London School of Economics. mimeo. Guillermo A. Journal of Monetary Economics 53(5). Gregor. 123-139. Michael B. Philip R. Bernanke. Local Currency Bond Markets. 115-132. Systemic Sudden Stops: The Relevance Of Balance-Sheet Effects And Financial Integration. European Central Bank (2009). Journal of Economic Perspectives 10. Eduardo and Paolo Mauro (2004). Bank of England Working Paper No. Caballero. Kaminsky. The Shifting Composition of External Liabilities. Ricardo. Reserve Bank of Australia Research Discussion Paper No. Dollar. Limiting Foreign Exchange Exposure through Hedging: The Australian Experience. Financial Integration Without the Volatility. Ricardo and Arvind Krishnamurthy (2001). Adrian Penalver. Foreign Asset Accumulation by Authorities in Emerging Markets. Felices. Bong-Chan. 73-85. 480-490. Capital Flows to Developing Countries in the 1990s: Causes and Effects. Leonardo Leiderman and Carmen Reinhart (1996). Financial Globalization. Stamp Lecture. 165--216. Neither a Borrower Nor a Lender: Does China's Zero Net Foreign Asset Position Make Economic Sense?.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 is the Trend. An Equilibrium Model of `Global Imbalances' and Low Interest Rates. Devereux. Faria. Barry and Ricardo Hausmann (2005). Caballero. Calvo. Graciela. Irwin. Emmanuel Farhi and Pierre-Olivier Gourinchas (2008). The Crisis and the Policy Response. Journal of Political Economy 115(1). Chris and Daniel Fabbro (2006). American Economic Review 98(1). Rene Stulz and Frank Warnock (2008). Monthly Bulletin (January). Chris Salmon and Ashley Taylor (2008). 38. International and Domestic Collateral Constraints in a Model of Emerging Market Crises. Philip R. Estimating the Determinants of Capital Flows to Emerging Market Economies: A Maximum Likelihood Disequilibrium Approach. Journal of European Economic Association 5 (2-3). Borensztein. Carmen Reinhart and Carlos Végh (2003). Becker. Burger. MIT and Inter-American Development Bank. The Economic Journal 116. 51-74.. NBER Working Paper No.. Guillermo and Bjorn-Erik Orskaug (2008). Caballero. 358-393. Economic Policy.. Guillermo A. 2006-09. Dealing with Country Diversity: Challenges for the IMF Credit Union Model. Eichengreen. David and Aart Kraay (2006). 354. Kho. Journal of Economic Perspectives 17(4). 943-971. 14026. The Unholy Trinity of Financial Contagion. 478506. Ben (2009). Bank of England Working Paper No. Paulo Mauro and Gian Maria Milesi-Ferretti (2007). University of Chicago Press. Lane. 46 . John and Frank Warnock (2006).
327-332. McGuire. Spring 2003. Obstfeld. American Economic Review. 265. forthcoming. Gian Maria (2008). McGuire. 519-573. Barry (2006). and International Reserves. Business Cycles and Macroeconomic Policy in Emerging Market Economies. Philip R. Journal of Accounting Research. BIS Quarterly Review. The Determinants of Cross-Border Equity 47 . IMF Staff Papers. Philip R. Economic Policy 22(51). Patrick and Nikola Tarashev (2008). International Investment Patterns. and Gian Maria Milesi-Ferretti (2007b). American Economic Review (Papers and Proceedings) 98(2). The Evolving Role of China and India in the International Financial System. Financial Stability. Kenneth Rogoff and Shang-Jin Wei (2008). Princeton University. Portes. and Central Bank Swap Lines in the Panic of 2008. Lane. Ayhan. The Macroeconomics of Financial Integration: A European Perspective. Lane. Vincenzo Quadrini and Jose-Victor Rios-Rull (2008). Emanuel and Mark P.S. Krugman. Journal of Japanese and International Economies. Financial Development and Global Imbalances. and Gian Maria Milesi-Ferretti (2008a). Taylor (2008). Gian Maria (2009). Open Economies Review 18(4). 67-80. 259-281. (2008). Lane. M. The Drivers of Financial Globalization. Maurice. Milesi-Ferretti. Financial Instability. forthcoming. Mendoza. 89-108. and the Evolution of the Home Bias. External Position. forthcoming. mimeo. Philip R. Obstfeld. Financial Globalization: A Reappraisal. 323 – 332. Financial Exchange Rates and International Currency Exposures. The International Finance Multiplier. 499-520. and Jay Shambaugh (2008). International Liquidity Swaps: Is the Chiang Mai Initiative Pooling Reserves Efficiently? International Journal of Finance & Economics 13(4). Europe and Global Imbalances. Richard and Helene Rey (2005). Milesi-Ferretti. mimeo. Journal of International Economics 73. Lane. Philip R. forthcoming. IIIS Discussion Paper No. Top-Down Control: SASAC and the Persistence of State Ownership in China. Naughton. Enrique. Lane. Philip R. NBER Working Paper No. International Finance 6(1). 223-250 Lane. A $2 Trillion Dollars Question. forthcoming. Eswar Prasad. Lane. and Gian Maria Milesi-Ferretti (2008b). Jay Shambaugh and Alan Taylor (2008). Financial Integration. and Gian Maria Milesi-Ferretti (2007a). (2003). Fundamentals at Odds? The US Current Account Deficit and the Dollar. BIS Quarterly Review (December). Bank Health and Lending to Emerging Markets. Patrick (2009). The External Wealth of Nations Mark II. Economic Notes 37(3). Philip R. Kohlscheen. Where Did All the Borrowing Go? A Forensic Analysis of the U. Kose. American Economic Review (Papers and Proceedings). The US Dollar Shortage in International Banking. Paul (2008). and Gian Maria Milesi-Ferretti (2009). the Trilemma. Journal of Political Economy. Jay Shambaugh and Alan Taylor (2009). 14217. Philip R. Maurice. and Sergio Schmukler (2007). Philip R. forthcoming.The Global Crisis and Capital Flows to Emerging Markets Governance. Philip R. Reserves. VoxEU. forthcoming. Review of Economics and Statistics 90(3). 538-549. University of California at San Diego. Lane. Lane.
52-58. 14321. India's Approach to Capital Account Liberalizaton. Thierry and Enrica Detragiache (2008). 3927. Fiscal Policy for the Crisis. NBER Working Paper No. Fixing Global Finance. Prasad. IZA Discussion Paper No. Olivier Blanchard and Carlo Cottarelli (2008). Carmen and Kenneth Rogoff (2004). Reinhart. Antonio. Steven Symansky. Schmitz. IMF Working Paper No 08/265. Journal of International Economics 65. Serial Default And The Paradox Of Rich To Poor Capital Flows. Tressel. IMF Staff Position Note No. Martin (2009). American Economic Review (Papers and Proceedings) 94(2). Yale University Press. IIIS Discussion Paper No. Spilimbergo. 48 . Capital Flow Bonanzas: An Encompassing View of the Past and Present.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Flows. Do Financial Sector Reforms Lead to Financial Development? Evidence from a New Dataset. Reinhart. Martin (2009). Carmen and Vincent Reinhart (2008). XXX. Financial Reforms and Capital Flows to Emerging Europe. 269-296. Eswar (2009). 08/01. Wolf.
First. in particular the infusion of equity capital in financial institutions to reduce counter-party risk and get credit to flow again. A particular risk at present is that the rapid decline in inflation in many countries in recent months will turn into deflation with highly adverse real economic developments. Second. (ii) regulation needs to be enhanced to ensure that all financial markets. products and participants are regulated or subject to oversight. is essential in order to restore market functioning. (iv) international cooperation among regulators must be enhanced.The Risk of Deflation Stefan Gerlach University of Frankfurt and CEPR 1. (iii) the integrity of financial markets should be improved by bolstering investor and consumer protection. how can a repetition of the crisis can be avoided? Much attention is being focused on regulation and supervision of financial intermediaries. as appropriate. and the presumption that markets would always be liquid. 1 See Bean (2008) and G-20 (2008). what are the roots of the crisis? Many factors have been emphasized in the debate. The G-20. noted that measures need to be taken in five areas: (i) financial market transparency and disclosure by firms need to be strengthened. massive reliance on wholesale funding. weak risk management by financial institutions. avoiding conflicts of interest. how can the consequences for economic activity be minimized? Many of the adverse developments in financial markets – in particular the collapse of term interbank markets – reflect deeply entrenched perceptions of counterparty risk. remuneration policies and the period of low interest rates – are also widely seen as having played a role. Third. Prompt and far-reaching action to support the financial system. and (v) international financial institutions must be reformed to reflect changing economic weights in the world economy better in order to increase the legitimacy and effectiveness of these institutions. at its summit in November 2008. raises a number of questions for policy makers. Introduction The onset of financial instability in August 2007. Petra Gerlach-Kristen and Madhu Mohanty for helpful comments and to Eva Koscher for research assistance. which quickly spread across the world. and by promoting information sharing. See also the Appendix. the excessive confidence in ratings. 2 Some countries experienced deflation in 19th century because of favorable supply shocks that also led to rapid output growth. poorly understood incentive effects – arising from the originate-to-distribute-model.1 Furthermore. including the opacity of complex financial products. 49 .2 This background paper considers how large the risk of deflation may be Author's note: I am grateful to Katrin Assenmacher-Wesche.
Finally. Inflation expectations and forecasts in the subset of economies we look at (the euro area. prices for some goods may always or frequently be declining. and therefore do not constitute deflation.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 and discusses what policy can do to reduce it. Much in the same way as expectations of future inflation may lead firms to raise prices already now. expectations of deflation exacerbate the downward pressure on current prices and make it more difficult to design policies to return to a low. indicating that deflation is not expected. 50 . the broader economy is likely to be unaffected. Section 6 offers some conclusions. Thus.that redistribute wealth from debtors to creditors are more likely to depress spending and lead to defaults and financial distress than unexpected increases in the price level. An Appendix discusses deflation episodes in the period 1882-1939. and on the broader economy. positive rate of inflation. It is organized as follows. While there are historical episodes in which deflation arose from positive supplyside developments and that tended to raise economic growth. while price falls in a specific sector may be associated with economic weakness in the sector in question. Section 4 reviews how monetary and fiscal policy can be conducted to ensure that deflation is avoided. By contrast. or because of changes in demand patterns. For instance. However. Because of changes in productivity and production costs more broadly.which by my definition do not constitute deflation . Similarly. the UK and the US) are positive. The section also looks at the evolution of headline and "core" inflation. Preliminaries As a start. implying that if the central bank's inflation target is sufficiently low. traded goods prices may be falling continuously. See Buiter (2003) or IMF (2003).3 3 Unexpected falls in the price level . Section 5 briefly discusses special issues arising in emerging market economies. focusing on data from the US and the euro area. prices of traded goods are typically rising at a much slower rate than services. declines in individual or sectoral prices do not constitute deflation. 2. only that the public expects the central bank to be successful in avoiding deflation. Section 2 defines deflation and discusses downward nominal wage rigidities and the zero lower bound on interest rates. purely temporary falls in the aggregate price level may not have any lasting effects on consumers' and firms' behaviour. This does not imply that the current concerns of deflation are unwarranted. this suggests that policy measures that seek to shield inflation expectations from current price developments are likely to help mitigate the macroeconomic effects of falls in the economy-wide price level. Section 3 looks at the current situation. it is useful to emphasize that deflation is a fall of the economy-wide price level that is sufficiently persistent to trigger expectations that prices will continue to decline for some non-negligible period of time. expectations may form that prices will continue to fall. they should not be overemphasized. cases of deflation are likely to be associated with pronounced macroeconomic weakness for several reasons. if the aggregate price level declines for some time. As discussed below. While these factors are frequently seen as two reasons why deflation can be associated with very poor economic outcomes.
Since price increases vary across firms.3% between May 1998 and August 2003. p. real wages will rise.4 Though some reported wage falls. Thus. positive rate of inflation. it seems unlikely that a fall in the nominal price level will trigger a decline in nominal wages. not that they are downwardly sticky. the distribution of wage changes became increasingly asymmetric over time. the distribution of wage changes of workers shifted towards the left and growing number of workers reported zero wage increases. in particular when inflation is very low. real unit labour costs can still decline even if real wages are rising.3% (Gerlach and Kugler 2007). There are two reasons for why that may be the case: nominal wages may be rigid downward and there is a risk that policy-controlled interest rates reach zero. 51 . This evidence demonstrates that downward nominal wage rigidity does impact on the labour market's ability to adjust to shocks. Indeed. there are reasons not to overestimate the importance of downward nominal wage rigidities. The importance of downward nominal wage rigidity is consequently likely to rise with falling inflation. deflation can induce non-linearities in the functioning of the economy. 788) show that as inflation in Switzerland declined from 4.7% in 1991 to 0% in 1997. labor market legislation may bar wage cuts in some circumstances. which can be changed in a counter-cyclical manner to support employment. downward nominal wage rigidity is not a structural feature of the economy but rather a consequence of having experienced a long period of positive inflation. 2.The Risk of Deflation First. Most importantly. there is a risk that a contractionary shock of a given size will be more difficult to handle if it pushes the economy into deflation than if the rate of inflation remains positive. one would expect that the fraction of firms that experience falling prices increases when the economy-wide inflation rate falls towards zero. If so.5 Indeed. which reduces the effectiveness of the interest rate channel of monetary policy. deflation may reflect particularly large and persistent declines in the demand for goods and services. Measured by the change 4 Buiter (2003) argues that this spike at the zero of the distribution of relative wage changes only indicates that wages are sticky. deflation is merely an indicator. reducing employment and economic activity. Thus.1 Downward nominal wage rigidity Downward nominal wage rigidity is an important reason why deflation is likely to be associated with poor real outcomes. with the peak rate of deflation being 6. In situations in which nominal wage growth and inflation have historically been positive. Second. unit labour costs depend also on indirect taxes and social charges. Monetary and fiscal policy measures that raise demand will in this case expand economy activity in much the same way as they would at a low. of slowing aggregate demand. triggered for instance by financial instability. and not a cause. Fehr and Götte (2005. However. 3. Fig. The CPI in Hong Kong fell a cumulative 16. The findings of Fehr and Götte (2005) contradict this conclusion. 5 In some countries. We discuss each in turn. Moreover. although less so than in the absence of downward nominal wage rigidity. Furthermore. if productivity growth is positive. the importance of downward nominal wage stickiness may decline if the economy enters deflation. as the experiences of Hong Kong suggest.
unemployment increased in Hong Kong during this period. Is deflation likely? There is much evidence that the expected rate of inflation plays a key role in determining the current rate of inflation. 52 . This suggests that any downward nominal wage rigidity disappeared as the economy experienced an extended period of deflation.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 in prices over twelve months. reducing aggregate demand and exacerbating the downward pressure on prices. The deflation rate soon became fully expected by firms and workers and wage cuts were common. If the nominal interest rate is zero. 35-36). Hong Kong experienced 68 months of deflation. pp. real interest rates rise. suppose that expected inflation is positive. 2. its importance for the overall transmission mechanism – which operates also through yields in longer-term securities.6 Nevertheless. the real interest is equal to minus the rate of inflation.5%.7 While the zero lower bound does impose a constraint on the interest rate channel of monetary policy. Box 3. The distribution of wage changes in 2002-2004 involved a large number of wage cuts and appears symmetric (HKMA. Thus. This naturally leads to the question what rates of inflation the public expects at the current juncture. reducing aggregate demand and triggering deflation. when the present author extended his employment contract with the Hong Kong Monetary Authority in 2004 after six years of deflation. he was offered a wage cut of 2.2 The zero lower bound on nominal interest rates A further reason why economic outcomes are likely to be adverse in a situation of deflation stems from the fact that central banks can not reduce nominal interest rates below zero. Overall. and below. as is discussed in Section 4. 2008. downward nominal wage rigidity is likely to worsen labour market outcomes if inflation falls towards. As deflation takes hold and turns increasingly severe. private securities. exchange rates and asset prices – is frequently exaggerated." Inflation expectations depend on (i) the shocks impacting on the economy and (ii) the public's beliefs about how the authorities will respond if deflation threatens and how effective these responses are likely to be. The nominal interest rate equals the sum of the real interest rate and the expected inflation rate. 3. Before addressing this question. Does this imply that policy makers need not worry about deflation and that there is no need for unusual policy measures to offset this risk? A moment's reflection indicates that the answer to this question must be "no. zero. 7 There is also a risk of a deflation trap developing. positive inflation expectations may thus result even if there is strong downward pressures on inflation rates if the public expect that the authorities will adopt aggressive policy measures to offset 6 More anecdotally. Suppose that interest rates and inflation are both zero and that for some reason the public starts to expect deflation. The expected real interest rate then rises. suggesting that the fall in nominal wages was not sufficiently large to prevent real wages from rising.
quite a bit below the Bank of England's inflation target of 2% and the ECB's objective of inflation "below." Other indicators of price expectations display a similar story. on average. are less likely to be contaminated by expectations of future economic policy. but close to. By January 2009. the lesson we draw from these graphs is that inflation is generally expected to be positive for 2009 in these countries.7% in December. made at various times in 2008 and in 2009. forecasts of inflation in 2009 were rapidly reduced from October onwards. But overall. two percent. that is. For instance. and the most recent data point is for November.9 Inflation forecasts for 2009 were raised as headline inflation picked up in 2008 in response to shocks impacting on the prices of oil. these fell by from 4. since economic policies impact on inflation only with a lag. Figure 1 shows average forecasts of inflation in 2009. food and other commodities. from the Economist poll of forecasters. In sum. Following the collapse of Lehman Brothers in September 2008 and the sea-change it caused in financial markets. rise by 1 percent in the UK and 1. Since inflation and expected inflation declined towards the end of the year.1 percent in the euro area. Figure 2 shows the Michigan survey of US inflation expectations for the next 12 months. the main advantages are that it is freely available and monthly. inflation expectations that are negative provide firm reasons for central banks to relax monetary policy.The Risk of Deflation them. expectations that inflation will remain positive say nothing about whether there is a need for the authorities to adjust policy to avoid deflation. 9 An obvious weakness of this survey is that it is based on a very small sample of 13 financial institutions. These data are quarterly. 53 .3% in September to 1. with the possible exception of the US and Japan.1 percent in Japan. forecasters expected consumer prices to fall over the course of the year by 0. it seems likely that the expected inflation rates have fallen below the rates tabulated here. Figure 3 shows the expected rate of inflation over the next 12 months taken from the Bank of England's Inflation Attitude Survey and the ECB Survey of Professional Forecasters. 8 By contrast.8 However. it can be useful to look at short-run measures of expected inflation which. stay constant in the US.
not shocks to the underlying rate of inflation.10 Core inflation (defined using the CPI less the food and energy components) was more stable. Figures 4 and 5 show that headline CPI inflation in the US and the euro area (as in many other economies) rose sharply in the fall of 2007. The recent fall in oil prices. reached a peak in July 2008. they are likely to have only a temporary impact on the rate of inflation. Since movements in oil prices are best thought of as price level shocks.1 Headline and core inflation in the US and the Euro Area Another way to assess the likely path of inflation is to look at measures of "core" and headline inflation.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 3. implying that these movements in headline inflation reflected largely oil and food price shocks. is thus unlikely to lead to deflation. which constitutes an expansionary supply shock. and declined rapidly thereafter. although it may lead to a brief peri10 The graph for the US would look similar if instead the deflator for personal consumption expenditure was used. 54 .
To explore this issue somewhat more formally. both of which have collapsed in recent months. together with 95% confidence bands. I selected a VAR(1) model for the US and a VAR(2) model for the euro area.11 The results for the US are displayed in Figure 6 and those for the euro area in Figure 7. 55 . reach a trough at -1. The point forecast for inflation in the US is that it will continue to fall. the financial crisis is captured indirectly by the last two variables. Gerlach (2007) shows that the latter displays strong correlation with future values of estimates of the euro area output gap. and compute dynamic out-of-sample forecasts of headline inflation for the period January 2009 – December 2010. I next estimate a forecasting model for inflation in the US and the euro area on data spanning January 1999 – December 2008.3% in May 2009. remain negative 11 In both cases I estimated a VAR model for CPI inflation. On the basis of the Schwarz information criterion. the rate of growth of oil prices and a business cycle indicator. As business cycle indicator I used the NAPM survey for the US and the Economic Sentiment Indicator of Eurostat for the euro area. core inflation.The Risk of Deflation od of falling prices. While there are no financial variables in the model.
they should not be overinterpreted. 56 . Overall. However. Turning to the results for the euro area. they assume that the inflation will return to its sample mean over time.8% in April 2009. by construction. However. These findings are broadly compatible with the inflation forecasts for 2009 presented above. Moreover. Also in this case are the forecasts highly uncertain and. and gradually rise to 1. the wide confidence bands indicate a great deal of uncertainty around those forecasts. such as monetary and fiscal policy measures. reach a trough of 0. in particular. these suggest that inflation will continue to decline in the months ahead.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 until October. these results indicate that the decline in inflation is expected to be temporary.9% in December 2010. They come from a very simple model and disregard a number of factors that impact on inflation. and recover rapidly thereafter. there is some probability that inflation will turn negative for a while.
14 Woodford (2003) is the by now classic reference. what tools can policy makers use to avoid them? 4. since modern macroeconomic theory holds that inflation is forward-looking and depends on expected future inflation. rather than as episodes in which policy makers were overwhelmed by a collapse in aggregate demand that was too large and too sudden for them to offset. Yet two points deserve being mentioned. the deflation experienced by Japan in the 1990s was largely due to a lack of consensus about what policy measures were necessary to support the financial sector and the economy more broadly. it is helpful to adopt a formal numerical objective for inflation. 4. and the "non-standard" case when they have reached zero and cannot be reduced further.The Risk of Deflation 4. The ration- 12 For a discussion of the role of the gold standard in the transmission of the Great Depression. It is useful to distinguish between monetary policy in the "standard" case in which policy-controlled interest rates are positive. inflation will soon return.1 Monetary policy Since inflation – and therefore deflation – is a monetary phenomenon. it is avoidable by appropriate monetary policy actions. Policy measures to reduce deflation risks The analysis in the previous section suggests that while inflation is declining rapidly and prices may be falling for a while in 2009. See also Galí (2008). 13 See Bernanke (2002) and IMF (2003).1. Thus. Can policy then be used to ensure that declining prices do not become a permanent feature of the economic landscape? It is useful to remember that the historical record clearly shows that episodes of deflation are best seen as evidence of serious policy failures. see Eichengreen (1992). Similarly. it becomes important for central banks facing falling prices to engender expectations that inflation will over time return to a low positive number. the deflation experienced by many countries in the interwar period is also typically seen as evidence of massive policy mistakes.13 When interest rates are positive.14 To do so. such as the failure of the Federal Reserve to prevent widespread bank insolvencies and the fact that many countries maintained their gold parities despite the collapse of demand following the onset of the Great Depression. Precisely how that is done – whether by announcing a target for inflation or by adopting price stability as the overriding objective for monetary policy and buttress this with numerical definition thereof – appears to be less important. But suppose that that prediction turns out to be wrong. 57 . the central bank can reduce the risk of deflation by cutting interest rates further. the best policy strategy is to prevent it from arising rather than to deal with it when it has become a fact.1 Monetary policy when interest rates are positive Given the costs of deflation. First.12 But if episodes of deflation are due to policy failures. In this case there is no analytical difference between preventing inflation from falling too low and preventing deflation from taking hold.
monetary policy impacts on the economy through a range of interest rates 15 To further strengthen this effect. by contrast. the longer the interest rate is maintained at a low level. the zero lower bound does not render monetary policy ineffective. 4. More importantly.2%.18 Of course. it seems that the zero lower bound does not necessarily imply very high real shortterm interest rates. such an objective should be adopted before the inflation rate reaches zero. 16 However. This has the added effect of requiring the central bank not only to raise the rate of inflation if it falls too low. but also to compensate for the fact that prices may previously have fallen below the targeted rate.2 Monetary policy when interest rates are zero While the fact that policy controlled interest rates cannot be cut below zero complicates the management of monetary policy. A price level target is a key ingredient of the foolproof way of escaping deflation suggested by Svensson (2001). the public will expect inflation in the future even if prices are falling today. If economic conditions then worsen. HICP inflation averaged 2. If. pegging the overnight rate at zero makes it difficult to revive the interbank market since in that situation a bank has no financial incentive to incur the credit risk associated with interbank lending. with a peak rate of deflation of 1.9% between September 1997 and February 2005. the public may doubt whether the central bank has sufficiently powerful tools to deliver on any announced inflation objective. As a preliminary. which risks damaging the central bank's credibility. the central bank could announce a price level target above the current price level. First. the average overnight interest rate in the euro area between January 1999 and October 2008 was 3. The objective will thus lack credibility and the public may simply disregard it. since the likelihood that additional policy easing is needed will decline if rates are cut aggressively at an early stage of the easing process. if policy rates reached the zero lower bound. it makes sense for the central bank to cut interest rates increasingly aggressively as the policy rate approaches zero.2%.17 Thus. the objective is adopted when prices are already falling and policy-controlled interest rates are at zero.16 This is consistent with theoretical models that predict a stronger decline in long interest rates and therefore a greater reaction of the economy. which depresses the expected real interest rate and supports demand. the zero lower bound need not imply unreasonably high real short-term interest rates. The argument that central banks should avoid cutting interest rates to zero since they then have no policy lever left to use if inflation falls further seems incorrect.15 However. 18 For comparison.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ale for such an objective is that. As an illustration. 58 . if it is credible. Second. note that if the rate of deflation is moderate. the importance of this constraint has frequently been exaggerated. In the same period. since monetary policy is likely to be less effective when policy rates have reached zero. 17 Inflation is defined as the realized change of prices over the past 12 months. in Japan the CPI (excluding fresh food) fell by 4. the central bank can demonstrate its commitment to the objective by cutting interest rates aggressively.2. while it would be desirable to have even lower real interest rates during a recession.5%. to be effective. deflation rates of 1% could be accommodated without pushing real interest rates above their historical mean. resulting in an average real short-term interest rate of 1%.
longer-term interest rates are likely to remain positive. Many observers have noted that even if overnight interest rates reach zero. If so. central banks can stimulate the economy by purchasing these securities and driving yields down to zero. For instance. 19 These valuation gains are greater for longer maturity bonds. the central bank can provide credit directly to borrowers. The valuation gains may be particularly important if the bonds are held by the banking system. in which case the balance sheet effects could reduce perceptions of credit risk in the interbank market and help spur additional bank lending when the economic outlook improves. where it currently is the Federal Reserve's intention to keep the federal funds rate in the interval 0 to 0. p. at the present stage with the policy rate in Japan being 0. the central bank can experience capital losses on its long bond portfolio if economic prospects improve and yields rise. Wickens 2008. While this is a "beggar-thy-neighbour" policy. purchases of private assets raise questions about credit risk.19 Furthermore. By purchasing long-term government bonds. 20 They also raise the issue what criteria the central bank should use when determining what private asset to buy.5%. which remains effective even if the interest rate channel has become dysfunctional. monetary policy also impacts on the economy through the exchange rate channel. and greater the lower the level of interest rates is. and depress other interest rates that use them as reference rates. efforts to provide macroeconomic stimulus by depreciating the exchange rate may in this case well turn out to be counterproductive if policy makers in other economies seek to undo the resulting appreciation of their currencies. For instance. it may be seen by other countries as appropriate if the shock triggering deflation is idiosyncratic. In the US. are related as follows p = (1+r)-n (e. these issues can be overcome by the financial authorities assuming any capital losses the central bank becomes exposed to as a consequence of such operations. For instance. To see this.1%. leading to valuation gains for bond holders and an improvement of their balance sheets. central bank purchases of long bonds and private assets raise a number of questions. p. This indicates how important close co-operation between the central bank and the financial authorities is in the present situation. Similarly.25%. Of course. Third. note that the price. even in a situation in which all government bond yields have declined to zero. monetary policy also impacts through credit availability effects. as long as some nominal yields are positive. As emphasized by Buiter (2003). The Federal Reserve's recent purchases of commercial paper provide an illustration of how this can be done. 267). 10-year yields are around 1. this strategy is of course not available. yields on private debt instruments will typically be positive. by depreciating the exchange rate a central bank can stimulate the economy and raise the rate of inflation. Bernanke (2009) notes that concerns about credit risk may limit the willingness of banks to extend credit even in the hypothetical case in which all interest rates have reached zero.25%.20 However. Moreover. At the current juncture. of an n-period pure discount security and the yield.The Risk of Deflation and not only through the overnight rates that central banks control.g. 10-year yields are around 2. central banks can reduce their yields. Second. where a number of countries are exposed to rapidly slowing demand. 59 . r.
For that. although that is not always the overriding target of policy. given the lags between changes in monetary policy and their impact on the economy. the risk remains that the measures already taken will only impact on the economy as it starts to recover on its own. banks are likely to reduce leverage by contracting lending. The measures taken in recent months by many countries to support banks' balance sheets will help reduce the risk of deflation. Second. 4. While it is possible to think of cases in which fiscal policy has no impact on aggregate demand – for instance. Moreover. interest rates are therefore adjusted to limit the risk of deflation. the infusion of public funds may become necessary. a debt financed tax cut may have no impact if there is debt neutrality – those seem unrealistic and of limited practical relevance. 21 This is the main message in Bernanke (2002) and Buiter (2003). Central banks must thus remain alert and ready to respond. (Moreover. to improve their balance sheets. To restore banks' creditworthiness. triggering liquidity problems in these markets and. since the stance of monetary policy can be changed rapidly in response to changing economic circumstances. they will naturally mature within a short time span. it is natural for it to be the first line of defence against deflation. which can depress aggregate demand sharply. changes in government purchases or taxes that boost spending can also play an important role in staving off deflation. potentially. Banks that have sustained large losses and have seen their capital evaporate are likely to want to scale back their balance sheets. Perceptions of credit risk may impair their ability to participate in interbank markets. 60 . fiscal policy measures are likely to be needed. leading to runs on the banks. episodes of deflation associated with instability in the banking system are likely to have particularly serious effects on output and employment. even if policy-controlled interest rates were to reach zero. These can come in at least two forms. But monetary policy cannot on its own ensure that deflation is avoided. As inflation falls towards zero. to the extent that the central banks' operations have been in short-dated instruments or repos.22 Overall.) However. fiscal policy measures have a role to play in supporting the financial system and in boosting aggregate demand. a permanent increase in government spending may be offset by one-for-one fall in permanent income and consumption. How concerned should we be about that possibility? It is difficult to see why central bank could not withdraw the policy stimulus at the same rate as it was introduced: interest rates can be increased as rapidly as they were cut and assets purchased by central banks can be liquidated rapidly if economic conditions improve. in severe cases.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Overall.21 Indeed. monetary policy retains considerable potency. if deflation materializes. Furthermore. First. rapidly when the economy starts to recover. 22 See the discussion in Buiter (2003).3 Fiscal policy Monetary policy in most countries is geared towards maintaining low and stable inflation. some observers worry that there is a risk that the vigorous easing of monetary policy across the world in recent months risks leading to a burst of inflation.
in some transition economies foreign banks play a dominant role in the domestic banking system. Since commodity prices have fallen sharply. this could engender expectations of further price falls and raise the likelihood that deflation will take hold. their initial inflation rates were relatively high (partially on account of the Balassa-Samuelson effect). while financial institutions in emerging markets countries had less direct exposure to structured financial products than banks in advanced economies. This provides a direct channel of transmission. Second. Third. Furthermore. If headline inflation turns negative. While it is difficult to draw any firm conclusions. If the exchange rate is fixed. while considerable progress has been made in the last decade or two. the credibility of monetary policy is generally lower in emerging markets economies than in advanced economies. which has maintained a peg to the US dollar for more than a quarter century. Interestingly. raising the question of how exposed emerging markets economies are to the risk of deflation. has been higher and more volatile than inflation in Singapore. the decline partially offsets an expansionary shock. which has used a managed float. which all managed or fixed the exchange rate against the US dollar. First.The Risk of Deflation 5. which in turn may support employment and economic activity. Moreover. 23 Gerlach and Gerlach-Kristen (2006) demonstrate that the rate of inflation in Hong Kong SAR. they are directly exposed to the rapid downturn in the industrial economies and to the process of global deleveraging. many emerging market economies have a high commodity concentration in their exports. As a consequence. expectations of future inflation may be relatively sensitive to the current rate of inflation.23 This suggests that the risk of deflation is greater in economies with fixed exchange rates. Fifth. some special considerations that arise for these countries are readily apparent. fixed exchange rate regimes are more common in emerging markets economies than in advanced economies. Thus. Hong Kong SAR and Argentina (before the abandonment of the currency board regime). Emerging markets issues The repercussions of the financial crisis are increasingly felt globally. and exposes emerging markets economies to the risk that if the foreign banks were to experience difficulties. have all experienced periods of deflation in the last two decades. commodity prices rose sharply before falling. the degree of downward nominal wage rigidity is likely to be lower in emerging markets economies (although there may be large variations between countries). raising the likelihood of deflation. the entire burden of adjustment to a shock will fall on the nominal price level. many of which have a large informal sector. China. This suggests that it may be beneficial to clarify the objectives for monetary policy by adopting an inflation target or a numerical definition of price stability. On the other hand. these countries have been exposed to a highly contractionary shock. allowing inflation to fall further than in the industrialized world before turning negative. they could withdraw from the market leaving the host country with a much reduced banking system at a time of great economic stress. If so. 61 . Fourth. the onset of deflation may tend to raise real wages by less than otherwise.
those are not likely to be of much practical relevance.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 6. 1882 – 1939 It is difficult to assess the risk and the consequences of deflation because very few economies. Table I shows the mean inflation rate and output growth rate for ten countries using data in the period 1882 to 1939. in theory. and. measures to support the financial system. given that the deflation episodes in the interwar period may have been different from those before the First World War. past episodes of deflation are best seen as reflecting policy mistakes or an inability to forge a political consensus about how policy should be conducted. The central bank can then. Fourth. That said. have experienced a prolonged period of falling prices since the end of the Second World War. and not to changes in the underlying rate of inflation. when it is associated with financial instability. the rise of inflation between mid-2007 and mid-2008 and its subsequent decline appear to have been largely due to fluctuations in food and oil prices.25 Any broad analysis must therefore be based on data from before 1939. 25 This Appendix draws on material prepared by the author and published in BIS (1999. 62 . Third. many cases of deflation reflect beneficial supply shocks. it makes good sense for policy makers to review their contingency plans in this area and to consider the potential benefits of adopting an inflation target or a numerical definition of price stability well before the economy risks slipping into deflation. and fiscal policy measures to shore up the banking system and to expand aggregate demand may become necessary. First.24 The economics of stopping a deflation is straightforward and calls for aggressive easing of monetary and fiscal policy. Moreover. with the notable exceptions of Japan and Hong Kong SAR. to a large extent because of the collapse of oil and food prices. In interpreting the results it should be kept 24 Historically. monetary policy also remains effective if some market participants are unable to borrow at the prevailing level of interest rates because of perceptions of credit risk. Second. 77-80). While it is possible to think of situations in which fiscal policy is ineffective. Conclusions The main policy conclusions to draw from this paper are four. purchase debt issued by these borrowers and expand aggregate demand. Appendix: Deflation and output growth. It remains operational as long as some interest rates – including those on longterm government debt and private securities – are positive. Furthermore. monetary policy may be unable to stop deflation if it takes hold. the interest rate channel of the monetary transmission mechanism does not become ineffective simply because short-term policy-controlled interest rates reach zero. some economies may experience a few months or quarters of falling prices. While it seems highly unlikely that the world economy will slip into generalized deflation in the coming year. the table presents results for the two subperiods 1882-1913 and 1923-39. pp. Deflation is defined as a decline of the CPI lasting at least two years.
3 1. which are cyclically more stable and less likely to experience falling prices.5 1.1 1882-1913 1.0 1.6 3.1 0.0 1.6 2.8 1.3 1.1 4.4 -1. deflation episodes were associated with falls in real output.4 2.2 -4.1 -2. Evidently.6 3.7 0.6 -3.6 0. are much more important in modern economies.1 2.8 1.0 1.6 6.1 3.2 1.0 -1.1 -3.5 1.9 2. services.7 -3.2 2.0 -5.3 5.The Risk of Deflation Table 1 Average annual growth rates in percent Deflation periods Inflation Output growth Belgium Canada Denmark France Germany Italy Japan Sweden United Kingdom United States Average Belgium Canada Denmark France Germany Italy Japan Sweden United Kingdom United States Average Belgium Canada Denmark France Germany Italy Japan Sweden United Kingdom United States Average -4. this finding appears 63 .8 2.0 2.8 11.5 1.5 6.6 1.6 6.1 3.3 5.1 0.1 2.2 4.4 7.4 7.2 1.7 7.1 1.3 -1.2 1.3 4. More strikingly.6 3.8 -3.8 -5.9 -1.5 -4. periods of declining price levels were quite common before the First World War.8 2.8 1.7 1.0 1923-1939.4 in mind that historical data were of lower quality than modern data and that the structure of the economy has evolved fundamentally over the last century.7 1923-1939 -1. output growth was positive in these periods.9 2.7 3.2 -3.9 -2.6 3.7 -3.4 2. By contrast.1 -5.3 9.7 0. In particular.4 -6.2 4.1 7.3 -1.1 5.1 1.0 -3.8 -6.0 -3.1 7.7 6.6 -4.2 1.6 3. However.0 -5.1 Non-deflation periods Inflation Output growth 1.7 8.4 4.2 1. in the 1923 – 1939 period.0 1.8 -1.2 -5.1 -4.5 3.8 -6.9 1.1 1.9 4.8 4.6 3.4 1.8 0.6 2.9 1.4 -5.5 4.1 4.7 -3.0 10.7 -2.1 -8. excluding 1930-1933 1.6 4.8 2.6 2.2 -5.2 -3.9 1.4 6.1 6.9 4.9 4.3 -2.5 -1. although not as high as in periods of rising prices.6 -6.
Istanbul. Buiter. Bernanke." Remarks at Conference on Globalisation. Gerlach. Another explanation is that prices did not fall long or far enough to engender extrapolative expectations of further price decreases and thus to raise expected real interest rates." Journal of Monetary Economics. "Fiscal Strategy and Sustainability. Gerlach. Stefan and Petra Gerlach-Kristen (2006). "Should We Worry about Deflation? Prevention and Cure. (2002). 31." Remarks before the National Economists Club. "Robustness and Real Consequences of Nominal Wage Rigidity. Available at www. Oxford University Press. Gerlach. (2003). Overall. Eichengreen. "The Crisis and the Policy Response. Ben S. exacerbated by insufficiently aggressive monetary policy. 1999-2006: Words and deeds. "Declaration of the Summit on Financial Markets and the World Economy. 1-45. Risks. G-20 (2008). "Deflation: Making Sure "It" Doesn't Happen Here. BIS (1999)." 2003 McKenna Lecture on International Trade and Economics. Galí. Princeton University Press. Monetary Policy. "Deflation: Determinants. 779 – 804. this suggests that episodes of deflation are particularly worrisome if they coincide with periods of financial instability." Unpublished working paper. and Policy Options – Findings of an Interdepartmental Task Force. (2009).imf. Willem H. Willem H. Bernanke." Stamp Lecture." See this volume. (2009). Jordi (2008)." International Journal of Central Banking. Charles (2008).C." In: Monetary Policy in Asia: Approaches and Implementation. Basel. It is interesting to hypothesize why periods of declining prices were generally not associated with severe recessions.html.gov/news/releases/2008/11/200811151. Fehr and Götte (2005). BIS Papers No. "Monetary policy regimes and macroeconomic outcomes: Hong Kong and Singapore. "Some Lessons for Monetary Policy from the Recent Financial Turmoil. London School of Economics. Inflation and Monetary Policy." Available at http://www. References Bean. Buiter. 52. which was characterized severe financial turmoil. Inflation and the Business Cycle: An Introduction to the New Keynesian Framework. Barry (1992). (Also published as BIS Working Paper 204). "Interest rate setting by the ECB. 22 November 2008. Golden Fetters: The Gold Standard and the Great Depression 1919-1939. "Deflation and price dispersion: Evidence from Japan and Hong Kong. Stefan (2007). Perspective on the Economy.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 to be entirely due to the occurrence of the Great Depression. IMF (2003). 64 . One possibility is that deflation episodes have historically occurred at times of relatively favourable aggregate supply movements. 3.org.whitehouse. 69th Annual Report." Mimeo. Stefan and Peter Kugler (2007). Ben S. Income growth rates were also positive in the second subsample if the years 1930-33 are disregarded. Washington D.
277 – 312. Chicago University Press. 19. Wickens." Monetary and Economic Studies (Special edition). Princeton University Press. "Zero interest rate policies and quantitative easing. "Non-Standard Indicators for Monetary Policy: Can Their Usefulness be Judged from Forecasting Regressions?" in N. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap. Woodford. Michael (2003). Fredric S. Lars E. Interest and Prices: Foundations of a Theory of Monetary Policy. Michael (2008).The Risk of Deflation Ito. Takatoshi (2009).G. Princeton University Press. Mankiw. HKMA (2008). Bank of Japan." See this volume. Mishkin. December. Macroeconomic Theory: A Dynamic General Equilibrium Approach. "Is Monetary Policy Effective During Financial Crisis?" Svensson.O (2001). 65 . Half-Yearly Monetary and Financial Stability Report. (2009). Monetary Policy. Michael (1994). Woodford.
Coordination among central banks may become important for this reason. want to depreciate to help encourage exports and discourage imports under a deflationary environment. Effective policy to fight deflation requires that the central bank (a) communicate 67 . which it says is "credit easing" (CE). Will ECB soon follow suit? Will BOJ again go into ZIRP/QE again? If all of them do simultaneously. but not all of them can do so simultaneously. The Bank of Japan tried one version of QE from 2001 to 2006 and. an expansion of the central bank balance sheet by purchasing risk assets that the central bank normally would not buy. and (4) how to influence inflation expectation. since one channel of stimulus from ZIRP.Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) Takatoshi Ito University of Tokyo and CEPR Executive summary Deflation is bad. Who should that be? Countries with large trade surpluses are obvious candidates. followed by several European central banks. the inflation expectation may stay positive. and keep inflation expectation positive. because even with the nominal interest rate being lowered to zero. The ZIRP/QE experiences of the Bank of Japan from 1999 to 2006 offers important lessons. and with anticipation of what is coming to Europe. What could the central bank do beyond ZIRP to stimulate the economy? Many researchers have suggested variants of unconventional monetary policies. Thus. With adoption of ZIRP by several major central banks. the following policy recommendations seem to emerge. that is the lower bound. some currencies have to appreciate vis-à-vis others. right now. QE variants differ with respect to (1) what is its primary purpose. rather than (a Japanese-type) QE. the effectiveness of QE in one country would be diminished. If deflation does not last long. the exchange rate depreciation. a country with large trade surpluses with positive GDP growth should refrain from large scale intervention since intervention to prevent appreciation would be equivalent to a beggar-thy-neighbor policy. namely. Under a global ZIRP environment. some to follow and some not to follow. All countries. we will enter an environment of global ZIRP and QE-clearly uncharted territory of international macro/finance. the real interest rate stays positive. so that the forward-looking real interest rate could be negative. It is most important to end deflation quickly. the Federal Reserve. (3) what assets to buy. if possible. is trying another version. Most of them fall into a category of the broadly-defined quantitative easing (QE)-that is. would not be available. (2) what would be the target instrument and communication strategy. Based on Japan's experience from 2001-2006 and on-going experience of FRB.
1 However. with the remunerated deposit rate at 0. the rate was near zero. Ito (2004a) and Ito and Mishkin (2006) for details of developments and statements of policy decisions. the Bank of Japan has lowered the policy rate to 0. The purpose of this note is to review facts of the BOJ ZIRP/QE policy. 2 Some may argue that the ZIRP had not been adopted firmly until April 1999.15% immediately. the first episode. This is another case of ZIRP. to draw lessons learnt from the BOJ ZIRP/QE. With that crisis mode. and to point out some issues associated with global ZIRP/QE if BOE. when the excess reserve as well as required reserve was not remunerated. and some other G20 countries adopt ZIRP/QE. See Okina and Shiratsuka (2004). February 1999 – August 2000 The Bank of Japan adopted the zero interest rate policy (ZIRP) in February 1999 in response to extremely weak economic conditions combined with lingering banking sector weakness. (d) find tools and strategies to keep inflation expectations in the positive territory. 2001-2006. several other major central banks will have to introduce ZIRP/QE in 2009 if gloomy economic predictions are realized. and target of ZIRP/QE policies. and in April. and the Federal Reserve Board (FRB) in recent months are prominent examples.1%. This is effectively ZIRP. 68 .2 The inflation rate measured by CPI excluding fresh food had become zero and had been declining since mid-1998. we have only a few episodes of the zero interest rate policy (ZIRP) combined with quantitative easing (QE): The Bank of Japan (BOJ) from 1999 to 2006. and (e) at the time of exit.1.00 . to show the difference between BOJ QE and FRB QE. 1.25%. The FRB lowered the policy rate to the range 0. The first lesson is that ZIRP should not be delayed when 1 The ZIRP does not necessarily mean literal 0. (c) keep various securities markets functional by direct purchase of those securities. Introduction In postwar history. I date the Japanese first ZIRP started in February 1999. the decision of ZIRP came too late.00% policy rate. The February decision was to lower the policy rate to 0. ZIRP. as the first capital injection in March 1998 was apparently not enough. But for simplicity. The growth rate in 1998 was negative and major banks were suffering from shortage in their capital in the process of writing off bad loans. 2. objective. (b) prevent the inflation rate from falling into the negative territory for an extended period with extensive purchase of risky assets. err on the side of later than earlier. and excess reserves are subject to remunerated deposit rate at the Bank of Japan.1%. The Bank of Japan experience of ZIRP/QE 2.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 the intention.0. By mid-March. ECB. if the markets become dysfunctional. and to induce the rate lower as soon as possible. In 2008. Major banks were scheduled to receive the second capital injection in March 1999. although that was the case in the BOJ experience. the Governor mentioned that ZIRP would continue until "the deflation concern would be dispelled".
The economy deteriorated in the fall of 2000. At the time of exit in August 2000. but the incident of August 2000 shows that the Bank of Japan had a "deflation bias. The exit from ZIRP in August 2000 by the Bank of Japan turned out to be too early. in March 2001 showed that the prediction and judgment by the government (Ministry of Finance and Cabinet Office). 69 . The Bank had to return to ZIRP. although presented as QE. In the literature of central banking. is always cited as a reason for central bank independence. The renewed fight against deflation with QE starting March 2001 was much tougher due to this lost credibility. in March 2001. the inflation rate was still negative. who do not have voting power. have a right to table such a motion. See Hayami (2000). ZIRP of 1999 came one year too late.Zero Interest Rate Policy and Quantitative Easing the economy is sharply declining. although the degree of deflation had been moderating. whether a forecasting model was wrong. He sounded like fighting inflation in the midst of deflation. The Bank of Japan should have adopted ZIRP soon after the banking crisis of November 1997 broke out and credit crunch became evident.3 The Bank of Japan may have proved itself in standing tall and "independent" by rejecting a transparent objection by the government. as the government representative tabled a motion to delay voting by one monetary policy meeting (about one month later). objecting to the end of ZIRP in August 2000. and the motion by the Governor to raise the interest rate from zero to 0. The government representatives. taking into account the zero bound of the nominal interest rate (Oda and Ueda (2005). an "inflation bias" caused by the government preferring a higher output. the prospect of economic growth should have been weak. as Governor Hayami after reintroduction of ZIRP with QE in March 2001 did not explain what went wrong: whether the objective was wrong." 4 In October 2000.25% was approved by a 7 to 2 majority. The decision of lifting the ZIRP in August 2000 was opposed by the government. The fact of back pedaling to ZIRP. including Tokyo. as the IT stock bubble was bursting in the United States and other major stock markets. a suspicion that the Bank of Japan would err on the side of too early exit rather than too late exit was proven. and the inflation rate is also fast declining toward zero. Accountability was lacking. in 3 Theoretical underpinning of this lesson can be given by modeling inflation expectations depending on the future policy commitment (Krugman (1998)) and by modified Taylor rule argument. However. 4 This was almost expected as Governor Hayami was quite negative on calls for additional measures. including quantitative easing in his speech in his speech in March 2000. Also. was more prudent than the Bank of Japan's. The second lesson from this episode was that a commitment to err on the side of "late" would be important in getting out of deflation. He cautions against the danger of inflation and is against the policy to call for aiming at inflation rate of 2 to 3 percent since inflation once occurred would be difficult to control. This was a substantial damage to the reputation and credibility of the Bank of Japan. the Bank of Japan initiated a semi-annual "Outlook" paper. according to the Bank of Japan Law. and it became clear that economic stimulus was needed by spring of 2001. The motion of "delay" was voted down by 8 to 1. but it eventually lost credibility. or whether judgment was wrong. only seven months later. although it was combined with QE.
since just two months earlier." This was an indirect way of admitting the mistake of August 2000-without saying so. possibly with a quantitative definition.2. The level of current account target was initially set at 5 trillion yen while the required reserve was about 4 trillion yen." Such a document had been promised since the spring of that year. not only in hindsight but in real time. a desirable (target) rate of inflation was still not defined.0 to 2. they had voted to raise the interest rate (with no major events in between). in that ZIRP would continue until the "deflationary concern would be dispelled. the market was still skeptical on how long the Bank would continue ZIRP/QE.1.2. essentially the sum of required reserve and excess reserves.4 to -0. the Bank of Japan came up with a new commitment: The QE/ZIRP would continue until the CPI (ex fresh food) inflation rate becomes "stably above zero. from ZIRP. The October document defined price stability as a state that is neither inflationary nor deflationary – a tautology.5 That was expected to be an attempt to define price stability in a transparent manner." Also in October 2000. This is remarkable. much like the FRB's FOMC participants' forecast in semiannual Humphrey Hawkins testimony documents. Members' forecasts for CPI (excluding fresh food) ranged from -0. the forecast horizon was just the current fiscal year (April 2000 to March 2001). the too-early exit. (Later. In the first Outlook.6 (Much later in March 2006. and that more than enough liquidity would be provided to the interbank market. At this point. given that excess reserves were not remunerated back then. Against this criticism.) In sum. 5 See Hayami (2000) for mentioning the initiation of the study in March 2000 as a part of enhancing transparency. 70 . Many observers saw contradiction to the commitment of April 1999. The MPC members were not afraid to raise the interest rate in the midst of deflation.0. ample liquidity had to be injected by purchasing qualified securities. "stably" was further defined as zero or above zero "for a few months" and no prospect to falling back to deflation) The definition of inflation (CPI ex fresh food) and the floor condition for an exit was finally defined. This policy can be called QE-reserve targeting. and maintaining the target balance above required reserve meant that the interbank interest rate would be automatically zero (ZIRP). It turned out to be a disappointment.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 which Monetary Policy Board members' forecasts were shown in a range. revealed that the Bank was too eager to raise the interest rate at the earliest opportunity. in 2003. the Bank issued a document called "On Price Stability. 2. When ZIRP was restored with an additional feature of excess reserve target (QE). In order to induce the commercial banks to deposit to the non-remunerated current account at the BOJ.5 to -0. while the trimmed range (excluding one max and one min eachsimilar to "central tendency" in FRB) was from -0. Quantitative Easing (QE)-excess reserve targeting The current account balance. at the Bank of Japan became a new target. the Bank of Japan published a document that says the "understanding" of price stability in quantitative points of all members ranging from 0. 6 See Ito (2004a) for in-depth analysis on why the Bank of Japan was reluctant to define price stability in the quantitative manner.
lowering the long-term interest rate. who became Governor in March 2003. possibly. and it did. Even if money supply increases. if most of increases of M2 is in the central bank reserve-that is. a sudden death of a commercial bank due to liquidity shortage became extremely unlikely. but did not happen. First. It is also important to note that the increase in long-term bond purchases was done under Governor Hayami. 2. Assessment of QE-reserve targeting It is not immediately clear from the traditional theoretical monetary policy models how QE. have had strong effects on financial systemic stability. and 1 trillion yen to 1. and the QE target was raised to 6 trillion. The purchase of long bonds had been done practiced on the assumption that monetary base had to increase with the nominal GDP growth and the long-term growth of monetary base can be provided with long-term assets on the liability side. 800 billion yen to 1 tillion yen in February 2002. When the QE-reserve targeting was wound up in 2006. it was also expected. counterparty risk in the interbank market was lessened. the Bank of Japan increased the amount of monthly (gross) purchase of long-term bonds.25% in July 2006.reserve targeting was ended in March 2006 and the policy target became ZIRP. 600 billion yen to 800 billion yen in December 2001. These changes in long-bonds purchase and QE were shown in Figure 1. required reserves went up to 5 trillion yen. possibly influencing the slope of the yield curve. The QE. the amount of monthly purchase of long-bonds did not change.3. So. The current account balance target was increased from December 2001 to January 2004 in several steps. smaller money multiplier-then the real side of economy (investment and consumption) would hardly be stimulated. It took several months to mop up excess liquidity and the interest rate was raise by 0. when the postal bank became a part of commercial banking system.reserve targeting would help the economy recover from stagnation and deflation. while the required reserve was at around 6 trillion yen. There are four different channels that QE-excess reserves contributed to restoring financial stability.Zero Interest Rate Policy and Quantitative Easing Shortly after this policy was introduced. This was the end of the second ZIRP period. bank loans were not dramatically increas- 71 . As one of the measures to increase overall liquidity. while large jumps in the target amount of QE were done under Mr. Fukui. The rapid increase reflects implies that the Bank was less reluctant in purchasing long-term bonds-no risk if held to maturity-than other kinds of risk assets. Since there was ample liquidity. Second. as monetarists would recommend in fighting deflation. the target level was maintained at 30-35 trillion yen. that credit crunch would not happen for the reason of liquidity shortage. the increase of monthly purchase of long-term bonds during the period between August 2001 and October 2002 was for helping increase the liquidity provision and. helping economic recovery and fighting deflation. From January 2004 to March 2006. However.2 trillion yen in October 2002. The monthly purchase was increased form 400 billion yen to 600 billion yen in August 2001. Governor Fukui's communication was clearer in carrying out large increase in QE. it was expected to. However. citing that the CPI (ex fresh food) inflation rate had been above zero for several months.
and it would take time to take out liquidity from the market. When the economy was stagnant and stock prices were falling. 72 . With high target of QE and the commitment of a clear exit condition. and flatter slope up to ten years. provided that the expected inflation rate for a longer term stays stable (that is. commercial banks may find it safe and profitable to invest in interest bearing securities like long-term bonds.and long-term interest rates came down. Therefore. For policy duration effects. ZIRP would be guaranteed for some time. QE-reserve targeting had sent a message to market participants that ZIRP would continue for some time. not dragged down with the nominal interest rate). with ZIRP in place with policy duration effects.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Figure 1 BOJ increased the purchase of JGBs and current account balances (excess reserves) ing at all during the QE period. equities. because banks were concerned with their capital adequacy ratios and deteriorating credit worthiness of corporations. in that the exit would not come until the inflation rate would be stably above zero. This has been called the "policy duration effect" (see Oda and Ueda (2005)). Oda and Ueda (2005) and Okina and Shiratsuka (2004) confirmed that the effect was strong in lowering the 3-year to 5-year JGB interest rate." Ugai (2007) provides a comprehensive survey of empirical work related to the policy duration effect and the portfolio rebalance effects. it would be very difficult to encourage Japanese banks (or any other banks) to lend more. and there would not be an abrupt end like August 2000. At the time of introducing QE in March 2001. high-grade corporate bonds. the medium. As extra liquidity provided to the market. (2005). The effect became even stronger in late 2002. Third. there was also a commitment. even with expanding QE. Then borrowers with investment project and potential house buyers may be encouraged to borrow and invest. the yield curve would become flatter: the zero interest rate up to approximately one year. This is called "portfolio rebalance effects. That would raise aggregate demand. The task should be taken up by financial supervision policy and fiscal operations in terms of capital injection to commercial banks. Baba et al. and low-grade corporate bonds. Fourth.
(See Ito (2004b)) Important lessons of ZIRP and QE from the experiences of the Bank of Japan are that it is important (a) to communicate the intention. but not on equities and low-grade corporate bonds. Variants of QE 3.) The Ministry of Finance conducted massive yen-selling intervention from January 2003 and March 2004. but evaluation losses had to be deducted from tier I capital. (4) Purchase of equities as monetary policy. (2) Outright purchase of corporate debts (except Asset Back securities). as foreign reserves are held in the fiscal special account.1.2 trillion yen per month in October 2002. Svensson called this a foolproof way out of deflation. The purchase was decided in the "regular" meeting of monetary policy board. but not in the low-grade corporate bonds. (3) Purchase of REITs.8 (1) Purchase of foreign currency denominated government securities. This would have two benefits via probably depreciation of the yen. Kimura and Small (2006) found some effects from BOJ's increased JGB purchases on high grade corporate bond yield. 8 See Meltzer (1999. as 45% of valuation gains can be counted toward tier II capital. foreign exchange intervention is under the Ministry of Finance jurisdiction. as the Bank of Japan emphasizes. Svensson (2001) recommended that BOJ would purchase foreign bonds that would amount to unsterilized intervention. 73 . Oda and Ueda (2005) actually did not find the measurable impact of this policy on the JGB yield. that would induce more loss cut selling. (See Ito (2007) for this mechanism. and others summarized in Ito and Mishkin (2006). 2001). 3. but it was explained as a "coincidence" by then Deputy Governor of Bank of Japan. Japanese commercial banks' holding of equities contributed to significant uncertainty over the prospect of their Basle Capital Adequacy Ratio. In Japan. This may be viewed as unsterilized intervention. preventing deflation through imported inflation and stimulating exports.Zero Interest Rate Policy and Quantitative Easing As for portfolio rebalance effects. despite many economists were the following. The Bank of Japan also purchased equities directly from commercial banks from 2002 to 2004 for the reason of financial stability. and (5) Guarantee of interbank liabilities. and not in the "monetary policy" meeting of the same board. and target of those policies.7 More than 2 trillion yen worth of equities were purchased. objective. not for monetary policy. The Bank of Japan decided to avoid self-fulfilling prophecy of banks' selling equities in loss cut that would actually cause the equity price to decline. Long bond purchases by BOJ were increased from gross purchase of 400 billion yen per month before QE to 1. and. BOJ What the Bank of Japan did not do as QE. Svensson (2001). Kimura and Small (2006) found some effects on high-grade corporate bonds (a 10 trillion excess reserve increase depressed the spread of Aa bonds by 1 to 4 basis points). coincided with BOJ expansion of its balance sheet. (b) to prevent the inflation rate from falling into the negative territory for an 7 See Ito (2004a) for political economy over the debate of purchasing equities by the Bank of Japan. What was once a cushion in CAR became a liability by 2002.
3. directly inject capital (if losses wipes out capital). but rather the differences in financial and economic conditions between the two episodes. although the Bank of Japan's policy approach during the QE period was quite multifaceted. in a pure QE regime. like corporate bonds. Here it becomes crucial that the central bank and the fiscal authority must cooperate. In contrast. In fact. in 2001-2006. the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. the policy approach used by the Bank of Japan from 2001 to 2006.2. but bank lending did not pick up the pace. much faster than BOJ did from 2001 to 2003. Indeed. FED. QE has several variations regarding (1) what is the primary purpose. Therefore we need to make it clear which QE we are talking about. The difference is best explained by his own words: "The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE). The Federal Reserve in 2008 directly intervened in the credit and capital markets and purchased the securities and provided guarantees. is the possible losses from holding risky assets. which are liabilities of the central bank. BOJ failed in some of these criteria and succeeded in some. This difference does not reflect any doctrinal disagreement with the Japanese approach. the focus of policy is the quantity of bank reserves. Balance sheet concern A common concern in expanding central bank balance sheet. and (c) to find ways to influence inflation expectation. we arrive at the conclusion that QE has many forms. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet.3. The central bank has to put the health of the economy ahead of the health of its balance sheet. hoping that providing ample liquidity to banks would change their behavior to lend more and that the yield curve would be flattened to stimulate aggregate demand. In particular. The yield curve did become less steep. went for QE-reserve targeting. or reim- 74 . credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. The Bank of Japan. The fiscal authority can take reduced payment of seigniorage from the central bank over the years. Bernanke (2009) explained the action as "credit easing" to make it differentiated from BOJ experiences. the concern was one of the reasons that the Bank of Japan did not take bolder actions. 3. However. (2) what would be the target instrument and communication strategy." From these explanations. the overall stance of its policy was gauged primarily in terms of its target for bank reserves. the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. and (4) how to influence inflation expectation. (3) what assets to buy.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 extended period. credit easing The Federal Reserve has expanded its balance sheet in 2008. either by BOJ style or FRB style. This CE (credit easing) action seems to be based on a recognition that the BOJ QE-reserve targeting was rather ineffective. and the fiscal authority has to find an implicit or explicit mechanism to fill losses from the central bank action of holding risk assets for the sake of economic recovery.
at around 1-2 % has the following benefits. The trust between the central bank and the fiscal authority is a key. say. It would be a challenge for ECB to build such trust with 16 different fiscal authorities of the euro area. Inflation targeting Flexible inflation targeting has been popular among many OECD and emerging market central banks. credible. Even if actual inflation rate becomes negative. Implications of global ZIRP When several major economies simultaneously fall into ZIRP.Zero Interest Rate Policy and Quantitative Easing burse the losses in risky securities holding in joint facilities. It has been argued that successful inflation targeting has effects of stabilizing inflation targeting. and other major countries that were growing at healthy pace did have room to absorb exports from Japan. QE-reserve targeting by the BOJ in 2001-2006 had "policy duration effects" that 75 . anchoring inflation expectation. Whether it is a result of natural consequences of monetary base expansion or a result of outright non-sterilized intervention. Japan needed this help in 2001-2006. Moreover. the widening interest rate gap induced the yen to depreciate in 2004 to 2006. rather than a positive interest rate. When Japan was suffering from stagnation while other major economies were booming like the late 1990s. 5. the currency depreciation should be considered as a part of the prescription. In the current context. possibly due to a crash over lifting the first ZIRP in August 2000. The FRB and the Treasury seem to enjoy such a trust. the correct policy prescriptions for Japan included currency depreciation. the public continues to believe that the inflation rate would return to 1-2% in the medium term (say. Japan did maintain the zero interest rate. The burden of appreciation should be shouldered by a country with large trade surpluses with relatively sound financial system and growth prospects. such as Maiden Lane that would assume possible liabilities of Bear Stearns assets. that is contractionary. The investment and consumption decision would be based on negative real interest rate (ZIRP minus positive nominal expected inflation) that is stimulative. and as other countries raised interest rates. 4. However. Thus. currency depreciation becomes difficult when ZIRP is practiced by many countries simultaneously. Svensson (2001) recommended non-sterilized intervention as a foolproof way of getting out of deflation. flexible inflation targeting would be beneficial to managing the economy during a deflationary period. The Bank of Japan in 2001-2006 did not have such a trust. two to three years). Some currency has to appreciate to help others. the effectiveness of QE is diminished as a stimulus via exchange rate depreciation may be limited. Currency depreciation is a potent weapon for getting out of deflation because it works directly via imported inflation and indirectly through stimulation of output among the export sectors.
First. given that the interest rate was zero. The Bank of Japan has been quite negative on adopting inflation targeting during the ZIRP period and even after the exit from ZIRP. without tools to achieve. Inflation targeting-such as aiming at returning to 1-2 percent inflation rate in three years-may be helpful as a clear. if the public happens to believe in the inflation targeting. Third. and ZIRP and QE from March 2001 to March 2006. Arriving at ZIRP should not be delayed until the inflation rate reaches zero. would damage the credibility of the Bank. inflation targeting was characterized as a simple-minded reflation policy and rejected. with some forecasts on what will be coming in Europe. the following policy recommendation seems to emerge. and FRB's experience of credit easing from mid-2008 to now. Ito (2004) discussed the political economy of the inflation targeting debate in Japan during ZIRP period.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 flatten the yield curve by lowering the long-term interest rate. communication strategy. Fourth. This logic was also used as one of the objections to inflation targeting proposal to the Bank of Japan. Thus. The credible inflation targeting may lower expected real interest rate. Most of the Board members and staff economists of the Bank spoke out negatively about inflation targeting. or low real interest rate expectation. the long-term interest rate would increase and it would damage the economy. As the central bank shows resolve to get out of deflation in a short period. Several reasons were mentioned. The Federal Reserve of the United States. some of the unconventional measures have to be taken. Would it be better for them to adopt inflation targeting at this juncture? Although the Group of Big Three (G3) central banks have not declared inflation targeting. Conclusion: Policy Recommendations Based on Japan's experiences of ZIRP from February 1999 to August 2000. since in order to achieve a positive inflation rate target. 76 . inflation targeting became somewhat a symbol of additional steps that the Bank of Japan should or should not take." 6. with some deficiency remaining. An introduction of credible inflation targeting amidst deflation may be counterproductive by raising the inflation expectation and in turn raising the nominal long-term interest rate. such as independence. "In fact. transparency. The lower long-term interest rate can be a result of low inflation rate expectation. Fifth. transparent message. there was no policy measures. or both. (1) Determination and communication of a do-everything attitude to avoid a prolonged deflation is critically important. Second. but not the nominal rate. it is important to have credible inflation targeting regime during a normal period with positive inflation rate. are available to lift the inflation rate to the positive territory so that announcement of inflation targeting. inflation targeting may be a useful tool. some of them have improved on many of the pre-conditions for inflation targeting. and history of inflation rates. no country had adopted inflation targeting to increase an inflation rate from the state of deflation. and to use it to prevent the inflation expectation falling into deflation territory in the beginning phase of deflation. the ECB (Eurosystem) of the Euro Area and the Bank of Japan have not adopted inflation targeting. He summarized the Bank of Japan's opposition as follows. a mere announcement of an inflation target would not change expectation.
London School of Economics. Problems in the Financial System and Monetary Policy. "Price Stability and Monetary Policy" Speech given to the Research Institute of Japan. Oda. Many variations of QE should be considered and attempted. Bernanke. (5) The trust between the central bank and the fiscal authority is important to induce the central bank to take bold actions in QE and/or CE. Issue 2. with a promise to raise a less-distortionary tax in the medium run may be prudent fiscal policy under the circumstance. (2000). that is. Masaru. "Financial Market Functioning and Monetary Policy: Japan's Experience. The higher the debt ratio is. "Myths and reality of foreign exchange interventions: An application to Japan". Naohiko. N. "Inflation Targeting and Japan: Why has the Bank of Japan not 77 . "Some Thoughts on Monetary Policy in Japan. (3) It is important for ensuring the end of deflation to have a commitment to err on the side of late than early for the timing of exit and an implementation of easier-than-usual monetary policy after the exit of ZIRP. vol. the more constrained is the country in implementing fiscal stimulus. stimulus via currency depreciation. England. S. 21. International Journal of Finance & Economics. Baba. Special Edition. Ugai. Japan. no. and H. 23. Bernanke. Takatoshi (2004a). but room for sustainable fiscal deficits is quite different from a country to another. 1: 47-111." Before the Japan Society of Monetary Economics. Ito. London. Tokyo. Under a global ZIRP environment. the FRB actions to purchase wide range of securities are remarkable and commendable. (2005)." At the Stamp Lecture. Takatoshi. 2003. Shirakawa. The currency of a relatively strong economy should appreciate (at least in the real effective exchange rate) in the globally deflationary environment. Volume 12. Ueda." Monetary and Economic Studies. a country with large trade surpluses with positive GDP growth should refrain from large scale intervention since intervention to prevent appreciation would be equivalent to a beggar-thy-neighbor policy. (6) Globally-coordinated fiscal stimulus is desirable. Tokyo. (2007). In this respect. April 2007: 133-154. K. (4) Global ZIRP would shut down one channel of recovery. Even in these countries. January 13. It is firmly believed at the FRB that restoring the economic health is more important than keeping the central bank's balance sheet clean and riskfree." Monetary and Economic Studies. Naohiko. "The Crisis and the Policy Response. (2009). vol. Hayami. (2006).Zero Interest Rate Policy and Quantitative Easing (2) The authorities should not hesitate to expand the central bank's balance sheet by buying risk assets that would most effectively restore financial stability. References Baba. March 21. (2003). May 31. December: 3971. Nishioka. current fiscal spending associated with structural reform removing inefficiency and with subsidies to green innovations. Ito. 2009. Ben S. M. Ben S. "Japan's Deflation.
(2006). Allan H. vol. Mishkin. 1. (eds. Rose. Small.au/PublicationsAndResearch/Conferences/2004/Ito.: Institute for International Economics: 171-196 Ito. "Two Decades of Japanese Monetary Policy and the Deflation Problem.pdf." North American Journal of Economics and Finance. no. Takatoshi (2009).) Monetary Policy with Very Low Inflation in the Pacific Rim.E. Kunio and Shigenori Shiratsuka (2004). (eds." Brookings Papers on Economic Activity 1998. pp." CARF Discussion Paper. D. 6. 25." C. Ito and A.) Dollar Adjustment: How Far? Against What?. vol. (2006). Takatoshi (2004b). NBER-University of Chicago Press: 131193. S-1. vol. Bergsten and J. University of Tokyo. Nobuyuki and Kazuo Ueda (2005). "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap. Krugman. and D." Bank of Japan. 15: 75-100. Monetary and Economic Studies. Washington. Hiroshi (2007).rba. (2001). F. " in Christopher Kent and Simon Guttmann (eds. Kimura T. No. Takatoshi and Frederic S." in T. 2.8. "Monetary Transmission at Low Inflation: Some Clues from Japan. Ito. 137-187 Meltzer. December: 189-191. Svensson. Paul (1998). "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach. (1999). vol 17.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 adopted Inflation Targeting?.) The Future of Inflation Targeting. Journal of Macroeconomics. "Quantitative Monetary Easing and Risk in Financial Asset Markets. S-1. Okina. ch. Williamson. no. February: 13-34 Oda. Allan H. no. "It's Baack! Japan's Slump and the Return of the Liquidity Trap. "The Yen and the Japanese Economy. Meltzer. August 2004: 220-267. (2001). Bank of Japan. "Policy Commitment and Expectation Formation: Japan's Experience under Zero Interest Rates. L. February: 277-312 Ugai. vol. 2004. "Comments: What More Can the Bank of Japan Do?" Monetary and Economic Studies. and ECB?" Presented at the AEA meeting January 3. "Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses." Monetary and Economic Studies 19. available at http://www. FRB. "How Close Are They to Inflation Targeting: BOJ. 19. vol. 2005. 2009 Ito. March: 1-47: 78 .gov." The B." Monetary and Economic Studies. F-013.O.C.
When I borrow. Repetition and reputation can sustain debt service that would not be individually rational in a one-shot or single-stage game. Section 4 considers the effect of sovereign default risk on the expansionary effect of fiscal policy. This is less true for sovereign borrowing. Debt and deficits Debt is a wonderful and dangerous social invention. Another way to put this is that it permits saving to be decoupled from investment. Section 3 considers the conditions under which different fiscal stimuli will boost aggregate demand. however. London School of Economics and Political Science and CEPR Introduction In this short paper I shall discuss the following issues. that emphasis intertemporal substitution effects over income effects. Section 5 considers the effect of a credit squeeze on effective supply and Section 6 reviews neoclassical fiscal measures. External or third-party enforcement of sovereign debt contracts is unusual. I can absorb more resources for consumption and investment than are provided by my current income.Fiscal Sustainability Willem Buiter European Institute. Such borrowing creates a legal obligation to repay the debt with interest at some future date. Because the net financial benefit from adhering to the terms of a debt contract sooner or later become negative for the borrower. although countries can at times be forced or bullied by other nations to meet some of their external obligations – the deposit insurance obligations of the foreign branches of Icelandic banks assigned to/imposed on the Icelandic sovereign by the British. 1. That is why it is essential that governments honour the sovereign debt bequeathed to them by their predecessors. even if the new gov- 79 . self-enforcing debt contracts are rare in the private sphere and third-party or external contract enforcement tend to be the rule. are an example. Self-enforcement is. Section 2 discusses fiscal sustainability. output and employment. the rule for sovereign debt contracts. Section 1 reviews the usefulness of debt and deficits for smoothing consumption over time and the limits on this usefulness due to aggregation constraints in a closed global system. nationally and globally. and because the anticipation of future access to borrowing facilities and a concern for one's reputation are often imperfect contract enforcement mechanisms. Dutch and German authorities. It permits individuals and groups of individuals to smooth consumption over time.
times the difference between the long-term real interest rate on the sovereign debt. a nation can only reduce its external borrowing if the rest of the world is willing to increase its external borrowing or to reduce its net external lending. a fiscal-financial-monetary programme is sustainable if the authorities have not taken a leaf from Bernie Madoff's handbook and are not engaged in an open-ended pyramid scheme or Ponzi finance scheme. Proposition 1: The current global economic slowdown makes it desirable for every country to seek to increase its external trade balance.g.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ernment disapproves of the spending programmes or tax cuts that generated that debt. This is given by 80 . than they appear to be when we consider the options open to an individual would-be borrower (individual. In equilibrium. 2.g. Countries with unsustainable external deficits (e. – be no less than the outstanding stock of sovereign non-interest-bearing s debt as a share of GDP. China). Formally. The scope for consumption smoothing created by borrowing is often much less impressive in equilibrium. In a closed economy. – and the long-run growth rate of real GDP. that just stabilised the debt-to-GDP ratio. – . when the interaction of all participants in the economic game are fully taken into account. This is logically impossible and represents an invitation for conflict. d . This can be written as the simple requirement that the permanent share of the state's primary surplus in GDP. which should seek to boost domestic demand and reduce their trade balance surpluses. the government can only borrow more if the private sector borrows less. the USA) should seek to boost their trade balances and de-emphasize domestic demand relative to countries with unsustainable external surpluses (e. Technically. s. government or country) facing a much larger national or global economy. in which existing debt – both interest and principal repayments due – is serviced forever by issuing additional debt. The primary surplus of the state is the financial budget surplus of the state – the consolidated general government and central bank – minus net interest income plus the monetary issuance of the sovereign (the change in the stock of base money issued by the central bank). but not an operational concept. In an open economy. I can only borrow if someone else is willing to lend. this means that the present discounted value of the sovereign's terminal debt goes to zero as the terminal period recedes into the infinitely distant future. It can be restated as the prima-facie operational requirement that the outstanding value of the non-monetary debt of the sovereign or the state (the consolidated general government and central bank) be no larger than the present discounted value of current and future primary budget surpluses of the state. So the r n smallest permanent share of the state's permanent surplus in GDP that is consistent with solvency of the sovereign is given by: – = ( – – n)d s r – (1) This is very similar to the expression for the current-period state primary surplus (as a share of GDP). Fiscal sustainability Fiscal sustainability is a useful conceptual tool.
in principle. social and political factors. First. since. the long-run real interest rate on the public debt and the long-run real growth rate of GDP are uncertain and have to be estimated and predicted. is the long-run average ratio of the pri– mary surplus of the state and that – and n are likewise future long run average values r of the real interest rate on the public debt and the growth rate of real GDP respectively. the willingness of the citizens to pay higher taxes or accept lower public spending programmes and the ability and willingness of the central bank to extract real resources through the issuance of base money – seigniorage. The net debt-to-GDP ratio is. The difference between the sustainability condition (1) and the debt-to-GDP ratio stabilising primary surplus of the state given in (2) is that – the s. permanent primary surplus as a share of GDP. governments have developed the habit of hiding significant liabilities and contingent exposures in offbudget and off-balance sheet constructs. The markets have therefore become doubting Thomases: they want to see before they believe. Sovereign default risk spreads have increased sharply in the current crisis. like Bunds or US Treasury bonds) when they announce counter-cyclical behaviour in the downswing while promising higher taxes and/or lower spending in the next upswing. The best guide to future primary surpluses is the government's capacity for generating primary surpluses in the past. Governments with a history of procyclical behaviour during the upswing will met with market scepticism (in the form of higher CDS rates and higher spreads of their sovereign debt rates over that of best-of-breed benchmarks. expected or planned is indeed at least as large as – depends s on a host of economic. Unfortunately. A higher sovereign debt default risk premium will be one possible cause of such an increase. Only costly signals are credible. Unfortunately. three of the four key parameters in (1) are unobservable. so measuring d accurately is no trivial matter. No government has the credibility to commit itself and its successors to such a strategy. A vicious 'positive feedback' mechanism from a higher debt burden to a higher default risk premium to a higher deficit and a further increase in the debt burden becomes a possibility. Given d and estimates of the long-run real interest rate and growth rate. even in the Eurozone. when doing so was not easy. letting ∆ denote 'change in': 81 . including the determination and credibility of present and future governments. the minimal required permanent surplus as share of GDP to achieve solvency can simply be calculated from (1).Fiscal Sustainability s = (r – n)d (2) where r is the current real rate of interest on the public debt and n is the current rate of growth of real GDP. Whether the permanent primary surplus (as a share of GDP) of the state that is predicted. Both (1) and (2) show that the minimum required primary surpluses (for long-run solvency or for stabilising the debt-to-GDP ratio at its current level) will increase whenever the real interest rate on the public debt increases. It is in principle possible for a policy maker to announce a thousand years of primary deficits followed by an eternity of sufficiently large primary surpluses that (1) is satisfied. reaching 300 basis points for 10-years sovereign debt instruments. measurable and verifiable.
however. credit. all these contingent liabilities should be priced (e. Much of the exposure is contingent and technically off-balance sheet. When does a fiscal stimulus boost aggregate demand? A fiscal stimulus is a key weapon in the policy arsenal used to address an undesirable weakening of aggregate demand. This can take the form of guarantees for and insurance of bank assets or liabilities. or σ. From the perspective of the fiscal sustainability. Quantitative easing (expansion of the monetary base through purchases of government securities) is an especially important source of revenue for the sovereign whenever short-term interest rates are well below long-term interest rates. or securities. exchange rates and other asset prices. and (2) minimizing moral hazard (creating bad incentives for future reckless lending and investment by rewarding past reckless lending and investment. these co-operative and coordinated actions will not threaten the price stability mandate of the central bank. the only way to stabilise the potentially explosive debt-deficit spiral is through larger primary surpluses. The financial crisis threatens government solvency through what amounts to an increase in the stock of net debt. as a share of GDP: s=t–g+σ (4) Proposition 2: Even operationally independent central banks must recognise that their profits or (equivalently) their monetary issuance are an important source of revenue/means of financing for the state. interest rates. either an increase in public spending on goods and services (public consumption or investment) or a tax cut (which includes an increase in transfer payments) must raise aggregate demand at a given price level. g. This is true regardless of whether the official monetary policy rate is at its zero floor or above it. d.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ∆d = –s + (r – n)d (3) If the default risk premium cannot be addressed directly. more solvent governments or from international organisations with deep pockets. 3. Close cooperation between the monetary and fiscal authorities is necessary to achieve the right timing and magnitude of monetization of public debt and deficits. say through guarantees from other.g. In the textbook IS-LM model this means that the fiscal measure shifts the IS curve to the 82 . but not outstanding stocks of loans. When done competently. that is. injections of capital financed through government debt issues etc. as a share of GDP. t. or increases seigniorage – issuance of base money by the central bank. higher taxes. using real option pricing methods) and added to d and the marked-to-market value or marked-to-model value of any (contingent) assets the government may have acquired as part of its banking sector or financial sector bail-out operations should be subtracted from d. For the policy to make sense. Proposition 3: From the point of view of (1) getting the maximum bang per buck as regards stimulating aggregate demand. including securitisation. and the reversal of this monetization when the economy recovers. the fiscal authorities should guarantee or insure flows of new lending and credit. wage. as a share of GDP. lower public spending.
Stating the assumptions required for Ricardian equivalence to hold is to deny its relevance. lower asset prices or a stronger exchange rate or because there is 'real crowding out' through scare real resources on the supply side. because there is 'financial crowding out' through higher interest rates. 83 . without changing the present discounted value. will boost aggregate demand because it redistributes resources from the young to the old. Postponing taxes through borrowing. real crowding out or 'factor market crowding out' occurs through rising real wages and other real factor costs. this requires that the tax cuts (transfer payments) be labour income tax cuts or lump-sum tax cuts or transfer payments accruing to persons (owners of human wealth -the non-traded present discounted value of future after-tax labour income). and through rising inflationary pressures. Life-cycle principles imply that. If we can identify the young and the old and the life-cycle and Keynesian consumers. even if the IS curve shifts to the right. life-cycle theories of consumption would imply that postponing taxes by government borrowing (that is cutting taxes today and raising them by the same amount in present discounted value at some later date) boosts aggregate consumption demand because it redistributes resources from people with longer expected remaining life-spans (the young and the unborn (future generations) to people with shorter expected remaining life-spans (the old and those current alive). A key point to note is that these aggregate-demand-boosting redistributions can also be achieved without the need for public deficits. the old will have a higher marginal propensity to consume out of current income than the young. But unless the fiscal stimulus shifts the IS curve to the right. To negate these life-cycle arguments for an expansionary demand effect from tax cuts. We may still not get any effect on output and employment. representative infinite-lived consumer. financial and real assets that are traded and owned by those currently alive. The unborn of course don't consume at all (at any rate prior to conception).Fiscal Sustainability right. Ricardian equivalence Tax cuts Even if financial markets were perfect. the Ricardian equivalence or debt neutrality school assumes (1) that the government always satisfies its intertemporal budget constraint (there is no default risk on public debt) and (2) that aggregate consumption can be viewed as the consumption of a single. live and die is finessed by assuming that everyone is linked to all past and future generations through an unbroken chain of operative intergenerational bequest motives. The awkward fact that people are born. because people try to smooth consumption over the life-cycle. from the unborn to those currently alive and from permanentincome or life-cycle households to households constrained by liquidity and current disposable income (Keynesian households). rather than tax cuts on the returns to or on the value of non-human. we can do balanced-budget redistributions that will boost aggregate consumption. it achieves nothing at all – we don't even have to investigate whether there is financial or real crowding out. and if we have sufficiently rich arsenal of taxes and transfers. Strictly speaking.
In the Ricardian view. even if the budget is kept balanced. private consumption would only fall by an amount given by the product of the long-term real interest rate and $ 1 bn – maybe by $ 30 mn or so. An increase in student grants financed fully through a levy on financial wealth (students are likely to be liquidity-constrained.) The consumer-oriented tax cuts and transfer payment increases recommended in the IMF Staff Position Note. a balanced-budget increase in public consumption or investment spending (funded with higher taxes or lower transfer payments) would boost aggregate demand. 3. China). looking after the insiders (existing distressed mortgage borrowers) at the expense of the outsiders (future mortgage borrowers). only makes sense if it does not amount to an involuntary mortgage write-down imposed on the banks and other mortgage lenders. even a permanent balanced-budget increase in public spending on goods and 84 . reduce permanent income by much less than $ 1bn – to a reasonable approximation. Unless fiscal resources are actually made available to make the lenders no worse off than they would have been under voluntary restructuring and write-downs of mortgages. 'Fiscal Policy for the Crisis' (Spilimergo et. If the Keynesian consumption function with its liquidity-constrained consumers describes reality.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Proposition 4: Balanced-budget redistribution between households with different marginal propensities to spend out of current income can boost demand as effectively as deficit financed tax cuts. Increased public spending on goods and services Even if there is Ricardian equivalence for tax cuts or increases in transfer payments. a permanent increase in exhaustive public spending would not boost aggregate demand. Support for homeowners facing foreclosures. If there are liquidity-constrained households. including a write-down of mortgages using public resources. al. The reason is that a one-year (say) increase in public consumption or investment of $1 bn will. Proposition 5: A temporary increase in public consumption or investment will always boost public spending.g. It would be a classic example of populist politics. (2008)) overlap mostly with what I recommend here (increased unemployment benefits. support for homeowners facing foreclosures would worsen conditions in the financial sector. Examples include the following: 1. An increase in short-term unemployment benefit financed by a reduction in long-term unemployment benefit (short-term and temporarily unemployed workers are more likely to be liquidity-constrained. a temporary increase in public spending on goods and services (exhaustive public spending) will stimulate demand. and would also reduce the availability of private mortgage financing for future borrowers. 2. unlike owners of financial assets). as it would lower permanent income and thus private consumption by the same amount as the permanent increase in public spending. increases in earned income tax credits and the expansion of safety nets in countries where such nets are limited (e. An increase in social security retirement pensions financed fully by higher social security contributions by workers and employers (pensioners have a higher mpc than workers).
real resource constraints (capital and labour bottlenecks) limit the expansion 85 . Different types of 'crowding out' The conditions for Ricardian equivalence are unrealistic and don't hold in practice. Proposition 7: Cooperatively designed international fiscal stimuli must be modulated according to the' fiscal spare capacity' of each country. Proposition 8: Very large fiscal deficits and public debt issuance by rich countries will risk crowding out sovereign and private sector borrowers from emerging markets and developing countries. current and anticipated future fiscal actions. real resource crowding out and direct crowding out. immediate. Even when the monetary authorities peg the short nominal interest rate. there will be full crowding out of an (unanticipated. Interest rate crowding out will be full or 100% when the nominal money stock is kept constant and velocity is constant. regardless of the degree of financial crowding out. Real resource crowding out Real resource crowding out occurs when. Financial crowding out Financial crowding out occurs though the response of interest rates. A large country or region (like the USA or the Eurozone) could use domestic expansionary fiscal policy to raise domestic demand to the extent that its actions raise the world real and nominal interest rate. interest rates. A smaller trade surplus (larger trade deficit) undoes the effect of the fiscal stimulus on output through an appreciation of the nominal and real exchange rate. exchange rates and other asset prices does not mean that it will boost demand when the response of prices. exchange rates and other asset prices to the fiscal stimulus is allowed for. the exchange rate and other asset prices to past. Longer-term risk-free global real interest rates are likely to rise. The textbook examples in the IS-LM framework are interest rate crowding out when the path of the nominal stock is kept constant and exchange rate crowding out under a floating exchange rate. a significant part of a domestic fiscal stimulus may end up raising output abroad through larger imports and reduced exports. that is. wages. Three of crowding out can be distinguished: financial crowding out. permanent) fiscal expansion under perfect international capital mobility when the exchange rate floats and there are no doubts about the fiscal sustainability of the government's fiscal-financial-monetary programme. according to its ability to generate (and to commit itself credibly to generate) larger future primary government surpluses.Fiscal Sustainability services will boost aggregate demand. This discussion has three obvious implications: Proposition 6: international coordination of cooperatively designed fiscal stimuli is likely to be necessary to allow the internalisation of the effective demand externalities of a fiscal stimulus through the trade balance and the real exchange rate. but even for large countries or region. interest rates. wages. Just because expansionary fiscal policy can stimulate aggregate demand at a given value of current and future prices.
It also depends on whether the real resources consumed or invested by the state are direct substitutes for or complements with private consumption and investment. railroads) may boost private investment in tourism or residential construction. Direct crowding out The effect on aggregate demand of an increase in public spending on real goods and services depends not only on the way it is financed and on the marginal propensities to consume of current and future tax payers. the domestic supply constraint on real final demand can be relaxed through the trade balance. Note that this has nothing to do with Ricardian Equivalence. I shall argue in Section 5 that credit policy may reduce working capital constraints on production and employment. So far. In an open economy. The issue is not considered in Spilimbergo et. For the world as a whole this is not possible. which assumes that the government never defaults but instead always meets its intertemporal budget constraint. Sovereign default risk and the expansionary effect of fiscal policy If a tax cut or an increase in public spending is deficit-financed. al. However. the increases 86 . in most of the industrial world and in the emerging markets. Public spending on policing is a substitute for private spending on security guards and other means of enhancing personal security and keeping private property safe. Public spending on free public education and healthcare may be a substitute for private spending on education and healthcare. 4. (2008).Macroeconomic Stability and Financial Regulation: Key Issues for the G20 of output in response to a fiscal impulse. A sufficiently large increase in the government deficit (or an increase in the effective net public debt through any other mechanism) could therefore increase the default risk premium on the public debt to such an extent that the net effect of the tax. if one ignores the relevance of changes in labour income taxes and other taxes on labour supply in a world where the problem is growing involuntary unemployment. perceived default risk will increase and the government's cost of borrowing will rise. and if markets do not believe it to be certain that the government or its successors will raise future taxes (including monetary issuance) or cut future public spending by the same amount in present discounted value terms as the up-front tax cut or public spending increase. often by rising real wages and by rising inflationary pressures. Government borrowing rates tend to set a floor for private sector borrowing rates. that could permit a fiscal stimulus to have a stronger expansionary effect. so credit easing policies may relax effective (financial) supply constraints on output. spending and financing decisions on aggregate demand could be negative. Fiscal policy cannot relax physical supply-side constraints in the short run. It will tend to be accompanied by rising prices and wages. such situations are few and far between. Although it is possible that the private sector could borrow on better terms than its sovereign. There is hardly any hard evidence on the presence and importance of such direct crowding out or crowding in. Public infrastructure spending (roads. But it is something that could usefully be taken into account when setting priorities for the detailed composition of public spending programmes.
and non-financial enterprises deemed too large. Deficit-financed fiscal stimuli should be modulated across countries according to the 'fiscal spare capacity' in that country. The increased political polarisation and is reflected. Another way of putting this is that nations like the US and the UK have much less social capital today than they had in 1945. In other large countries. The political constraints on spending cuts and tax increases are much tighter than they were immediately following WWII. only balancedbudget measures or central bank money-financed support measures would have any expansionary effect. Renault. Chrysler. The accumulation of public debt and of other hard or contingent exposure to the banking sector. Democrats are likely to veto any future cuts in public spending. Don't take that as a guide to what the fiscal authorities will be able to get away with today. national cause – a war against an evil aggressor – is not present today. debt-financed policy through this default-risk driven financial crowding out mechanisms. including the US. both as regards its competence. Germany and France. administratively and politically sustainable. although the two may well be driven by common third factors. the polity is much more polarised today than it was in 1945. and Republicans any future increase in future taxes. This is the difference between the current permanent primary surplus and the maximum value of the permanent primary surplus that is economically. We must not be fooled by the contemplation of the very high public debt to GDP ratios found in the US and the UK immediately after WWI and WWII. the UK and Germany. is such. Airbus). the UK. the decline in the risk-free rate for a while was larger than the increase in the default risk premium on the sovereign debt and the total cost of government borrowing actually declined. and both government default risk premia and longterm interest rates on sovereign debt have been rising. Citizen's trust in government. including the US. In that case. This increased polarisation is not the same as the increased inequality in income and wealth that characterises both countries. Freddie Mac). especially in the US. current tax cuts and public spending 87 . In a number of European countries (Greece. were incurred as a result of a war on ourselves. In a number of countries. too interconnected or too politically connected to fail (GM. in the existence of a large number of de-facto veto groups. when the US had public debt around 120% of GDP and the UK around 220% of GDP. This situation began to reverse itself at the end of 2008. that can prevent the imposition of higher taxes or cuts in public spending. In such a deadlocked society. Ireland. that financial crowding out through rising sovereign default risk premia could become a real issue soon. we may not yet have reached that position. Spain. In the US Congress. Fannie Mae. including fiscal sacrifices in order to pay down a debt incurred in a noble. other financial institutions and instruments (AIG. The increases in public debt we have seen in recent years and are likely to see in the next few years. The willingness of the public to make great sacrifices. Opel. Both in the US and in the UK. and some of the Central and Eastern European countries) sovereign default risk premia have now risen to the point that financial crowding out of debt-financed fiscal stimuli seems quite likely.Fiscal Sustainability in sovereign default risk premia have not been of sufficient magnitude to create worries about the effectiveness of expansionary. however. Portugal. but more importantly as regards its veracity – its capacity to live up to its commitments and promises is at an all-time low.
This is most easily seen if production is subject to a lag (inputs go in before saleable output comes out). the credit constraint on production and employment becomes binding. lead to greater upward pressure on prices or inflation than would be inferred by considering the output gap defined not as the gap between effective demand and effective supply. The "Austrian" or working capital supply side model of the supply side was introduced into mainstream macroeconomic analysis by Alan Blinder (1987). although its antecedents go back much further to the Austrian school of Hayek.g. both through higher risk-free rates and through higher inflation and exchange rate depreciation risk premia (if the unsustainable government deficits are eventually monetised) and higher sovereign default risk premia (if the unsustainable government deficits eventually lead to sovereign default). Will a fiscal stimulus work as effectively when the economy has been hit by a credit crunch? The credit crunch is now hitting the non-financial enterprise sector hard. cut taxes and raise public spending today and reverse the stimulus at some cyclically appropriate future time. which is determined by the available physical resources of capital. Increased demand can be met from inventories. see Buiter (2008)). Mises and to Marx. and its neo-Structuralist successors (e. and that may provide some working capital.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 increases are likely to be ineffective in boosting demand. 5. even if demand is depressed. A severe contraction in economic activity induced by a credit crunch could. land and labour and is independent. so a determined executive could. How does a fiscal boost affect demand when the enterprise sector is credit-constrained? If the constraints are tight enough. but it has not become part of the standard professional tool set (for a non-technical description. The key question in the UK is how likely it is that a future executive will have both the insight and the courage to inflict the necessary fiscal pain. of the cost and availability of 88 . I believe that the Great Credit Crunch of the Noughties will demonstrate its usefulness. in all likelilhood. In the UK. was first developed by the South-American structuralist school of Raul Prebisch and Celso Furtado. The notion that a credit crunch could lead to effective supply constraints being binding in the market for goods and services. in the short run. if effective supply contracts even faster than effective demand. because of its key assumption that production cannot take place without credit. Lance Taylor and Domingo Cavallo (1977)). Notional supply or potential output. Longer term nominal and real interest rates will rise. but once inventories have been worked off. they will weaken and may even completely neutralise the effect of a fiscal stimulus on output and employment. the stronger position of the executive branch of government and a docile parliament make a US -style deadlock unlikely. This means that firms need working capital to get production going. because the market anticipates corrective that future fiscal restraint is unlikely to be forthcoming. but instead between effective demand and notional supply.
twisting the intertemporal terms of trade like that causes consumers to switch their expenditures (especially on durables) to the temporary low tax period. Initially. Qualitative easing or credit easing is therefore likely to be complementary to fiscal policy in economies badly affected by a credit squeeze.1 Proposition 9: Because production takes time. compared to that of measures that both target the flow and give a boost to owners of existing capital. this was not a stupid idea. a temporary investment tax credit or investment subsidy could be an effective means of shifting investment towards the present. much of the resulting deficits can be monetised by the central banks (quan1 In the long run. It so happened that the fierce price wars that were going on at the time may have drowned out these relative minor cuts. for a given effect on investment demand. but the principle of using the substitution effect where it reinforces the income effect is surely correct. In principle. A temporary investment tax credit/subsidy Provided there is no binding external finance constraint on investment. working capital is essential. Working capital can affect effective supply at much shorter horizons. Conclusion Fiscal sustainability imposes strict limits on the amount of additional government debt that can be incurred as part of a fiscal stimulus plan. The budgetary cost of such measures (which target just the flow of new investment) is much lower. Perhaps a cut to 10 % for a shorter period would have made more impact on the cognitively challenged. modulated according to national fiscal spare capacity is desirable. 89 . the physical capital stock is endogenous and is therefore affected by the cost and availability of finance. up 20% after 13 months). and which was given such a hard time by many observers. Neoclassical fiscal measures Keynesians believe in the power of (current) income effects on spending. Neoclassical economists believe in the power of the intertemporal substitution effect.Fiscal Sustainability credit. but apart from that (and apart from the menu costs inflicted on restaurants and shopkeepers).5% down now to 15%. A globally coordinated fiscal stimulus. as a cut in corporation tax or in the capital gains tax would. Policies to provide credit to the non-financial enterprise sector may therefore be a precondition for expansionary fiscal policy to have any material demand on production and employment. of months or quarters. made sense. Why not use both when there is no additional price tag attached to the Neoclassical effect? A temporary VAT cut I believe the temporary VAT cut introduced in the UK by Chancellor Darling last year (2.
Alan S (1987).com/maverecon. (1977). the earlier appropriate increase in global liquidity will become inflationary. Royal Economic Society. "Stagflationary Effects of Monetarist Stabilization Policies. Buiter. References Blinder. (2008)." unpublished Ph. vol. Harvard University. Olivier Blanchard and Carlo Cottarelli (2008). Financial Times Maverecon blog. pages 327-52. dissertation. IMF Staff Position Note. Unless the markets are convinced that future tax increases or public spending cuts commensurate with the massive additional public debt that will be issued during the next two or three years will indeed be implemented. "Credit Rationing and Effective Supply Failures. December 29. "Fiscal Policy for the Crisis".Macroeconomic Stability and Financial Regulation: Key Issues for the G20 titative easing) without risking an undesirable increase in inflation. Cavallo. "Credit crunch.D.ft. June. But when the global and national economies recover. unless it is reversed promptly. Willem H. Steve Symansky. Even if sustainability and solvency are not deemed to be at risk." Economic Journal. 90 . http://blogs. SPN/08/01. Domingo F. the spending stimulus may well be crowded out through increases in sovereign default risk premia. Antonio. the enormous forthcoming public debt issues by rich countries are likely to crowd out foreign currency borrowing by governments and private parties in developing countries and emerging markets and put upward pressure on real risk-free interest rates. Spilimbergo. October 19. obtainable with a subscription from JSTOR). effective supply failure and stagflation". 97(386).
Both trends led to a housing and credit bubble.S. securities both to peg the exchange rates on an export-friendly level and to hedge against a depreciation of their own currency against the dollar. Lending standards eroded. First. Prevention and Management1 Markus K. The traditional banking model. in which the issuing banks hold loans until they are repaid. in which loans are pooled. the U. this article first outlines the underlying amplification mechanisms that turned several hundred billion dollars of losses in the subprime mortgage market into a multi-trillion dollar destruction of wealth. The final part of this report discusses elements of crisis management useful in handling and minimizing the impact of such crises. and because the U. The creation of new securities facilitated the large capital inflows from abroad. tranched. 91 . Asian countries bought U.S. Federal Reserve had adopted a lax interest rate policy. The understanding of these mechanisms is an important prerequisite for setting up a new financial architecture whose objective is to minimize the risk and impact of a recurrence of a similar crisis. A large fraction of funding was arranged through the so-called "shadow banking system. I discuss specific proposals for crisis prevention that are described in more detail in Brunnermeier et al." which turned out to be very fragile.Financial Crises: Mechanisms. 1) Underlying mechanisms Trends leading up to the crisis Several trends in the last decades have made the financial system vulnerable to a sharp financial downturn with detrimental implications for the real economy.S. economy was experiencing a low interest-rate environment. since it relied primarily on short-term financing. (2009). a lesson learned from the South-East Asia crisis in the late 1990s. was replaced by the "originate and distribute" banking model. Building on my earlier work in Brunnermeier (2009). the banking system underwent a deep structural transformation. especially from Asian countries. Second. and 1 I am grateful to Martin Schmalz and Stephen Yeo for feedback. In the second part. both because of large capital inflows from abroad. and then resold via securitization. Brunnermeier Princeton University The recent financial turmoil has led to disruptions in credit flow second only to the one during the Great Depression in the 1930s. The Federal Reserve Bank feared deflation risks after the bursting of the Internet bubble and thus did not counteract the buildup of the housing bubble.
Conversely.S. A funding shortage arises when it is prohibitively expensive both to (i) borrow more funds (low funding liquidity) and (ii) sell off assets (low market liquidity). leading to a further erosion of wealth. all of them have to cut back on their positions. maturity mismatch. (ii) hoarding of funds. problems arise if both funding liquidity dries up (high margins/haircuts. Leverage.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 inflated house prices served as collateral to finance unsustainable high consumption levels in the U. i. if there is a maturity mismatch. a leveraged institution that suffered a mark-to-market loss of $x has to reduce its position by $x times its leverage ratio. In short. Liquidity spirals A funding shock can trigger two distinct liquidity spirals: the loss spiral and the margin spiral. When market liquidity is low. leverage can cause a risk-shifting problem resulting in excessive risk-taking. and two liquidity concepts The problem with the increased lending was not only the high leverage ratio. restrained lending) and market liquidity evaporates (fire-sale discounts). Funding liquidity describes the ease with which investors and arbitrageurs can obtain funding. The savings rate for U. Funding liquidity is high-and markets are "awash with liquidity"when it is easy to raise money because collateral values are high (and/or rising). This depresses the price level of the assets. market liquidity is low when selling the asset depresses the sale price considerably. which forces financial institutions to cut back on their positions even further. it was high leverage ratio combined with increased maturity mismatch that led to a fragile situation. New funds are needed only when debt matures earlier than the assets pay off. who anticipate excessive risk taking. The lack of new funding is however no problem if existing funds are secured with long-term debt contracts. If many financial institutions suffer a similar funding shock. In short. and haircuts and margins are low. which outpaced domestic production. and cut back their funding. both forms of liquidity are influenced by the financial soundness of other financial institutions. as will be explained below. households shrank close to zero percent.S.. To be more specific. From the point of view of a bank. Hence lenders. the latter of 92 . (iii) runs on financial institutions and (iv) network effects via counterparty credit risk. they can mutually reinforcing through (i) liquidity spirals. The loss spiral is due to asset price effects.S..e. Note that if financial institutions can defer losses and do not have to mark-to-market. since no new funds need to be raised in the interim. but also the maturity mismatch -most of the long-term lending through the shadow banking system was funded by (very) short-term borrowing that relied on the repo and Asset Backed Commercial Paper market. The margin/haircut spiral reinforces the loss spiral as it forces the financial institution to reduce its leverage ratio on top of the effect of the loss spiral. Most of the U. Furthermore. Overall. it is very costly to shrink a firm's balance sheet.. the loss spiral is much less powerful. consumption increase was financed by a growing current account deficit. Market liquidity is high when it is easy to raise money by selling one's assets at reasonable prices.
for example through repurchase agreements or commercial paper. The spirals are most pronounced in a financial system in which banks obtain their funding through markets instead of deposits.Financial Crises: Mechanisms. but also reduce risk appetite within banks. Allowing financial institutions to hide losses by not forcing them to mark-to-market is not necessarily a solution: it introduces more information asymmetries and makes the margin/haircut spiral worse. Prevention and Management Figure 1: Loss and margin/haircut spiral that arise due to leverage and maturity mismatch Source: Brunnermeier and Pedersen (2009) which arises even if leverage is to be held constant. As asset prices drop. Hence. risk measures like Value-at-Risk increase. But even for traditional deposit-taking banks. haircuts and banks' internal risk tolerance are typically based on risk measures such as Value-at-Risk (VaR). Brunnermeier and Pedersen (2009) – see Figure 1 – show that a vicious cycle emerges. Risk managers step on the brakes and force traders to de-lever their positions. their marginal source of funding has been the capital markets. not only lead to higher margins and higher external funding costs. which increase margins further and force more sales. There are at least three reasons: (i) backward-looking risk measures. Margins/haircuts spike in times of large price drops and thereby lead to a general tightening of lending. as well as a more cautious attitude towards lending. losses mount and margins/haircuts increase. As asset prices drop. and (iii) adverse selection. Margins. Margins and haircuts implicitly determine the maximum leverage a financial institution can adopt. Typically these risk measures are estimated 93 . Margin/haircut spiral and procyclicality. it leads to more transparency and hence reduces the adverse impact of the margin spiral. So far I have not explained why a drop in asset prices leads to higher margins and haircuts. where higher margins and haircuts force de-leveraging and more sales. (ii) time-varying volatility. leading to the possibility of multiple equilibria. These liquidity spirals are the underlying cause of procyclicality. while mark-to-market exacerbates the loss spiral.
financiers become more careful about whether to accept a pool of assets as collateral since they fear receiving a particularly bad selection of assets. Consequently. They Figure 2: As the cash flow distribution shifts towards the left. 94 . The hockey stick depict the payoff of a debt contract as a function of firm's cash flow. leading to a deleveraging process described by the margin spiral. each debt holder is eager to collect information. assetbacked commercial paper was almost risk-free because of overcollateralization – i. leverage will be procyclical. making such assets much more risky. As a consequence. which allows higher leverage and supports the expansionary phase. margins and haircuts should be larger and lending should be reduced after such a price decline. constrains investors. the forced fire sale might justify the sharp increase in the risk-measure ex-post. As losses mount. the initial losses would be borne by the lower tranches. margins will be low. Second.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 using historical data. Suddenly asymmetric information problems emerge which can lead to market break-downs. However. the overcollateralization cushion evaporated. debt payoff becomes more sensitive to information 2 Beng Holmström drew the connection to the current crisis. However. The bell-shaped curves depict two different probability distributions of the cash flow.2 Figure 2 illustrates this point. if the objective of individual institutions is to maintain return on equity. debt becomes more risky and hence more "information sensitive" (a point first stressed in Gorton and Pennacchi (1990)). Consequently. the debt holder does not care much about the exact cash flow of the firm. Hence.e. after the firm faces a negative shock. the cash flow shifts towards the left (as depicted by the dashed black curve). If the cash flow is sufficiently high. or value at risk. when the asset-backed commercial paper market dried up completely within a few hours. a sharp temporary price drop leads to a sharp increase in the estimates of these risk measures. The third reason why margins increase when prices drop is the emergence of frictions due to asymmetric-information. Prior to the crisis. and may force them to sell off their assets. if the cash flow is distributed as depicted by the solid blue curve. In a boom phase volatility and default estimates are low. When the first adverse shocks hit. investors were unwilling to let structured investment vehicles roll over their debt. For example. An extreme example was the situation in August 2007. On top of it. the face value of the debt is paid off in full. A sharp price decline may signal that we are about to enter more volatile times. in August 2007. Paradoxically. the volatility of a price process can vary over time. This leads to an increase in margins/haircuts. In short. the volatility estimates shoot up.
in effect. since it was not known to what extent other banks faced similar problems.g. and adversely affect the balance sheets of others. Since lending at a shorter maturity grants one de-facto seniority over other lenders. Holmström and Tirole. i. and other off-balance-sheet vehicles would likely draw on credit lines extended by their sponsoring bank. The troubles in the interbank lending market in 2007-8 are a textbook example of precautionary hoarding by individual banks. Why do financial institutions overexpose themselves to the risk of getting caught in a liquidity spiral by holding highly levered positions with excessive maturity-mismatches? The reason is a fire-sale externality. and b) outside funds are expected to be difficult to obtain (see e. As it became apparent that conduits. It arises if potential lenders are afraid that they might suffer from shocks in the near future. Financial institutions either refuse to lend at all or lend only at very short maturity. relative to the Treasury bill interest rate. Not rolling over commercial paper is. In a classic bank every investor has an incentive to preempt others and run to the bank. "lemons. it became more uncertain whether banks could tap into the interbank market after a potential interim shock. structured investment vehicles. A first-mover advantage triggers a dynamic preemption motive. In September 2008. 2009). "sellable" assets and left as collateral only the bad.Financial Crises: Mechanisms. AIG faced a "margin run" as explained in Gorton (2008). Prevention and Management might. 1998). but runs can occur on other financial institutions and especially to the shadow banking system. a maturity rat race can emerge where all lenders only lend very shortterm (see Brunnermeier and Oehmke. The fire-sale externality is arguably the main rationale for bank regulation. which typically park a sizable amount of liquid wealth with their prime brokers. These requests would have brought the 95 . when they will need funds for their own projects and trading strategies." Fire-sale externality. which constitutes a negative externality. each bank's uncertainty about its own funding needs skyrocketed. fire sales by some institution spill over. Deposit insurance has made classic bank runs almost obsolete. pulled out those funds. 1997. These effects led to sharp spikes in the (3 months) interbank market interest rate. Precautionary hoarding therefore increases when a) the likelihood of such shocks increases. Runs Runs on financial institutions constitute another mechanism that amplifies an initial shock. Hence. This was first pointed out in Stiglitz (1982) and Geanakoplos and Polemarchakis (1986).e. a situation in which the institution does not bear the full cost of its own actions. Bear Stearns essentially experienced a bank run in March 2008 when hedge funds. a run on the issuer of asset-backed commercial paper. At the same time. LIBOR. It arises since each individual financial institution does not have an incentive to take into account the price impact its own fire-sales will have on asset prices in a possible future liquidity crunch. Hoarding and maturity rat race The second amplification mechanism is due to precautionary hoarding. less valuable. be worried that structured investment vehicles have already sold the good. for example. Several counterparties requested additional collateral from AIG for its credit default swap positions.
96 .3 3 While most economist favor models with a unique equilibrium in order to make clear predictions. the more interconnected a financial institution is. For example. This can most easily be seen in the following example. each individual institution does not take into account that it introduces additional risk to its counterparties. Consequently. but has only a vague idea what financial obligations its counterparties have. This makes it more likely that this institution will be bailed out by the government. This lack of information significantly increases uncertainty and counterparty credit risk. I think that models with multiple equilibria provide important insights for studying financial crises. If all credit derivatives were traded via a clearing house. One main problem with these instruments is that each financial institution knows its own financial. Modern financial architecture consists of an interwoven network of financial obligations. 2009). it is very important to note that liquidity is endogenous and that one bank's micro-prudent behavior to cut back its funding to others hurts other banks and hence might not be macro-prudent. Once the economy falls into the low funding liquidity equilibrium. Endogeneity of liquidity – micro-prudent versus macro-prudent behavior Finally. in Brunnermeier and Pedersen. each institution has the perverse incentive to become as interconnected as possible in the most opaque way. depicted in Figure 2: if bank 1 sheds assets and cuts back on its lending to bank 2. bank 2 is forced to shed assets and cut back its lending to bank 3 and similarly bank 3 has to cut its lending to bank 1. many of the abovedescribed mechanisms can lead to multiple equilibria: one with low funding liquidity levels and one with high funding liquidity (e. since the agent withdrawing his funds does not take into account that this causes negative externalities on others who withdraw with a delay.g. Such runs can lead to socially inefficient outcomes. Indeed.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 firm down if the Fed had not injected additional funds. The obligations of its counterparties' counterparties are even more difficult to estimate. Consequently. The argument resembles Keynes' paradox of thrift. The problem is exacerbated because most of these credit derivatives are traded over-the-counter. Network effects: counterparty credit risk – interconnectedness externality Most financial institutions are lenders and borrowers at the same time. Formally. When signing a bilateral credit derivative contract. exposures could be netted out and the clearing house would know the exposure of each financial player. Hence. it is not easy to return to the "good" equilibrium since it is difficult to coordinate all investors' beliefs and ensure that trust and confidence return to the credit markets. the more difficult it is for a regulator to predict the repercussions of the bank's default on the financial system. nobody has a good idea what effects the default of a particular institution would have as it ripples through the financial system. which involves a wealth transfer from tax payers to bank's debt and equity holders. new credit derivatives like credit default swaps made financial institutions very interconnected. it shrinks its leverage ratio but worsens the balance sheet of bank 2.
the higher the probability that a financial institution will be bailed out in times of crisis. (ii) protects the essential needs of ordinary people when information is costly to acquire (e. This is in sharp contrast to the current regulatory framework which does not focus on externalities and. losses tend to spread across financial institutions. if it (i) constrains distortionary effects due to monopoly power.g. Macro-prudential regulation – focus on systemic risk contribution During times of financial crisis. threatening the financial system as a whole. Regulation based on VaR reduces likelihood of the failure of an individual bank. rather than the risk of an individual bank in isolation." since the larger an institution. For a more detailed discussion about policy measures I refer again to Brunnermeier et al (2009). even provides an incentive for financial institutions to become "too big to fail" and "too interconnected to fail. and the more interconnected it is. ironically.Financial Crises: Mechanisms. which only captures an individual's bank risk in isolation. the most commonly used risk measure. irrespective of whether this bank causes. or (iii) internalizes significant externalities. A financial institution's contribution to systemic risk can be large either if it (i) causes financial difficulties at other institutions or if it is (ii) correlated with financial difficulties among other financial institutions. New measures of systemic financial risk need to be developed that ideally encompass both channels. This is in sharp contrast to existing regulation that focuses primarily on the risk of an individual financial institution in isolation. Future regulation should provide incentives for financial institutions to reduce risk concentrations that lead to contagion. It is therefore imperative to focus on the risk spillovers (externalities) an institution creates or is correlated with. In this section I outline some specific measures that internalize externalities and hence should be reflected in a new financial architecture. Any regulatory intervention built on sound economic principals is justified. The Basel II regulation is based on Value at Risk (VaR). or is correlat- 97 . Prevention and Management Figure3 Three interconnected banks 2) Crisis prevention The mechanisms outlined above help to design a financial architecture that is less prone to periodic financial crisis. prevent fraud).
one would like to provide an incentive structure that internalizes all externalities outlined in Section 1. In Brunnermeier et al. and b) affect the degree to which regulatory constraints bite. This revenue stream compensates the tax payer for bailing out 98 . such measures are not effective measures against systemic risk. The CoVaR of an institution is defined as the Value-at-Risk (VaR) of the financial sector conditional on this institution being in distress. Such a systemic "co-risk measure" should a) determine financial institutions that should be subject to macro-prudential regulation. However. VaR may be useful for micro-prudential regulation whose main objective is investor protection (against fraud). distress in other financial institutions. The advantage of such a tax system is that it generates a revenue stream for the government. whose correlated may concern systemic risk Pension funds and insurance companies that are not highly levered unlevered macroprudential yes microprudential yes "systemic as part of a herd" yes no non-systemic large no yes "tinies" no no Regulatory charges: capital charges. (2009) we propose to assign all financial institutions to one of four categories: Table 1 Classification of financial institutions based on their systemic risk contribution Institution "individually systemic" Examples Large and interconnected banks and insurance companies that cause risk spillovers Leveraged hedge funds. or compulsory insurance premium. Pigovian taxes: Pigovian taxes increase with a bank's CoVaR and other systemic corisk measures. Pigovian taxes. Ideally. compulsory insurance Financial institutions that are subject to macro-prudential regulation have to be constrained in their activities. The larger a financial institution's contribution to financial risk is the larger should be the capital charge. One risk measure that focuses on the contribution of a financial institution to systemic risk is CoVaR (as suggested in Adrian and Brunnermeier (2009)). The percentage difference between the usual VaR and the CoVaR captures the degree to which a particular institution contributes (or is correlated with) to the overall systemic risk. Each incentive scheme has its advantages and disadvantages: Caps: Current regulation focuses to a large extent on capital charges and hence limits (caps) the extent to which banks can leverage up and extend their business activities. Pigovian tax.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ed with. Absolute caps limit the total amount of leverage. but they might stifle competition among the banking sector.
On top of a regulatory incentive. they should be most stringent in times of credit booms. We would eliminate hold-to-maturity accounts and the vagaries associated with it. The rationale for this regulatory element is the fire-sale externality outlined in Section 1: each individual institution chooses a socially excessive maturity mismatch because it does not take into account the fact that it will be forced to sell its assets at fire-sale prices if it is unable to roll over its short-term debt during a crisis. a two-year asset with six months debt. Prevention and Management the financial sector whenever a crisis occurs. should provide an incentive for long-term funding in order to minimize the asset-liability maturity mismatch. any future regulation. a Pigovian tax system does not hinder competition among banks.Financial Crises: Mechanisms. We propose that banks be forced to publish two balance sheets: one mark-to-funding balance sheet on which the regulatory charges are based on and one mark-to-market balance sheet. However. the implications for systemic risk are substantially different. as assets are shifted from the trading book to the loan book. If two institutions have the same asset. an investor who holds the same asset. Also. unlike a capital charge system. should be forced to mark-to-market his position on a daily basis. but one funds them with long-term debt and the other by borrowing overnight from the money market. Pigovian tax. The idea of mark-to-funding is that an investor who has secured the funding of say. Compulsory private insurance scheme: A well-designed private insurance scheme whose insurance premium is based on a financial institution's contribution systemic risk (as e. but relies on overnight borrowing. Countercyclicality All regulation restrictions should be countercyclical. and thus imposes a negative externality on others. the regulators have to ensure that the insurance scheme is properly administrated and a sufficiently large amount of capital is set aside and invested in safe government bonds. mark-to-funding. In contrast. They have to counteract the margin/haircut spiral 99 . The latter ensures that all positions are valued in a transparent way. It gives financial institutions an additional incentive to reduce their asset-liability maturity mismatch. he should be allowed to value the assets with the expected price of the asset in six months time. or private insurance scheme. measured by its CoVaR and other inputs) would work similar to a Pigovian tax.. but might be less effective in achieving a total maximum leverage ratio than capital requirements. Liquidity regulation The reliance on short-term funding of long-term assets with potentially very low market liquidity has been the main source of financial fragility. Note that the government is the natural insurance provider against systemic risk.g. systemic risk has as much to do with how assets are funded. our Geneva report (Brunnermeier et al. be it a capital charge. While current regulation focuses primarily on the assets' quality. i. An investor with funding secured for another six months should not need to worry about price volatility within the next six months. since investors' flight to quality makes it cheap for the government to issue debt in times of crisis.e. 2009) proposes a new accounting rule. Consequently.
The primary objective should be to minimize the adverse impact on the real economy. secure efficient lending. Variables regulators should be vigilant about are credit growth.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 which causes higher leverage in times of booms and deleveraging in times of crisis. Furthermore. since it primarily benefits existing debt holders rather than the new investors. That is. The recapitalization of a leveraged sector such as banks can be done at the expense of (i) debt holders and/or (ii) tax payers. Once in a crisis. most financial crises are preceded by asset price and credit bubbles. haircuts. might lead to long-run adverse effects. In addition. 3) Crisis management History suggests that financial crises can be abated but never fully prevented. i. Any recapitalization at the expense of debt holders is limited by the fact that one cannot wipe out short-term funding from the money market or demand deposits since this would induce a run on the banks. Financial regulation should be particularly vigilant for bubbles whose bursting might adversely affect the financial intermediation sector. an incentive structure has to be put in place that ensures that regulators are forceful in implementing these policies and withstand lobbying efforts from banking industry and politicians. This distinction is important as it involves large wealth transfers. As a consequence. credit spreads. It is important to determine whether a funding and credit expansion at a time is sustainable or may be subject to sudden reversal. The goal is to eliminate financing frictions by reducing asymmetric information problems. While the bursting of the technology bubble in the early 2000s caused a lot of localized disruptions. however. One of the first steps is to freeze dividend payments for institutions that are in trouble. The big difference between them was that the technology bubble did not severely damage the lending sector. crisis management comes to the forefront. In Brunnermeier et al. increasing their maturity mismatch. where banks fund themselves on a more short-term basis. it bears no comparison to the turmoil that the bursting of the credit and housing bubble has caused. Favoring short-term debt. Furthermore. b) low equity levels make new debt funding very informationally sensitive (as illustrated in Figure 2 above). with detrimental consequences for the economy. and loan-to-value ratios. banks often do not have sufficient equity to engage in lending activities. This is especially acute if the face value of debt exceeds the bank's asset value. It is important that regulation leans against credit bubbles early. investors refuse to inject additional equity. Myers (1977). (2009) we also propose a laddered response structure to ensure a prompt and early intervention before things get out of hand. it is often impossible for banks to raise additional private capital without government support since a) troubled financial institutions typically suffer from debt overhang problems. 100 . In a financial crisis. margins.e. crisis management typically necessitates some form of recapitalization or restructuring of the banking sector by the government. Emerging asymmetric information problems hinder an injection of new funds.
successful policy should bring confidence and trust back to the market place. the government has to commit to let the bank go bankrupt. which should be liquidated. policy intervention should coordinate investors' beliefs such that the "good" equilibrium with an active lending market is reinstalled. the value of the debt increases. This is essentially a nationalization of the bank. to induce current debt holders to sell their bonds. Any nationalization should be followed by re-privatization of the good bank. Nationalization via prompt corrective action An alternative way to let the debt holders participate in the recapitalization is to induce a controlled bankruptcy through prompt corrective action that ultimately leads to a forced merger of the troubled banks with a government entity. Translated to economists' language. Tender offer by government to buy debt at current market price To avoid the tax payers subsidizing current debt holders. Debt-equity swap provisions for particular debt classes have the disadvantage that in the long-run investors steer away from these types of debt funding and opt for more short-term debt funding. Partial nationalization via public equity injection This approach requires large sums of funds. Otherwise. Debt-equity swap provision Swapping long-term debt for equity has the advantage that it recapitalizes the bank at the expense of the debt holder and hence does not involve a large wealth transfer from tax payers. since the government takes on a majority stake in banks. law should contain a provision that allows forced conversations in pre-specified circumstances. As the government injects equity.g. Importantly. which ensures that (junior) debt holders pay their part. banks are subject to political pressure in their lending decisions. this combined with a subsequent equity infusion would be an efficient way to resolve the undercapitalization problem. in a setting with multiple equilibria. Prevention and Management In addition. Overall. and debt holders of banks with a debtoverhang problem are the primary beneficiaries. exacerbating the maturity mismatch problem. 101 . if it fails to buy the debt at the current price. e. there is the danger that this provision be abused and inefficient banks. since remaining private equity holders will try to delever banks in order to pay out the government as quickly as possible. are rescued. More specifically. while "toxic" assets are held in a bad bank for a while. If legally possible. a debt-equity swap should only be invoked if the financial sector is in a systemic crisis. the government could try to buy up the debt at the current market price. this approach involves large wealth transfers from tax payers to banks' debt and equity holders. Also.Financial Crises: Mechanisms. Ideally in the future. It is questionable whether public equity injections necessarily reignites lending. when it is in public interest.
and Gale. Non-recourse loans are one way to offer a floor on asset values. these assets should only be sold in big bundles (the whole portfolio of a bank) since otherwise banks have an incentive to cherry pick and to sell off bad assets and keep good assets. Understanding Financial Crises. The hope is that by putting a floor on asset values. only portfolio of assets should be guaranteed. Banks' cherry picking would lead to a lemons' problem and hence would rule out a private co-investment scheme. References Adrian. K. There are numerous other schemes that are debated. Propping up house prices via mortgage subsidies In addition to introducing refinancing schemes to minimize the number of home foreclosures. Importantly. since the banks receive $ x dollars in exchange for toxic assets. Allen. the borrower of funds can simply give up its collateral without being forced to repay his loan. many of these assets would change hands and price discovery for toxic assets would start. it involves a wealth transfer from tax payers to bank's debt and equity holders. Like an equity injection. and Brunnermeier.edu/~markus/research/papers/CoVaR. D. It is ingenuity of our imagination combined with careful economic analysis that will help us overcome the current financial crisis. To avoid cherry picking and lemons problems. 'CoVaR'. No private investors would participate. If the purchase involves public and private capital. (2007). Using non-recourse finances for newly issued securities that are backed by new mortgages and loans can help to stimulate lending to end users and seems to be an attractive option. the government can try to lower mortgage rates and thereby push up house prices. there is the danger that artificially high house prices lead to other distorting effects.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Purchase of toxic asset bundles The purchase of toxic assets leads to recapitalization of banks only if the government pays an artificially high price. This can be done by allowing the central bank to directly buy longdated securitized mortgage products or accept them as collateral for non-recourse loans. it provides less "bang for the buck" than a $ x equity injection. Oxford University Press. then price discovery might help to value these assets at reasonable prices. M. F.princeton. the government can guarantee a minimum price for assets (for a limited amount of time). Compared to equity injections such a scheme terminates automatically when the underlying assets mature. working paper. which presumably still have some value. T. At http://www. However. If the price of the asset falls below its collateral value. However. Guaranteeing a floor for asset bundles To stimulate trading of assets. especially in areas in which higher demand is met with additional construction activity. 102 . (2009).
. Brunnermeier. (1989). Journal of Political Economy 106(1). (Clarendon Lectures in Economics)." with George Pennacchi. M. Gorton. Hansen & S. D. (1990). Journal of Finance. Brunnermeier.. Dewatripont. 'The debt-deflation theory of great depression'. A. pp. Vol. and Vishny. 49-72 Holmström. L. 5. (1997). (1933). 401-419. and Dybvig. Fisher. J. U. 'Private and public supply of liquidity'. Crocket. G. and liquidity'. K. and Pedersen. in M. 45(1). M. 1-39. M. Shleifer. I. 35-55. B. J.pdf. Journal of Finance 52(1). 'Financial intermediation. G.Financial Crises: Mechanisms. forthcoming . (2009). 1(4). B. P. Econometrica. 337-357. eds. and Tirole. deposit insurance.K. 14-31. 'Market liquidity and funding liquidity'. (1997). (2008). Quarterly Journal of Economics 112(1). 170-205. (1998).. default and crashes: Endogenous contracts in general equilibrium.08. Prevention and Management Oxford. 'Determinants of Corporate Borrowing'. G. Federal Reserve Bank of Kansas City Symposium 2008. (2009) 'Deciphering the Liquidity and Credit Crunch 2007-08'. 2. Persaud Avi and Shin Hyun. at http://www. Turnovsky. R. 'Agency Costs. and the real sector'. and Business Fluctuations'. Advances in Economics and Econometrics: Theory and Applications II. 103 . K. and Gertler. Journal of Economic Perspectives. J. P..04. 'The limits of arbitrage'. 11th Geneva Report on the World Economy. J. (2009). Myers S. (1977). 'The Panic of 2007'. W. K. Bernanke. 147-75. Cambridge.kc. L. Gorton. Journal of Financial Economics. and Pennachi. M. A. American Economic Review 79(1). H. and Tirole. 'Bank runs. Journal of Political Economy 91(3). Cambridge University Press. Goodhart C.10. Net Worth. Geanakoplos. loanable funds. Financial Intermediaries and Liquidity Creation. (1983).org/publicat/sympos/2008/Gorton. Econometric Society Monographs: Eighth World Congress. Liquidity. Review of Financial Studies (forthcoming). Fundamental Principles of Financial Regulation. Brunnermeier. (2003). Holmström. B. 35-52.frb. Diamond. UK.
bank capital regulation had the potential to be procyclical because bank profits may turn negative during recessions. known as Basel II. Banco de España Introduction The Basel Committee on Banking Supervision (BCBS) approved in 2004 a reform. So the concern about Basel II is that the worsening of borrowers' creditworthiness in recessions will increase the requirement of capital for banks and lead to a severe contraction in the supply of credit. Banco de España. but that the buffers maintained in expansions are typically insufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. and these parameters are likely to rise in downturns.Mitigating the Procyclicality of Basel II Rafael Repullo. The analysis is based on the results of the estimation of a logistic model of the oneyear-ahead probabilities of default (PDs) of Spanish firms during the period 19862007 using data from the Credit Register of the Bank of Spain. Key Issues for the G 20". The empirical model provides an estimate of the point-in-time (PIT) PDs of the Authors' note: The views expressed in this paper are those of the authors and should not be attributed to the Banco de España or the Eurosystem. paragraph 5). a widespread concern about Basel II is that it might amplify business cycle fluctuations. whose primary goal is "to arrive at significantly more risk-sensitive capital requirements" (BCBS. Repullo and Suarez (2008) show that forward-looking banks have an incentive to hold precautionary capital buffers (defined as capital in excess of the minimum required by regulation). The purpose of this paper is to analyze the leading alternative procedures that have been proposed to mitigate the procyclical effects of the Basel II capital requirements. 2006. We thank the comments of Patricia Jackson as well as those of the participants at the CEPR/RWBC Conference on "Financial Regulation and Macroeconomic Stability. and that some simple cyclical adjustments in the 99. Even in the old Basel I regime of essentially flat capital requirements. capital requirements are an increasing function of the probability of default (PD) and the loss given default (LGD) estimated for each borrower. Furfine and Lowe (2001). Jesús Saurina and Carlos Trucharte CEMFI and CEPR. 105 . They also show that Basel II leads to a substantial increase in the procyclicality induced by bank capital regulation. impairing banks' lending capacity. 1 See Borio. forcing banks to restrict their lending when the economy goes into recession.9% confidence level (used to derive the Basel II capital requirements) may significantly reduce its procyclical effects.1 Under the internal ratings-based (IRB) approach of Basel II. As a result of the increased risk-sensitivity.
age. so we can compute the corresponding Basel II capital requirements per unit of loans (assuming an exogenous LGD). yit+1.2% for each standard deviation in GDP growth. 106 . We then consider the effect of different procedures to mitigate the cyclical behavior of these requirements. failing to meet its financial obligations on a certain loan or if. 2006. Model of probabilities of default Empirical model In order to compute the cyclical profile of the Basel II capital requirements with real data (if Basel II had been in place). is a dichotomous (zero-one) variable which takes value 1 if the firm i defaults in year t+1. If a borrower has several loans. The results show that the best procedure is to use a simple multiplier of the Basel II requirements that depends on the deviation of the rate of growth of the GDP with respect to its long-run average. Following the work of Saurina and Trucharte (2007) on mortgage portfolios. total borrowing (proxy for size). and 2 A firm is considered to have defaulted if it is 90 days overdue. maturity of exposures. the rate of growth of aggregate lending. it is considered unable to meet its debts. and then compute the corresponding series of Basel II capital requirements per unit of loans. with a high probability. by using some sort of through-the-cycle (TTC) adjustment in the PDs. or the return of the stock market. According to Gordy and Howells (2006) there are two basic alternatives: One can smooth the inputs of the Basel II formula. The explanatory variables (all dated in year t) include previous delinquencies and defaults. Specifically. we analyze different adjustments to the PIT-based capital requirements using macroeconomic variables. utilization of credit lines. such as the rate of growth of the GDP. fraction that is collateralized. number of banking relationships. The dependent variable. or smooth the output by using some adjustment of the Basel II final capital requirements computed from the PIT PDs. Thus we can estimate the credit risk profile of the Spanish banks over the sample period using the metric of Basel II. failure to meet payments on any of them means that this borrower is in default. the requirements would be increased in expansions (or decreased in recessions) by 7. paragraph 452).Macroeconomic Stability and Financial Regulation: Key Issues for the G20 loans in the portfolio of commercial and industrial loans of the Spanish banks. The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each smooth series with respect to the trend of the original series computed by applying the Hodrick-Prescott filter. Second. we first construct TTC estimates of the PDs by setting the value of the macroeconomic controls in the logit equation at their average level over the sample period. and 0 otherwise:2 Pr(yit+1 = 1) = F(β1RISKPROFILEit + β2LOANTYPEit + β3MACROVARt) where F(×) is the cumulative standard logistic function. we estimate a model of firms' defaults using the information contained in the Spanish Credit Register. This definition is similar to that established in Basel II (see BCBS.
and assuming an LGD of 45% (as in the foundation IRB) and a 1 year maturity. All the variables are significant at the 99% confidence level. On the other hand. such as the rate of growth of the GDP. To facilitate the estimation we have randomly selected a 10% sample of the population.000.Mitigating the Procyclicality of Basel II changes in the firms' main lender. paragraph 272) and the estimated PD for each firm. which suggests that GDP growth rates may be useful to correct the cyclicality of bank capital requirements. collateralization. Additionally. The period covered goes from 1984 to 2007. and changes of main lender. The purpose of computing this trend is to provide a 107 . and firm' age. although for regression purposes it spans from 1986 to 2007. Empirical results Point-in-time PDs derived from the logit model are increasing in previous delinquencies and defaults. The macroeconomic controls included in the regression have negative signs. The Hodrick-Prescott benchmark To identify a trend of the Basel II capital requirements series we apply a HodrickPrescott (HP) filter with a smoothing parameter λ = 100 (annual data). Figure 2 shows the HP trend in dashed lines. and in the predictive power of the regression model. Then we compute the aggregate PIT capital requirements per unit of loans for the period 1986-2006. Figure 1 shows how PIT capital requirements would have evolved in Spain during this period had Basel II been in place. macroeconomic controls. Smoothing the Basel II capital requirements Point-in-time (PIT) capital requirements We first compute the PIT capital requirements for each firm using the Basel II formula for corporate exposures (BCBS. number of banking relationships. indicating that they proxy for the level of economic activity which reduces PDs. together with the Spanish GDP growth rate. 2006. An indication of the goodness of fit may be found in the signs (expected ones) with which all variables enter the equation. This Register records monthly information on all credit operations granted by all credit institutions operating in Spain for a value higher than €6. utilization of credit lines. the rate of growth of the commercial and industrial loans in the Credit Register. Both series are highly negatively correlated. Our paper focuses on commercial and industrial loans. and two sets of industry and regional dummies are also included. and the return of the Spanish stock market index. Database and sample data The database used in the estimation of the model of PDs is the Credit Register of the Bank of Spain (CIR). PDs are decreasing in total borrowing (proxy for size).
Basel II capital requirements and the Hodrick-Prescott trend 13% 12% 11% 10% 9% 8% 7% 6% 5% 1986 Capital HP filter 1990 1994 1998 2002 2006 benchmark for the comparison of the alternatives procedures suggested in the literature to mitigate the cyclicality of the Basel II requirements. 108 . Basel II capital requirements and the business cycle 13% 7% Capital (left) 12% 11% 10% 9% 2% 8% 7% 6% 5% 1986 1% 0% -1% -2% 2006 GDP growth (right) 6% 5% 4% 3% 1990 1994 1998 2002 Figure 2. and stock market index growth) by their average over the sample period.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Figure 1. Figure 3 shows the results. to obtain these PDs we replace the current values of the macroeconomic controls (GDP growth. credit growth. In practical terms this is equivalent to use TTC ratings (and its associated PDs) in the computation of the capital requirements. Following the work of Saurina and Trucharte (2006) on mortgage portfolios. Adjusting the inputs of the Basel II formula: TTC ratings The first procedure that we analyze is to smooth the PD input of the Basel II formula by using through-the-cycle (TTC) PDs.
Also note that the multiplier ranges g between a maximum of 2 and a minimum of 0. the criterion for the choice of α (for each proxy for the business cycle) is to minimize the root mean square deviations (RMSD) of the smoothed series with respect to the HP trend. – is its average and g its standard deviation over the sample period. what is the variable that should be chosen to proxy for the business cycle? Second. α(GDP growth) = 0. and if we proxy the business cycle by the rate of change of the stock market index. Note that with this functional form for gt – – we have a unit multiplier µt = 2N(0) = 1. 5.086.066.Mitigating the Procyclicality of Basel II Figure 3. Following this criterion the results are as follows: When the variable selected to proxy for the business cycle is the GDP growth rate. A possible functional form for the multiplier is: α ( gt − g µt = µ ( g t . and 6 show the adjustment of the capital requirements series for the three selected proxies. together with the original series and its HP trend. First. gt is the growth rate of some indicator variable of the business cycle. Point-in-time and through-the-cycle Basel II capital requirements 13% 12% 11% 10% 9% 8% 7% 6% 5% 1986 Capital HP filter TTC adjustment 1990 1994 1998 2002 2006 Adjustment of the output of the Basel II formula The second procedure to smooth the Basel II capital requirements is to use a business cycle multiplier of the form: ∧ kt = µtkt ∧ where kt is the original series and kt is the smoothed series. if we use the credit growth rate α(credit growth) = 0. α ) = 2 N σ g where N(×) is the cumulative distribution function of a normal random variable. how do we choose parameter α? Consistent with the proposed HP benchmark. Two issues related to the proposed adjustment have to be addressed. The adjust- 109 .017. α(stock market) = 0. Figures 4.
Smoothing the Basel II capital requirements with GDP growth 13% 12% 11% 10% 9% 8% 7% 6% 5% 1986 Capital HP filter GDP adjustment 1990 1994 1998 2002 2006 Figure 5. Smoothing the Basel II capital requirements with credit growth 13% 12% 11% 10% 9% 8% 7% 6% 5% 1986 Capital HP filter Credit adjustment 1990 1994 1998 2002 2006 Figure 6. Smoothing the Basel II capital requirements with stock market returns 12% 11% Capital HP filter Stock market adjustment 10% 9% 8% 7% 6% 1986 1990 1994 1998 2002 2006 .Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Figure 4.
Figure 7 shows the autoregressive adjustment of the capital requirements series.30. together with the original series and its HP trend. Alternatively. TTC-based capital requirements and autoregressive Table 1.30) 0.086) Credit growth multiplier (α = 0. the criterion for choosing δ is to minimize the RMSD of the smoothed series with respect to the HP trend. Figure 7. Root mean square deviations (RMSD) from HP trend RMSD (%) TTC ratings GDP growth multiplier (α = 0. whereas the stock market multiplier seems rather useless in smoothing capital requirements. The results are summarized in Table 1.45 0. Using this criterion we get δ = 0.48 111 . Autoregressive adjustment the Basel II capital requirements 13% ∧ Capital 12% 11% 10% 9% 8% 7% 6% 5% 1986 HP filter Autoregressive adjustment 1990 1994 1998 2002 2006 What is the best procedure? Smooth the inputs of the Basel II formula using TTC ratings? Or smooth the outputs through either a business cycle multiplier or an autoregressive adjustment? In line with our previous discussion. the criterion that we propose is to choose the procedure that minimizes the RMSD of each smooth series with respect to the Hodrick-Prescott trend.066) Stock market returns multiplier (α = 0. Again.017) Autoregressive adjustment (δ = 0.60 0.75 0. we could follow Gordy and Howells (2006) and use an autoregressive filter to smooth the PIT capital requirements: ˆ ˆ ˆ kt = kt −1 + δ (kt − kt −1 ) where kt is the original series and kt is the smoothed series. The best approach is to smooth the output using the GDP growth multiplier.36 0.Mitigating the Procyclicality of Basel II ment using the GDP multiplier is the best in terms of approaching the proposed benchmark.
2." International Journal of Central Banking. Howells (2006): "Procyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?. C. Lowe (2001): "Procyclicality of the financial system and financial stability: issues and policy options. and C. 15. 3 Jiménez and Saurina (2006) explain the rationale for such dynamic or countercyclical provisions. C. G. The procedure presented in the paper could also be applied to expected losses. for gt = g + σg we have µt = 2N(0. the multiplier should be increased in expansions (or decreased in recessions) by 7. The results show that the best procedure is to use a simple multiplier of the Basel II requirements that depends on the deviation of the rate of growth of the GDP with – respect to its long-run average. Conclusion This paper aims to contribute to the growing policy debate. which provides a rationale for a dynamic provisioning mechanism. Specifically." Federal Reserve Bank of Chicago Economic Perspectives. 1. according to our results for the portfolio of Spanish commercial and industrial loans. 6862. which have been applied in Spain since 2000 and further adjusted when IFRS came into effect in 2005. Trucharte (2007): "An Assessment of Basel II Procyclicality in Mortgage Portfolios." BIS papers.. Kashyap.. Hence.086) ≅ 0. 65-98. 32. and B. Borio. M. Stein (2004) "Cyclical Implications of Basel II Capital Standards..3 References Basel Committee on Banking Supervision (2006): International Convergence of Capital Measurement and Capital Standards.." CEPR Discussion Paper No. Gordy.2% for each standard deviation in GDP growth. Jiménez. A Revised Framework. while the credit growth multiplier and the stock market multiplier perform much worse. Repullo. We propose a benchmark for comparing different procedures suggested in the literature to mitigate the cyclicality of Basel II. Basel: Bank for International Settlements. and apply it to the smoothing of the estimated capital requirements for commercial and industrial loans in Spain over the period 1986-2006. initiated by Kashyap and Stein (2004). and J. Saurina (2006): "Credit cycles. 18-31. R. Furfine. Suarez (2008): "The Procyclical Effects of Basel II. 1st Quarter. and J. and J." Journal of Financial Services Research. J." Journal of Financial Intermediation.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 adjustments of the capital requirements are second best alternatives. 81-101. 395-417. 1-57.072. A.. and P. 112 . credit risk. and prudential regulation. on how risk-sensitive bank capital regulation may be adjusted to smooth lending and business cycles. Saurina. Whether the adjustment to cyclicality should be confined to capital requirements or could be extended to loan loss provisions is a very interesting policy issue that is beyond the scope of this paper.
This is now called into question. for example. for two reasons.Key Issues for the G20" for useful comments. Before one can decide on what appropriate measures would look like. nor a security. First. (2) The great uncertainty about banks' positions in the credit derivative market contributed to the disturbances in interbank markets. counterparties and even equity holders of the respective financial firms. and more importantly. What conclusions should policy makers draw from these events? In this paper. We see three important aspects: (1) The credit derivative market has allowed market participants to build up enormous risk positions. we 1 We thank Guy America. nor a future (as was stipulated by the Commodity Futures Modernization Act of 2000). In the United States. who surmounted to the large margin calls after the Lehman debacle and who had an exposure of $ 441 billion in credit derivatives (out of which $ 58 billion referred to subprime securities). and specifically of CDS (credit default swaps). The demise of Lehman triggered the breakdown of the insurance giant AIG. The collapse of a major dealer could potentially lead to severe domino effects. they are neither considered an insurance contract (because the protection buyer does not necessarily hold the underlying asset of the reference entity). which now became more or less worthless. Currently. Introduction Credit derivatives have been made out as one of the main culprits of the current crisis. Martin Hellwig. This has led to calls for regulation of credit derivatives. (3) The CDS market contributed to the increase in "connectivity" of global financial markets. The default of Lehman Brothers is a case in point. The CDS market has taken center stage in that episode. Second. Regulatory suggestions range from a complete ban of credit derivatives to doing nothing.The Regulation of Credit Derivative Markets1 Hendrik Hakenes and Isabel Schnabel University of Hannover and MPI Bonn. and – in an extreme scenario – to a complete unwinding of the CDS market. the outstanding volume of CDS contracts with Lehman as reference entity was huge. University of Mainz. MPI Bonn and CEPR 1. at the time it was estimated to be around $ 400 billion. 113 . which could be hidden from the eyes of regulators. one has to understand what specific role credit derivatives played in the recent crisis. and the participants of the conference on "Financial Regulation and Macroeconomic Stability . CDS are more or less unregulated. Lehman had issued large volumes of CDS. Vittorio Grilli.
Besides banks and insurance companies. Our study will proceed as follows: In the following section. from its ownership. in particular of CDS. hedge funds are playing an increasing role in the credit derivative market. Section 4 presents some arguments why regulation may be needed in credit derivative markets. we summarize the major arguments why credit derivatives may be desirable from a welfare perspective. Section 6 summarizes our major conclusions.2 In their simplest form. since the protection can never be perfect. and capital adequacy. 2006). i. transparency. In this sense.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 will give a tentative answer to this question. According to BBA (British Bankers' Association. trying to balance the benefits and dangers of credit derivatives. we focus on credit derivatives in the narrow sense of the word. These structured products are not the focus of this paper. such as mortgage-backed securities. 2 Credit default swaps also play an important role in a number of complex structured instruments. In this paper. However. excluding securitization. According to BBA. only one third of transactions are used for the purpose of managing credit risks. and what should be left to the markets. the use of collateral. Most credit derivatives are unfunded transactions. Credit derivatives Credit derivatives are used to separate the credit risk of an asset. CDS on other assets. However. the buyer delivers the underlying to the seller in exchange for the notional value (physical settlement). In case of a pre-specified credit event. In Section 3. such as a bond or a loan. The largest share of single-name CDS is based on reference entities from the corporate sector. the outstanding notional value of CDS is typically much larger than the notional value of the underlying debt. 2. there are often margin requirements attached to a CDS contract. to set the stage for the following analysis. One important question will be where regulatory action is necessary. the creation of a central counterparty. We will discuss current policy proposals regarding the regulation of credit derivative markets. standardization. Single-name CDS are highly customized and are traded over-the-counter (OTC). CDS are bilateral contracts where the protection seller insures the protection buyer against the credit risk of the reference entity. the two dominant forms of credit derivatives are single-name credit default swaps (where the reference entity is one specific debtor) and index trades (where the underlying is a CDS index). 114 . he receives a periodical payment. the difference being that the protection buyer does not necessarily own the underlying. In line with this observation. For this service. constitute only a small share of the market.. meaning that the protection seller does not provide any upfront funding in a transaction (an exception are creditlinked notes). we discuss several regulatory responses: a ban on credit default swaps. we briefly describe the functioning of credit derivatives. e. or the seller pays the buyer the difference between the notional value and the market value of the underlying (cash settlement). which depend on the credit standing of the protection seller. credit derivatives are similar to an insurance contract. In Section 5. a significant counterparty risk remains in any CDS transaction.
In addition to being used to insure the credit risk of a large loan directly.6 Second. 33).5 These numbers do not.The Regulation of Credit Derivative Markets Therefore. the aggregate numbers on the credit derivative market are highly uncertain (not to mention the exposures of single market participants). 31). credit derivatives complete markets. 2008b. Hence.4 Index products are more standardized and hence more liquid. allowing agents to achieve an efficient allocation of risk that – in the absence of state-contingent claims – could not be obtained otherwise (see Allen and Gale. 4 According to Gorton (2008). depends. exposures from CDS are often hedged by entering offsetting transactions with another party. i. This leads to complicated chains of linked exposures. For example.3 In practice.isda. 6 Whether such exposures can actually be netted. e. many market participants are holding offsetting positions. They propose the use of gross market values. showing up in lower bid-offer spreads and more rapid reactions to corporate news (Bank for International Settlements.2 in December 2007). where any party knows the direct counterparties. an insurance company). the notional amount of outstanding index trades caught up with single-name CDS (Bank for International Settlements. However. however. First. p. Out of the total notional value of $ 72 billion in Lehman CDS (which was much lower than the expected volume of $ 400 billion). Finally. While these numbers are huge. however. the counterparty risk from CDS is frequently hedged by another CDS. the uncertainty about the location of risk was one of the driving forces of the "Panic of 2007. The major argument was that credit derivatives can be used to efficiently allocate risks in an economy. a bank can buy credit protection in the form of a CDS to transfer credit risk to another party that can bear that risk at a lower cost (for example. which in turn hedges its exposure with yet another party. credit derivatives were welcomed by many academics and policy makers. the actual location of risk is unknown to market participants and regulators. the CDS market has become more liquid in recent years." 5 See http://www. they are still much smaller than the notional amount of interest rate derivatives ($464. transparency and liquidity are relatively low. p. In 2006. on the exact legal arrangements. the CDS market has become more liquid than the corporate bond market.6 trillion as of June 2008 (down from 62. 2008b. Moreover. 2008c).. many contracts are subject to margin requirements. instead of notional values (Bank for International Settlements. replacement values of CDS contracts. 115 . 2006). The ISDA (International Swaps and Derivatives Association) reports the notional amount of outstanding credit default swaps to be $ 54. but not the parties farther away in the chain.2 billion are said to have actually changed hands in the settlement. the BIS has argued that notional values are not informative about the actual risks. In effect.7 trillion as of June 2008).html. Exact numbers on the extent of margin requirements are. only $ 5. yield a correct picture of the risks stemming from the CDS market. For some reference entities. however. credit 3 However. not available. 3. The importance of both considerations became clear in the settlement of claims after the Lehman default. Why are credit derivatives desirable? In the years before the subprime crisis.org/press/press092508.
Why is regulation necessary? The current crisis has changed the view of many observers about the benefits of credit risk transfer. the aggregation of information requires some degree of transparency in credit derivative markets. 116 . Predescu. a situation where banks shed systematic risk may be preferable. let us now turn to the potential downsides of credit derivatives. If bank failures are associated with large social costs. rather. Consequently. the market for credit derivatives may yield information on firms that complements (and is potentially even superior to) the information provided by rating agencies. For example. From an ex-post perspective. it is necessary to differentiate between an exante and an ex-post perspective. 8 Hull. for example. While credit derivatives contributed to a larger availability of credit. households and firms will benefit from a better availability of credit. 2005) or high bankruptcy costs (as in Wagner and Marsh.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 derivatives can also be used to insure any kind of counterparty risk. credit derivatives may be used for speculation purposes. they seem to have increased it. a firm enters a contract with a third party. 4. In addition to hedging. and possibly even lower loan rates. g.7 If banks have limited riskbearing capacities. 2008). the use of collateralized loan obligations (CLOs) has enabled banks to expand their loan volumes by 50 percent. Consequently. they seem to have led to a propagation of the crisis from the United States to the rest of the world. Consequently.. for example due to bankers' risk aversion (as in Morrison. Another benefit of credit risk transfer is its potential to improve the access to finance for households and firms (Hakenes and Schnabel. Such risk transfers may increase systemic stability. And instead of providing useful information. it can insure the default risk of this third party using a CDS.8 However. (2006). If. the opacity of CDS markets seems to have contributed to disruptions in interbank markets. and White (2004) show that CDS markets anticipate rating announcements. Hellwig (1994) has argued that banks may not be well suited to hold non-diversifiable (systematic) risk and that it may be efficient to shift such risks to third parties (e. These downsides may then yield a rationale for the regulation of credit derivatives. In identifying reasons for regulation. 2006). after the CDS has 7 According to Goderis et al. many of the additional loans maybe should not have been granted. The information on a firm's credit standing can be aggregated in the market for credit derivatives. a transfer of credit risk to a third party allows banks to take on new risk. CDS can help to improve the efficiency in any market where counterparty risk is an issue. to their depositors). market participants can sell or buy CDS to express their views on the credit standing of a firm. Credit derivatives do not seem to have stabilized the financial system. Therefore. The CDS would then be traded by a bank on behalf of the original firm. This would make the bank invulnerable to macroeconomic shocks. for example by granting additional loans. Instead of reducing systemic risk.
If risks are shifted to parties that are not able to bear them. As was argued above. a regulator may want the insurance sector to hold part of the risks originated within the banking sector (Wagner and Marsh. but the joint probability of the default of several banks increases. they were not at all able to bear the risks from maturity transformation that they were facing (Hellwig.The Regulation of Credit Derivative Markets expired. 2008). Hence. A case in point is the observed risk-shifting to structured investment vehicles (SIVs). some negative impact of CDS on a third party. 2006). In such a situation. 2008). Regulation cannot be justified by the fact that someone has been losing money. This can be achieved by smaller capital requirements for insurance companies. When several banks share their risks using CDS.1. and is interpreted as shirking the legal framework. Given that these SIVs were largely financed by short-term commercial paper. One problem is that risks were not shifted outside of the banking sector (as suggested by Hellwig. Systemic risk Instead of reducing systemic risk. the transferred risks 9 Pennacchi (1988) was the first to motivate credit risk transfer by regulation. either the buyer or the seller has lost money. However. 2006). Consequently. if regulation is inefficient. banks appear to have used credit derivatives in order to transfer credit risks to (unregulated) hedge funds simply to avoid the regulatory capital requirement. the reason for regulation must always be some externality problem. If the underlying has defaulted. 4. 117 . From an ex-ante perspective. Banks may even have an incentive to deliberately increase systemic risk. the opposite is true. none of the parties was forced into the contract. For example. Hence. The contemporaneous default of several banks may entail large costs for the economy. However. regulatory arbitrage may induce risk transfers that increase the fragility of the financial system (Allen and Gale.9 This bypassing of prudential regulation is often referred to as regulatory arbitrage. 2008).. but a large share of it remained in the banking sector. the regulation of different financial sectors should take into account that different institutions are exposed to different types of risk (Hellwig. Another problem was that risk was not always shifted to the parties that were best able to bear it.e. the banking sector is typically considered to be more fragile than the insurance sector. 1994). This implies that the probability of the default of a single bank drops. but to parties that were subject to laxer regulatory constraints. the transfer of risk to other sectors may be desirable and regulators can design regulatory policies to instigate desirable risk transfers. the seller has lost and the buyer has won. i. By becoming part of a chain of credit derivatives (like AIG). each single bank becomes safer. they may choose to become "too interconnected to fail" (Brunnermeier. However. 2009). the policy maker should encourage insurance companies to sell CDS to banks. Hence. if the underlying has not defaulted. For example. the banks also become more similar (Wagner. credit risk transfer seems to have contributed to a rise in systemic risk. Other examples are Gorton and Pennacchi (1995) and Hakenes and Schnabel (2008). the CDS must have been considered beneficial by both parties at the time of the conclusion of the contract (at least if both parties understood what they were selling or buying). such arbitrage would not be a problem if regulation were efficient.
making the insurance worthless when it is needed most. 1998. banks and other financial institutions have generated huge incomes by writing CDS. a chain structure can emerge. Credit risk is passed on from institution to institution. However. and monitoring incentives disappear. Excessive risk-taking Credit derivatives lend themselves particularly well to excessive risk-taking due to their specific return structure. the deposit insurance. banks may knowingly grant loans with negative net present values. The highly unlikely event of huge losses is not taken into account because the losses can be shifted to other parties (such as creditors. due to compensation schemes that lead to "short-termism" of traders and bank managers) may exacerbate the problem of excessive risk-taking. moral hazard in the origination of loans. They earn a small positive return with a high probability. As has been argued forcefully by Hellwig (1995. Credit risk transfer may also lead to a moral hazard problem in the origination of loans. If the positive welfare effects. there is a negative externality on the underlying firm and on other creditors of the firm. Therefore. the buying and selling of credit risk is not observable. One important question is how regulation can deal with this in a sensible way.3. as was shown by Hakenes and Schnabel (2008). 2008). such as the increase in profitable loans. for the question of securitization. Given the opaqueness of CDS markets. 2005). traders may excessively sell CDS to raise their bonuses. with no-one having any monitoring incentives as long as credit risk can again be resold. Although banks will benefit from reselling credit risk. only a relatively small part of the securities underlying CDS refers to subprime mortgages. if credit risk is easily transferable to a third party by buying a CDS. especially in subprime mortgages. In the current crisis. Given limited liability. seems to have played an important role (Hellwig. In fact. are large enough.2. this commitment breaks down (see Morrison.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 may come back to the protection buyers in the form of counterparty risk. 118 . Credit risk is spread in the economy. this does not necessarily mean that the overall welfare effects of credit risk transfer are negative. e. or the tax payer). these types of arguments seem to have less relevance for the CDS market than. This is exactly what we have seen in the current crisis. 2008). 4. Given the opacity of cred10 Parlour and Winton (2008) have argued that the costs from lacking monitoring incentives may over-compensate the benefits of credit risk transfer for risky borrowers. such a return structure is attractive because it generates reliable income streams most of the time. and entail huge losses with a low probability.10 Potentially. If credit risk can be transferred to other parties. 4. the risk to be insured tends to be highly correlated with counterparty risk. overall welfare effects may also be positive. Moral hazard Granting a loan is an implicit commitment to monitor the borrower. However. For example.. Problems in the governance structure of financial institutions (for example. This is in line with the empirical study by Ashcraft and Santos (2008) who find that CDS trading has increased the cost of corporate debt for highrisk borrowers. However.g.
for example. In any case. In fact. speculation may yield useful information on the underlying reference entities. a complete ban of credit derivatives is in our view undesirable. on the buying of a CDS when one does not own the underlying asset. p. 5. 12 Cf. it seems that an improvement of the infrastructure of CDS markets is preferable to a complete (or defacto) ban on credit derivatives. Furthermore. and capital adequacy. such risk-taking was controlled neither by "market discipline.11 The risk position of a (naked) CDS buyer is the same as that of a short seller of the underlying bond. as argued above. been made by Collin Peterson. the testimony of Christopher Cox. 119 . A somewhat milder proposal is a ban on "naked" CDS trading. 13 See Hellwig (2008. This may lead to undesirable incentive effects. the CDS buyer benefits from the bond going into default. 5. It would limit the purpose of CDS to hedging and would prohibit speculation. CDS may be prohibited for the same reasons as the short sales of stocks.12 As a consequence. Ban on credit default swaps The most drastic regulatory measure would be a complete ban on credit default swaps. i. such as CDS on asset-backed securities. it is hard to argue for a permanent ban on CDS on these grounds. just as the permanent prohibition on short sales of stocks is generally not considered to be desirable. In fact. The question is how future regulation can best contain risk-taking in credit derivatives. a U. the use of collateral. such a prohibition would be almost tantamount to a complete ban on CDS because the current volume of CDS outstanding largely exceeds the volume of the underlying bonds." nor by the regulator.13 Apart from this. Regulatory measures We will now discuss the regulatory measures that have been discussed most prominently in the recent past concerning the regulation of credit derivative markets: a ban on credit default swaps. We are now experiencing the tail event that was deemed to be highly unlikely.. Senate on September 23.1. the CDS market appears to have functioned more smoothly than other markets during the crisis. their prohibition may well be justified. these are instruments that involve several layers of securitization. Therefore. which have been banned in a number of countries since fall 2008. 2008. Nevertheless.The Regulation of Credit Derivative Markets it derivative markets. standardization. CDS allow investors to short a company's debt without any restriction. However. transparency. 23-25) on this point. in January 2009.S. Chairman of the Securities and Exchange Commission. the creation of a central counterparty. Since the usefulness of such instruments is doubtful. Given the arguments in favor of credit derivatives presented in Section 3 of this paper. the market seems to have produced some instruments with unclear benefits.S. 11 Such a proposal has. before the U.e. In particular. democrat.
int/press/key/date/2008/html/sp081201. 15 In November 2008. Increased transparency would help to solve moral hazard problems. it does not take into account the interconnectedness of different market players.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 5. Typically. this would still give an incomplete picture of the actual risks because. including information about margin requirements. See http://www.2 are due to the opacity of credit derivative markets. it is important to distinguish between the disclosure of information to the regulator and the disclosure of information to market participants. the moral hazard problems described in Section 4. This refers to the bilateral or multilateral termination of CDS contracts by discovering and removing offsetting positions. again. which prevents banks from committing to the monitoring of loans (Morrison. the speech by Lorenzo Bini Smaghi. Indeed. This means that risk-taking could not be controlled by market discipline. 2005) or to the granting of profitable loans (Hakenes and Schnabel. In order to judge the true risks from CDS. for example. The regulators may consider requiring market participants to disclose "large" exposures in the CDS market to the public (where "large" would have to be defined). it made it impossible for regulators to discover and hence prevent the build-up of risk concentrations. one of the world's largest settlement and clearing houses. 1 Dec 2008.000 largest underlying reference entities and all indices as well as aggregate data on the gross notional values of these instruments on a weekly basis. Voluntary transparency initiatives by the industry.en. Another question is to what extent information should be disclosed to other market participants. While the com- 14 See. 120 . However. began publishing the outstanding gross and net notional values of credit default swap contracts for the 1. In fact.2. Also. reporting requirements (such as any other regulation) will lag behind the process of financial innovation. it seems obvious that the regulators need more detailed information about the individual risk positions of banks in order to be able to recognize and control risk concentrations. it made it difficult for market participants to judge the risk of other market players.15 However. it was one of the reasons for the drying-up of liquidity in interbank markets. such as that by the Depository Trust & Clearing Corporation (DTCC) to publish more information about CDS cleared through their platform are to be welcomed. Regarding the first point. reporting requirements will never be able to fully uncover the chain of linked exposures in credit derivative markets.dtcc. regulators have to be regularly informed about financial institutions' exposures split up by counterparties and maturities. the Depository Trust & Clearing Corporation (DTCC). Second.14 Third.com/products/derivserv/data/. they are insufficient because they do not contain any information about individual exposures. a lack of transparency over exposures in CDS markets contributed to the crisis in several ways: First. Of course. Market discipline can only work when "the market" can observe the risk-taking of market participants.html#. Another way to increase transparency would be the forced compression (or tear-up) of outstanding CDS contracts. http://www.ecb. In discussing transparency. ECB. it has to be recognized that such reporting requirements capture only the risks from instruments that are already known to be a threat to systemic stability. which played an important role in the propagation of the crisis. 2008). Transparency The enhancement of transparency is at the core of many proposals regarding the improvement of the infrastructure of credit derivative markets.
margin requirements are typically calculated on a daily basis.3. This leads us directly to the next regulatory measure. such as the level of margin requirements. which can be highly complicated. With large 121 . but it also requires that the provided information is understood. Margin requirements are generally useful in reducing counterparty risk. Whether at least part of the CDS market is going to end up being traded in organized exchanges is an open question. This concerns especially the conditions and terms of CDS contracts. Transparency requires not only that more information is provided. many contracts are now concluded under an ISDA master agreement. 5. One is related to the previous point – it increases transparency. unnecessary. 63 percent of all over-thecounter derivatives transactions are subject to collateral agreements. the trend towards a standardization of contracts is likely to continue in future years. The benefits of standardization have already been recognized by the industry. In fact. for example. Today. reduce the possibilities of price manipulation. have to be known and understood. the contract's conditions. In particular. which contains the details specific to a given contract. According to the ISDA Margin Survey of 2007. Use of collateral The use of collateral is one way to mitigate counterparty risk. Another argument is higher liquidity. regulatory action seems unnecessary in this area. and make the practice of offsetting trades. standardization reduces legal disputes.4. In order to judge the risk from a CDS contract. This concerns. Any standardization entails a loss of flexibility and a lower correspondence between risks to be insured and the insurance contracts. The confirmation again draws on a number of definitions pre-specified by ISDA. Nevertheless. 5. For example. which adds to the low transparency of the market. margin requirements seem to play an important role in CDS markets (even though information is sparse). which contains general terms and conditions for OTC derivative contracts. A functioning secondary market would improve the efficiency of price formation. There is another dimension of transparency that should be taken into account. Standardization Current OTC markets are attractive because they allow market participants to tailor CDS contracts to their specific needs. This master agreement is typically complemented by a confirmation.The Regulation of Credit Derivative Markets pression leaves the net exposures unchanged. it reduces gross exposures. and therefore increases the information content of aggregate notional amounts outstanding. Finally. a CDS contract can be arranged such that it allows a bank to perfectly hedge the risk from a loan in its books. namely the standardization of contracts. Margin adjustments have become much more frequent than in earlier years. Given the movement towards the creation of a central counterparty (which will be the topic of a later section). the definition of credit events triggering payments. there are a number of arguments in favor of more standardization. Given the industry's interest in promoting a further standardization. This could be facilitated by standardization. The according number for credit derivatives is unknown.
122 . market liquidity and funding liquidity are mutually reinforcing and may lead to a "liquidity spiral. The banks in different countries were connected through chains of bills of exchange. however. The underlying mechanism is. At that time. and between liquidity risk and credit risk. The case of AIG is the best example for the destructive effect that such margin calls can have. 23-24. This example makes clear that such liquidity spirals are not at all specific to modern credit derivative markets. The key advantage of such a CCP is the possibility of multilateral netting of credit exposures. especially in times of market distress. However. the volatility of the value of collateral has become a minor issue. exerting a procyclical effect. implying huge margin calls in the case of a credit rating downgrade. 17 Similar mechanisms were at work during the LTCM crisis of 1998. margins can be destabilizing and may precipitate the crisis that they are supposed to prevent.17 Brunnermeier and Pederson (2009) have shown that in times of crisis.16 When counterparties are required to post additional collateral at short notice. the whole chain of bills unraveled and bankers were forced to sell their assets (such as grain and sugar). margin requirements give rise to new risks. When one prominent banker failed and could not pay his bills. but the CCP itself. are a first step in this direction (Bank for International Settlements. on the one hand."18 This spiral forces traders to de-lever during crises. The problem is even reinforced when margin requirements are linked to credit ratings.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 parts of the collateral consisting of cash. the most important being funding liquidity risk. Also. 18 See also Adrian and Shin (2008). The strong focus on capital requirements in today's banking regulation may have to be given up in favor of a broader approach that encompasses liquidity as a major determinant of the soundness of financial systems. The close relationship between funding and market liquidity risk. The proposals of the Working Group of Liquidity. this can lead to severe liquidity problems. banks were merchant bankers and traded in grain and sugar. point to the important role of liquidity for systemic stability. p. 19 See Bank for International Settlements (2007) for an overview of current arrangements and regulatory issues regarding the clearing and settlement of OTC derivatives. 2008a). Asset prices dropped sharply.19 The basic idea is that the counterparty in any transaction cleared by the CCP would not be another market participant. Schnabel and Shin (2004) have documented very similar effects in a crisis in Northern Europe as early as 1763. In this sense. the members would have to deal with only one counterparty that would enjoy a large degree of creditworthiness due 16 See Bank for International Settlements (2007). 5. Creation of a central counterparty The threat of counterparty risk in the CDS market can also be tackled by the establishment of a central counterparty (CCP) in the form of a clearing house. by no means specific to modern financial instruments. which reduces counterparty risk by reducing members' credit exposure. exerting pressure on other bankers. on the other. established by the Basel Committee on Banking Supervision.5.
for example in case of a member's default. The creation of a CCP would at the same time reduce the degree of connectivity in the system. Given that members will probably need less capital to back up the CCP than they would need individually as a safeguard against potential losses. but especially the handling of a default of a member. default procedures have to be adjusted to take into account the instruments' illiquidity. Finally. 20 See Kroszner (1999. Moreover. are going to establish their own clearing houses. in order to be considered fully creditworthy. This problem can best be solved by requiring a minimum degree of standardization and by excluding highly complex products from the CCP. which would reduce legal risk. One important issue will be the harmonization of regulations across different jurisdictions. If not. strict regulation is needed to ensure that market participants do not shift risks to the clearing house and from there to the tax payer. At the same time. Moreover. a solid financial backing. one may consider regulatory incentives. 2000) on the effectiveness of markets in controlling risks through the creation of clearing houses 123 . the clearing house. The markets will also decide how many clearing houses will be needed. their valuation is much more difficult. For example.The Regulation of Credit Derivative Markets to the backing from all of its members. The creation of a CCP is already well under way and should be left to the markets. there are some additional obstacles in the establishment of a CCP related to the OTC nature of many CDS. it would clearly be considered to be "too important to fail. the CCP needs a strong risk management. Given the lower liquidity of these instruments. The costs in terms of increased moral hazard would be moderate because the CCP would in any case be subject to an implicit government guarantee: Given its size and systemic importance. and close supervision by regulatory authorities. Some arguments such as the centralization of collateral seem to support the convergence towards a low number of clearing houses." As a consequence. It is likely that important economic areas. However. credit risk mitigation using instruments cleared by the CCP may receive a favorable treatment in the capital regulation framework. Therefore. such as the EU. all procedures and legal provisions could be standardized. reducing operational risk.20 The government should intervene only in the regulation and supervision of CCPs. This affects the determination of margin requirements. The danger of domino effects vanishes as long as the CCP remains solvent and liquid. However. this would increase transparency because it would break the chain of exposures in favor of direct exposures to the CCP. such as a government guarantee. the CCP may need an additional public backing. In CDS markets. In addition. Strict membership criteria and margin requirements play an important role in ensuring the credibility of the CCP. there should be sufficient incentives for banks and other financial institutions to become members of the clearing house. the participation in other members' losses helps to maintain the members' interest in enforcing tight risk controls. the CCP could develop efficient procedures. A sufficient capitalization by its members is needed to be able to absorb the losses deriving from a member's default. the creation of a CCP means that counterparty risk is now concentrated in a single agent.
crucially hinges on the determination of correlations between the risk to be insured and the counterparty risk. Many of the problems. Therefore. While there is now a consensus that regulation should follow a macro-prudential approach. One aspect that has been discussed at length in recent years is the extent to which credit risk mitigation techniques should be taken into account in the calculation of capital requirements. These problems should not be solved by measures directed to specific instruments. However. This approach allows for a broader consideration of credit mitigation effects because it takes into account that a default occurs only if both the original debtor and the protection seller default. This leads to the more general criticism of the current approach to banking regulation. but also by a measure called CoVaR. This implies that a financial institution subject to substantial spillovers from other institutions would be required to hold more capital than an institution that is not subject to such spillovers. One may question whether the double default approach adequately takes into account the high correlation of risks in times of crisis. as the one seen in the CDS market in recent years. Importantly. this measure is able to quantify the tail-risk dependency among financial institutions. such as the relationship between funding and market liquidity. Importantly. This means that the capital charge cannot be lower than a direct exposure to the protection provider.6. implying that the protected exposure is assigned the risk weight of the protection provider. a substitution approach is generally applied to credit derivatives. It still largely focuses on the solvency of individual financial institutions and is not able to capture correlations among financial institutions adequately. a bank using the internal ratings-based (IRB) approach has – under a number of restrictions – the option to choose the double default framework. we would like to stress some general lessons for regulation that are not specific to the credit derivative markets: 124 . proposals of how this can be done have appeared only recently. such an approach may be able to prevent an accumulation of risks. however. are much more general and are not specific to credit derivative markets. Conclusion Our major conclusions are summarized in the following bullet points: • In spite of the disruptions observed after the Lehman default.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 5. • Therefore. A promising route is the suggestion by Adrian and Brunnermeier (2008) to measure an institution's risk not only by the conventional value at risk (VaR). such as CDS. 6. defined as the VaR of a financial institution conditional on other institutions being in distress. The reliability of this approach. they may prove to be too low when a severe crisis arrives and correlations suddenly become exceptionally high. Even if these correlation parameters are set at a high level by the regulators. Under the new Basel Accord ("Basel II"). this reduces banks' incentives to choose strategies increasing their CoVaR in the first place. it seems farfetched to blame credit derivatives for the crisis as a whole. Capital adequacy The final question is what role capital adequacy rules can play in the regulation of credit derivative markets. They rather seem to have played an accelerating role.
3. In particular. F. 3." in The Risks of Financial Institutions. and M. 2. University of Chicago Press. Stulz. In any case. • Finally. Brunnermeier (2008): "CoVar. it is well known that any regulation is bound to produce evasive behavior by market participants and may therefore prove to be ineffective or even counterproductive. K. there is little doubt that financial institutions should be subjected to stricter reporting requirements about credit derivatives towards the regulators. However. and D. References Allen. Carey and R. Financial regulation should give up its strong focus on capital adequacy in favor of a broader approach that encompasses liquidity as a major determinant of the soundness of financial systems. some scope for market participants to employ customized contracts and to experiment with novel types of instruments should remain. the basis of which is a strong risk management and a solid financial backing. for example. 341-375. any regulation should consider that credit derivatives serve a number of useful purposes in an economy. there are a number of specific suggestions that are directly related to credit derivative markets: 1. by Solvency II in the insurance sector) is not desirable. in turn. requires strict regulation in order to combat moral hazard problems. Current capital regulation has to be complemented by a systemic.. Additionally. Moreover. A homogenization of regulation (as envisaged. Although there is always political pressure to respond to crises by enforcing stricter regulation. reporting requirements are likely to lag behind the process of financial innovation. The proposal by Adrian and Brunnermeier (2008) is an important step in this direction. The creation of central counterparties has the potential to mitigate the problem of counterparty risk and at the same time increase transparency in credit derivative markets. • Moreover. such as the further standardization of contracts and the decision to move credit derivatives to organized exchanges. Adrian. Sector-specific regulation should take into account that different types of financial institutions are exposed to different types of risks. regulation should leave some scope for financial innovation. ed.The Regulation of Credit Derivative Markets 1. This. Other improvements of the infrastructure of credit derivative markets. should be left to the market. M. macroprudential perspective. An additional government guarantee may be unavoidable to ensure the creditworthiness of the CCP. Regulation should interfere only if there is a clear indication of a market failure. Gale (2006): "Systemic Risk and Regulation. Regarding transparency. by M. 2. regulators may consider requiring market participants to disclose large exposures to the public. Finally. their success will depend crucially on the CCP's creditworthiness. more regulation does not necessarily lead to higher financial stability." Federal Reserve Bank of New York 125 . T.. A complete or de-facto ban on credit derivatives is therefore undesirable.
Banking. R. B." Journal of Financial Services Research." Committee on Payment and Settlement Systems. Castello. G. Gorton. Hull. and A. Heider. Ashcraft." Journal of Monetary Economics. (2005): "Credit Derivatives. G. I. 28(11). London. Santos (2007) "Has the CDS Market Lowered the Cost of Corporate Debt?". M. R. and the Allocation of Interest Rate Risk. Bank for International Settlements (2008c): "OTC Derivatives Market Activity in the First Half of 2008." Federal Reserve Bank of New York Staff Reports No. Holthausen (2008). "Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk. Shin (2008): "Financial Intermediary Leverage and Value-at-Risk." Journal of Institutional and Theoretical Economics. 31(2). K. Predescu. forthcoming. H. Bank for International Settlements (2008a): "Liquidity Risk: Management and Supervisory Challenges.. S. Marsh. Disintermediation. S." Working Paper. British Bankers' Association (2006): BBA Credit Derivatives Report 2006." Working Paper. White (2004). "The Relationship between Credit Default Swap Spreads. Kroszner. J. and Investment 126 .. 338." Working Paper. April 2008. 328-351. Hellwig. Morrison." Working Paper.. Bond Yields. "Banks and Loan Sales – Marketing Nonmarketable Assets. Hoerova and C. G. 38(7). Kroszner. and Pennacchi. "Liquidity Provision. 348. M. D.." Journal of Money. Bank for International Settlements (2008b): "Credit Risk Transfer – Developments from 2005 to 2007." Schweizerische Zeitschrift für Volkswirtschaft und Statistik. M." Review of Financial Studies. (2008): "Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis. Hakenes. and the Allocations of Risks. "Credit Risk Transfer in Banking Markets with Hard and Soft Information. Cass Business School. 389-411. M. November 2008. and W. Hellwig. 131(4). Pederson (2009): "Market Liquidity and Funding Liquidity. Brunnermeier. Federal Reserve Bank of New York Working Paper. M. F. Markets. M. (1998): "Banks. M. Goderis. and L. (2008): "Deciphering the Liquidity and Credit Crunch 2007-08. J. M. Schnabel (2008). 723-737. 596-618. Hellwig. and I. B. and H." Working Paper." Monetary and Economic Department.. A." European Economic Review. (1999): "Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearinghouses and Recent Over-the-Counter Innovations. Brunnermeier... February 2008." Journal of Banking and Finance. 154(1). T. 157-171.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Staff Reports No." Basel Committee on Banking Supervision. Credit. 35(3). (1995): "Systemic Aspects of Risk Management in Banking and Finance. A. 1363-1389. K. 18(2-3). (2000): "Lessons from Financial Crises: The Role of Clearinghouses. S. Gorton." Preprints of the Max Planck Institute for Research on Collective Goods Bonn. 2789-2811. 2008/43. March 2007. (2008): "The Panic of 2007. Adrian." Basel Committee on Banking Supervision. and Credit Rating Announcements. Wagner (2006): "Bank Behavior with Access to Credit Risk Transfer Markets. and Banking. (1994). (1995). H. Hellwig. Bank for International Settlements (2007): "New Developments in Clearing and Settlement Arrangements of OTC Derivatives.. and J.
forthcoming. G. 621-647.The Regulation of Credit Derivative Markets Decisions. (1988): "Loan Sales and the Cost of Bank Capital. and I. 78(2)... Parlour." Journal of the European Economic Association. Pennacchi. Shin (2004): "Liquidity and Contagion: The Crisis of 1763. and A. 929-968. 43(2). 375-396." Journal of Finance." Journal of Financial Stability." Working Paper. 2(2). W. C. and H. Wagner. S. Schnabel." Journal of Business. W. 127 . (2009): "Diversification at Financial Institutions and Systemic Crises. 2(6)." Journal of Financial Intermediation. W. 173-193.. Wagner. Marsh (2006): "Credit Risk Transfer and Financial Sector Performance. Winton (2008): "Laying Off Credit Risk: Loan Sales versus Credit Default Swaps. I. G.
Now that a scenario of widespread default has materialized. …This over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. which played a key role in this process (see for instance the Financial Stability Forum Report. structured debt securities find no buyers. This suggests that their initial ratings greatly understated the risk of structured debt securities. 2008. this detailed information would have been essential to identify the "toxic assets" in the maze of existing structured debt securities. Given the way they are designed. and their market is frozen.000 structured finance instruments. rated triple A. 1 Both rating inflation and naïve investors' excessive reliance on ratings are well captured by Lloyd Blankfein. Two issues fare prominently in this respect. CEO of Goldman Sachs. This information loss is particularly serious in view of the heterogeneity of the collateral and the great complexity of the design of structured debt securities. Absent such information. ratings provide very coarse and limited information about these characteristics. there were 64. First. p. 2009. such as collateralised debt obligations. there were 12 triple A-rated companies in the world. Authors' note: We thank Vittorio Grilli.Credit Ratings Failures: Causes and Policy Options Marco Pagano and Paolo Volpin Università di Napoli Federico II. Rather than undertake their own analysis. Vikrant Vig." (Blankfein. In January 2008. Janet Mitchell.1 Second. Rafael Repullo. So the information loss involved in the process of securitization and rating is largely at the source of the illiquidity that plagues securities markets since the crisis broke out. 7). they relied on the rating agencies to do the essential work of risk analysis for them. Such "ratings inflation" is central to the understanding of the crisis: insofar as many investors naively based their investment in these securities mainly or solely on inflated credit ratings. 129 . CSEF. when he writes that before the crisis "too many financial institutions and investors simply outsourced their risk management. much attention is currently directed at the flaws of the securitization process and particularly at the failures of the rating agencies (CRAs). EIEF and CEPR. since 2007 even very highly-rated structured debt products have performed very poorly: the value of AAA-rated mortgage-backed securities (as measured by the corresponding credit default swaps prices) has fallen by 70 percent between January 2007 and December 2008. London Business School and CEPR 1. in the process of securitization and rating much detailed information about the risk characteristics of the underlying assets has been lost. and to price them correctly. these led to a massive mispricing of risk. David Watts and Susan Woodward for helpful information and comments. At the same time. whose correction later detonated the crisis. 2008). Introduction As the ongoing financial turmoil originated in the market for subprime mortgagebacked securities. and International Monetary Fund.
CRAs are not unique: a similar conflict of interest also exists for other "financial gatekeepers". we draw on existing research to assess the likely causes for these two failures of rating agencies in the securitization process . But switching from the "issuer pays" to the "investors pay" model may be 130 .pay for their services. since both of the problems discussed above arise from the conflict of interest between rating agencies and investors. as indeed was the case before the 1970s. they levelled the playing field so that unsophisticated could buy these securities without losing money to sophisticated ones. What can policy makers do to improve things for the future? We argue that the preferred policy would require a drastic change in regulation . if and when the neglected information becomes price relevant. and thereby attracted the former into their primary market. In this respect. This enhances ratings inflation in comparison to a situation where ratings are set on a finer grid. As we shall see. if ratings are set on a discrete scale. in each rating class a disproportionate number of issues or tranches will feature a risk corresponding to the low end of that class. complacent rating agencies can suggest to issuers how to structure their securities or their tranches so that they can just attain a given rating. issuers and rating agencies grasped the counterintuitive principle that. or else complement their ratings with any additional data necessary for such assessment. But arguably issuers saw an even larger benefit in providing relatively coarse information: that of expanding the primary market of structured debt securities. but as we shall see regulation has been much more lenient with credit rating agencies. since one would expect the provision of detailed public information to reduce the rents of informed traders.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 In this paper. By providing little information to all.and review the policies that may be adopted to correct or mitigate them in the future. the coarseness of ratings may reinforce the tendency to inflate them.not issuers . and therefore the conflict of interest with investors. less rather than more disclosure enhances market size and liquidity.not just in specific rules but in their guiding principles as well. The reason for disseminating only coarse information when issuing structured debt securities is less obvious. Moreover. it is of essence to eliminate (or at least reduce) this conflict by addressing the issue of "who pays". leading issuers to ask CRAs to provide the most detailed assessment of the risk characteristics of their issues. The most obvious motive for the inflation of credit ratings is an incentive problem: CRAs are paid by issuers. Moreover. However the current crisis shows that the implied information loss can have dire consequences for market liquidity further down the road. then the most appropriate solution is to have investors . to market very complex securities to a clientele that includes relatively unsophisticated investors. in the case of ratings the problem is exacerbated by the possibility for issuers to engage in "rating shopping". and thereby to enhance secondary market liquidity. Indeed. such as auditing companies. by making them palatable also to investors who could not easily process complex information. First. This should in turn increase the issue price of the securities. Therefore. If rating agencies are tempted to please issuers by inflating their credit ratings and/or by choosing excessively coarse ratings. as it expands the room for collusion between issuer and rating agency. by soliciting only the most favourable rating among those potentially available from a set of competing agencies. so that their interest is more aligned with that of securities' issuers than with that of investors.ratings inflation and their coarseness .
regulators could enhance transparency not by forcing issuers to grant open and free access to all relevant data. it would induce many naïve investors to persist in the bad habits of the past. even if issuers must pay an upfront fee and cannot engage in explicit rating shopping. who will supply financial advice to investors and provide healthy competition to CRAs. few buy-side investors would have the technical skills to do this. which they can identify by comparing the models that the agencies use to rate securities. First. in order to attain greater disclosure the issuers should make publicly available the complete (anonymous) data about the pool of loans (or bonds) underlying their structured finance products. Clearly. they may retain the "issuer pays" model but constrain the way in which agencies contract with issuers and are paid by them: issuers should pay an upfront fee irrespective of the rating issued (the so-called "Cuomo plan. issuers will have less of an incentive to circumvent the "investors pay" principle. the market for securitized products will be considerably smaller. But their effectiveness in addressing the failures of credit agencies exposed by the current crisis is likely to be quite limited.Credit Ratings Failures: Causes and Policy Options difficult to implement in practice in a situation where delegation by banking and securities regulations has conferred a tremendous power to a select group of rating agencies over issuers. but also that of regulators due their considerable transitional costs. so that buy-side investors may feed them into their own models to assess their risk characteristics. It may also expose such detailed regulation to the danger of failing to keep pace with financial innovation. However. that is. policy makers may also want to consider a second-best policy." named after NY Attorney General Andrew Cuomo) and credit shopping should be banned. as in this setting there is no guarantee that these will be come to be regarded by investors as the most reliable ones. A more direct (and consequential) way to deal with the problem would be to eliminate the many regulations that delegate powers to rating agencies: once the rents that these regulations confer to these agencies are gone. or will survive the competitive challenge mounted by other information processors. Second. Specifically. since less sophisticated investors will tend to stay away from it. Therefore. Therefore. and therefore mandating a more complete format for the information to be disseminated by CRAs. which tries to address the above-discussed problems without overhauling the current setup. Second. but by determining the information that they must disseminate to the investing public. This highlights an additional reason to revoke the current regulatory delegation to a select group of CRA. this problem is likely to be partially and gradually relieved by the entry of specialized information processors. especially in the design of structured debt securities. Similarly. some of which may even be induced by regulation itself. it will be essential to prevent indirect payments by issuers to credit rating agencies in the form of the purchase of consulting or pre-rating services. that of forgoing an inde- 131 . These more limited reforms may still be consistent with the current regulatory delegation of vast powers to a select group of rating agencies. prescribing which pieces of information and which statistics CRAs should disseminate would shift the burden of identifying such information on the regulator. implicit collusion may still be sustainable: issuers may systematically patronize the agency that offers them the best ratings. which can be very costly in the presence of very diverse financial products. Hence. Finally. Such sweeping changes will meet not only the opposition of credit rating agencies.
the tangle of regulations in this area.980 680 730 570 Subprime Origination ($bn) 190 231 335 540 625 600 93 56 28 (% of total mortgages) 8. 2.920 3.885 3.3% 74. In that way. poor credit history or limited documentation.9% 53. non-prescriptive approach by regulators would shift on issuers and investors the burden of determining the pieces of information that are most relevant to evaluate the risk of each security.1% 13.1% 80. or by portfolios of tranches from MBS and other CDOs. Securities Industry and Financial Markets Association. the rating provided access to a pool of potential buyers. Inside Mortgage Finance.3% 81.6% 57. instead of further increasing.215 2.4% 60. and CDOs or Collateralized Debt Obligations. In contrast.0% 20.5% 18.0% 52. and Creditflux. The reason is simple: for this market to succeed. the market for subprime MBS and CDOs needed be a "rated" market.120 2. 132 .9% Subprime MBS Issuance ($bn) (% of subprime mortgages) 95 121 202 401 507 483 52 30 16 50. it needed to attract the large pool of institutional investors that are subject to ratingbased constraints.0% 8. from $100 billion to more than $1 trillion. As shown in Table 1. in which the risk of tranches was assessed by CRAs using the same scale as bonds. in contrast to what is currently suggested by many. This is an instance in which less regulation might also be safer and better regulation. It would also reduce. In other words. This remarkable growth in the market for asset-backed securities would have been impossible without the help of CRAs. pendent evaluation of the risk characteristics of these securities (by turning to additional data sources or other information processors) once a CRA has provided the information required by regulators. since 2001 we have witnessed a spectacular growth in two new types of structured debt products: subprime MBS or Mortgage Backed Securities. CDOs are backed by pools of corporate bonds and other fixed income assets.5% 55.5% 20.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Table 1 Issuance of Mortgage Backed Securities and CDOs over time Total Mortgage Origination ($bn) 2001 2002 2003 2004 2005 2006 2007Q1 2007Q2 2007Q3 2.945 2.7% 7.1% CDO ($bn) 6 36 30 157 272 552 186 176 93 Source: Gorton (2008). Securitization process and rating agencies Asset-backed securities have been around for decades. Subprime MBS are backed by pools of mortgage loans that do not conform with the standards set by Fannie Mae and Freddie Mac because of low FICO score.6% 8. and would not run the risk of obsolescence. However. between 2001 and 2006 the combined issuance of subprime MBS and CDOs grew ten times. an open-access.7% 4.
all tranches (even the AAA-rated securities) experienced a substantial drop in value. Interestingly. with respect to 32 percent of revenues from the traditional business of rating of corporate bonds (Coval et al. The rating agencies benefited a lot from the growth of structured products. It is clear from the graph that the crisis was first felt in March 2007 by the BBB-rated MBS. 4). which offer protection against the default of asset-backed securities containing subprime mortgages of different ratings. The extent of the crisis in the market for asset-backed securities can be best appreciated by looking at the dynamics of the ABX price indexes reported in Figure 1. In other words. a decline in the ABX index indicates an increase in the cost of insuring a basket of mortgages of a certain rating against default. in contrast to less than 1 percent of the corporate issues.. p. In other words. "Our ratings represent a uniform measure of credit quality globally and across all types of debt instruments. until the collapse in the late 2007. an 'AAA' rated corporate bond should exhibit the same degree of credit quality as an 'AAA' rated securitized issue" (S&P 2007. who would have otherwise perceived these securities as very complex and would have possibly shied away from them. in June 2007. ABX indexes provide an indicative measure of the value of MBS. The index is set at 100 on 1 January 2007 for all ratings. 2008). A few months later. rating agencies were very explicit in reassuring investors that the rating of structured securities was directly comparable with the rating of bonds. By 2006. In this way the issuers of structured products and the rating agencies became very much dependent on each other.Credit Ratings Failures: Causes and Policy Options Figure 1 Value of MBS securities as implied by the ABX indexes Notes: Each ABX index is based on a basket of 20 credit default swaps. as they are based on the price of credit default swaps offering protection against the default of baskets of subprime MBS of different ratings. as UBS shut down its internal 133 . This led to a massive repackaging of risks into a vast quantity of newly issued AAArated securities: according to Fitch (2007). 60 percent of all global structured products were AAA-rated. Source: Brunnermeier (2008). 44 percent of Moody's reported revenue came from rating structured finance products.
2 24.000 $11.0 1.000 $7.0% and 10.000 $6.4 Credit Rating S&P Moody's AAA AAA AAA AAA AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB NR Aaa Aaa Aaa Aaa Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 NR Coupon rate 1-month LIBOR + 0. Dillon Read. 38.35% 0. The SPV funded the purchase of this loan through the issue of asset-backed securities (listed in Table 2). Prospectuses contain several summary statistics on the underlying pool of loans.000 $14.7 1.000 $8.0 3. The average mortgage 134 . 90. As the crisis worsened.00% 2.4% have a FICO score below 600.24% 0.649.9 1.2 1. The sale to the public required the publication of a prospectus.9% between 600 and 660.000 $13.000 $35.000 $214.000 $42.7% above 660. 98.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Table 2 Example of REMBS: GSAMP-Trust 2006-NC2 Tranche description Class Notional A-1 A-2A A-2B A-2C A-2D M-1 M-2 M-3 M-4 M-5 M-6 M-7 M-8 M-9 B-1 B-2 X $239. originating $51.15% 0.000 $12.998. The arranger of the deal is Goldman Sachs who bought the portfolio from the originator and sold it to a SPV named GSAMP-Trust 2006-NC2.32% 0.50% 2.995 Width % of total 27.7 1.2 0. SEC-filed prospectus for GSAMP 2006-NC2 hedge fund.019.900. The originator of the underlying loans is New Capital Financial.748.37% 0. All but tranche X (the riskiest one) were rated and sold to the public.30% 0.7 11. The average borrower in the pool has a FICO score of 626: 31. we learn that 88. 51. it is best considering a real example of a subprime MBS.340.5% are secured by residences in California and Florida.052.7% are first-lien (that is. It later filed for bankruptcy on 2 April 2007.4% of the mortgaged properties are single-family homes. the two dominant states in this securitization.15% 0.000 $28.000 $102.7% are for first homes.7 1.949 subprime loans for an aggregate principal of $881 million.864.663.2% of the loans have adjustable rate (the remaining have a fixed rate).618. and 16.000 $14. It is interesting to notice that the first 5 tranches representing almost 80% of the total were AAA rated.700.545. 73.07% 0.90% 1.4 1.341.090. the indexes never recovered and kept declining across all ratings. Source: Ashcraft and Schuermann (2008).815.000 $99.09% 0. after suffering about $125 million of subprime-related losses.3 4.000 $16.170.9 4.46% 0.50% .6 1. respectively.8 0.31% 0. the first mortgage on the property).6 billion in mortgage loans in 2006. From the prospectus of GSAMP-Trust 2006-NC2.3 11.986. To understand the way in which securitization works and could be reformed.05% 2. which is a document of 555 pages deposited at the Securities and Exchange Commission (SEC) on 31 March 2006. The special-purpose vehicle shown in Table 2 is called GSAMP-Trust 2006-NC2 and owns 3.000 $12. at the time the second largest subprime lender in the US.
and contains a list of disclaimers. Mukherjee. and local laws. the presence of title and hazard insurance.78%. 28. and provide them to clients who want to perform prepayment and default benchmarking analysis on their mortgage asset holdings. Seru and Vig (2008) show that among loans with similar observable characteristics those that are more likely to be securitized (because their FICO score is just above the 620 cutoff) are more likely to default than those that are less likely to be securitized (because their FICO score is just below 135 . and 9. the provide information about income and assets of the applicants. statement that the lender did not encourage or require the borrower to select a higher cost loan product intended for less creditworthy borrowers when they qualified for a more standard loan product). This information might have been very important to help investors to assess to value of MBS securities because securitization of subprime loans generates a clear moral hazard problem. The ratio of total debt service of the borrower to gross income is 41. As stated on the website of McDash Analytics. no information is available on the stake retained by originators and arrangers and on their subsequent trades. compliance of the mortgages with federal. that is. the valuation of these securities because very complicated and information about the underlying securities became very important but was not available in the prospectus and in the yearly reports produced by the SVPs.Credit Ratings Failures: Causes and Policy Options loan in the pool has a LTV of 80. Second.1% have a LTV of 80% or lower. why should they spend their money to replicate what rating agencies were (supposed to be) doing for free? Third. However. First. Valuing these risks was of limited importance when house prices were rising and defaults were few. it is entirely made of summary statistics. As loans are sold to the market.3% between 90% and 100%. Loan Performance's securities databases are the industry's largest and most comprehensive: they include loan-level data on more than 90% of the market for MBS securities. the arranger (Goldman Sachs). the underwriting guidelines. which may be critical to assess the risk of default of the portfolio and its tranches. while the remaining ones have no information about the income or assets of the applicants. these companies "collect loan level data directly from servicers into an anonymous database. originators have less incentive to collect the soft information that is needed to screen the applicants.6% between 80% and 90%. most investors did not bother to use them to assess the risks of their investment decisions (and check the quality of the credit ratings) until the crisis hit them. as only 52% of the loans have full documentation. Keys. the servicer (Ocweb). the data provided in the prospectus is not enough to help pricing or detect default. detailed information on the pool of underlying securities is available through data providers like Loan Performance and McDash Analytics. the absence of any delinquencies or defaults in the pool. But as house prices stopped rising and the number of defaults started increasing. In fact. state. distribute the cleansed data. After all. At this point. the securities administrator (Wells Fargo). Hence.34%: 62. it is worth making three observations on the quality of the information available to investors. this information is not available for all borrowers. which deliver information on the average claim but not on the individual loans in the portfolio. reps and warranties (for instance." The catch is that the subscription to these datasets is very expensive (over $1 million per year) and a lot of skills are required to analyze this data. disclosure of fees and points to the borrower. The rest of the document describes the originator (New Capital Financial). The above information is contained in 20 pages.
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
620). This effect is there only for loans with low or no documentation, suggesting that securitization reduces the incentives to collect soft information. If so, holdings and trades of originators and arrangers would signal the quality of the underlying pool of loans, and thus provide very valuable information for investors.
3. Conflict of interest and rating inflation
As noted by Partnoy (2006), among all "financial gatekeepers" CRAs are those who face the most serious conflicts of interest. This is due to a combination of factors. First, differently from analysts (but not from auditors), since the 1970s they are paid by the issuers whose instruments they rate. This change in practice came at the same time as the approval of a body of U.S. regulations that depend exclusively on credit ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs), a status until recently awarded only to Moody's, Standard & Poor's, and Fitch.2 Being paid by the issuers creates an obvious incentive for rating agencies to distort ratings so as to please their clients, and win further business from them. Second, unlike other gatekeepers, CRAs are allowed to sell ancillary services to the clients whose instruments they rate, in particular pre-rating assessments and corporate consulting. For instance, an issuer can ask a rating agency how it would rate a financial instrument with certain characteristics, and even ask how these should be modified to (just) obtain a certain rating. This type of activity facilitates rating shopping, that is, it allows an issuer to identify the rating agency that would provide the most favourable rating to its financial instruments, a point highlighted by Bolton et al. (2008), Skreta and Veldkamp (2008) and Spatt, Sangiorgi and Sokobin (2008). In particular, Bolton et al. (2008) show that precisely due to credit shopping the conflict of interest is exacerbated under duopoly compared to monopoly.3 That competition has undesirable effects in this situation is also confirmed by the evidence in Becker and Milbourn (2008), who show that the entry by Fitch has been associated with greater ratings inflation. Of course, for the conflict of interest to result in rating shopping it must be the case that there are some naïve investors who can be gullied by the inflated ratings, an element present both in Bolton et al. (2008) and in Skreta and Veldkamp (2008), or by regulations that induce the issuer to strive for the highest possible rating, as in Spatt et al. (2008). Importantly, regulation does provide such inducement, as pension funds, banks, investment funds and insurance companies are all subject to regulation based on ratings, and the scope of this regulation has greatly expanded over time. For
2 Since 2003, the number of the NSSRO has risen to ten: between 2003 and 2005, the SEC designated two new NSSRO, and pursuant to the passage of the Credit Rating Agency Reform Act in 2006 by the U.S. Congress it designated five more - two Japanese ones and three small U.S. ones. 3 In their model, there are naïve investors who believe the credit rating agencies' stated ratings. The issuers of commercial paper will never buy a bad rating, so credit agencies have an incentive to overstate the quality of any given issuance if the reputation costs (i.e. future lost profits) are low enough or the share of naïve investors large enough. An increase in the number of credit agencies, i.e. more competition, makes investors actually worse off as it gives issuers more opportunity to shop around for a good rating.
Credit Ratings Failures: Causes and Policy Options
instance, since 1989 U.S. pension funds are allowed to invest in highly rated assetbacked and mortgage-backed securities. The minimum capital requirements of banks, insurance companies and brokerage companies are also affected by the credit ratings of the assets that they hold. Therefore, regulation per se has been an increasing source of demand for high ratings by financial institutions. Thirdly, ratings agencies are largely immune to civil and criminal liability for malfeasance, because according to several U.S. court decisions they are to be considered as "journalists" and therefore their ratings are opinions protected by the First Amendment (freedom of speech). In contrast, after the Sarbanes-Oxley Act auditors and corporate boards face new rules regarding conflicts of interest, and financial analysts at investment banks are subject to restrictions on their activity and compensation. Therefore, for CRAs regulators have made much less of an effort to mitigate the conflict of interest than for other financial gatekeepers. These considerations suggest that the inflation in credit ratings might have been exacerbated (i) by the regulatory implications of ratings due to the NRSRO status, which confers an intrinsic value to ratings over and above their true ability to measure risk, (ii) by the presence of naïve investors, whose number may have increased with the popularization of finance in recent years, and ironically (iii) by the increase in competition associated with the entry of a third NRSRO (Fitch). But these considerations can still not explain why the spectacular failure of ratings occurred in conjunction to structured debt securities and not (at least not on the same scale) until CRAs confined themselves to evaluating the default risk of corporate bonds, which for a long time was their main activity. To understand this, it is important to realize that the shift from corporate debt to structured debt securities increased tremendously the gap between the complexity of the instrument being rated and the coarseness of ratings.
3.1 Why complex securities and coarse ratings exacerbate rating inflation
The complexity of structured debt securities greatly expands the scope and incentive of rating agencies to collude with issuers, if ratings remain relatively coarse - e.g., if they are based on a few discrete classes such as AAA, AA, A, BBB, etc., rather than on a continuous scale. The complexity of structured debt securities arises from the fact that these are portfolios of assets, often numerous and highly heterogeneous in their risk and return characteristics. The extent to which the risk of these assets is correlated is very important to determine the sensitivity of structured debt securities to aggregate risk, as underlined by Coval, Jurek and Stafford (2008). In addition, for MBS securities the risk of the underlying mortgage loans stems from two quite different sources: prepayment risk, which materializes when borrowers find early repayment worthwhile because of the improved refinancing conditions, and default risk, which instead occurs when interest costs escalate, housing prices decline, or there are adverse shocks to the borrowers' employment or income. The socio-economic and geographic composition of the underlying loan portfolio determines the exposure of the MBS to each of these risks. Complexity is further increased by "tranching", which implies that the interest and principal paid by the pool of underlying assets are distributed to the holders of the various tranches in a pre-specified way according to a "waterfall" scheme, that is, a
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
system of seniority. The scheme is such that the "junior" tranche is the first to absorb losses from the underlying collateral loans, and when it becomes worthless the "mezzanine tranche" starts absorbing further losses, with the senior tranche (typically AAA-rated) being the most protected against default risk. The issuer of a MBS or of a CDO solicits a rating from a CRA - possibly after shopping, as already explained above - for the security as such if it is not tranched, or otherwise separately for each tranche. Since each ratings class corresponds to a range of possible values of credit risk, the CRA may provide a pre-rating assessment to the issuer, explaining which rating the security would obtain depending on different potential structures of the underlying portfolio of assets. This allows the issuer to choose the portfolio structure that just enables the MBS or the CDO to be, for instance, AAA-rated. Therefore, AAA-rated structured debt issues will end up having not the rating corresponding to the average AAA-rated corporate bond but rather to the marginal one, implying that they are correspondingly riskier. The same "trick" could be applied to the rating of tranches, in which case the issuer can adjust not only the composition of the underlying portfolio but also the details of the "waterfall" scheme of seniority between tranches. This may go a long way towards understanding the true meaning of the very large "credit enhancement" achieved by structured debt issuers relative to the credit risk of the underlying portfolio. Indeed, Bemmelech and Dlugosz (2008) find, using data on 3,912 tranches of CDOs, that "while the credit rating of the majority of the tranches is AAA, the average credit rating of the collateral is B+" and observe that the CDOs were structured according to a very uniform pattern - not only in their tranche structure but also in the composition of the underlying portfolio. They suggest that this uniformity may be explained by CRAs helping issuers to structure their CDOs so as to just fit their requirements to achieve an AAA rating. In support of this interpretation, they note: "Anecdotal evidence suggests that the S&P rating model was indeed known to CDO issuers and was provided to them by the rating agency". For instance, by making its CDO Evaluator software available via its web site, S&P allowed issuers "to simulate different scenarios of expected default given the characteristics of the collateral they have chosen. The CDO Evaluator is an optimization tool that enables issuers to achieve the highest possible credit rating at the lowest possible cost." This is reflected even in the wording that S&P uses to define excess collateral: "what percentage of assets notional needs to be eliminated (added) in order for the transaction to provide just enough support at a given rating level" (p. 22). Of course, if investors were all sufficiently sophisticated, they should take this behaviour by rating agencies into account, that is, they should recognize that an AAA-rated CDO is riskier than an AAA-rated corporate bond, so that the CDO would be priced at a discount relative to the bond. This, however, will not occur if many investors are so naïve as to blindly use ratings to assess the riskiness of claims, as argued by Brennan et al. (2008). To support this claim, they quote the statement by the SEC that "certain investors assumed the risk characteristics for structured finance products, particularly highly rated instruments, were the same as for other types of similarly rated instruments", and that "some investors may not have performed internal risk analysis on structured finance products before purchasing them" (Federal Register, Vol. 73, No. 123 page 36235, June 25, 2008). Indeed, precisely on this basis the SEC later recognized the need for differentiated ratings for structured products
rather than simply their probability of default. a fact that may contribute to account for the massive failure of credit ratings of structured debt in the current recession. Moody's ratings reflect its assessment of the expected default loss.Credit Ratings Failures: Causes and Policy Options and corporate bonds. First. and a 5 percent correlation if they are from different sectors (Bemmelech and Dlugosz. Indeed he interprets this as evidence that "some investors might base their pricing decisions almost exclusively on ratings" 5 Well before the crisis. that is. 2008). which happens to be precisely one of the weakest spots of the methodology commonly used by credit agencies: for instance. the default probability captures only one dimension of default risk: it does not indicate the magnitude of the "loss given default". 3) Clearly it was not! 139 . which is crucial to assess the security's or tranche's risk.5 A proper assessment of the risk of such a security would in fact require also information regarding the covariance between default losses and the marginal utility of consumption (that is. S&P simply assume two corporate bonds to have a 15 percent correlation if they are in the same sector. in tranched CDOs. But default correlations are clearly much higher in economic downturns than in expansions.2 Why rating coarseness supported the expansion of the structured debt market The previous section only considered one sense in which ratings can be regarded as coarse. even this is not sufficient to assess the risk of a structured debt security. the distribution of risk across the various tranches is very sensitive to the assumptions made by the rating agency about the correlation structure of defaults in the underlying portfolio. their discreteness (if ratings were continuous. Instead. irrespective of the state of the aggregate economy. Firla-Cuchra (2005) documents that ratings explain between 70 and 80 percent of launch spreads on structured bonds in Europe. that is. But in reality there are several other dimensions in which existing ratings are coarse. Indeed. At another level. Of course. (2008) show that mispricing arises even if the valuation of structured debt securities is based on ratings that assess their expected default loss. Brennan et al. These authors study the mispricing that arises if the rating only assesses the probability of default but fails to indicate whether default is likely to occur in high-marginal utility states. the ratings released by S&P and Fitch reflect their assessments of the default probability of the corresponding security or tranche. 23). the Committee on the Global Financial System (2005) already warned that "the one-dimensional nature of credit ratings based on expected loss or probability of default is not an adequate metric to fully gauge the riskiness of these instruments. its "beta"). as pointed out by Coval et al. (2008). Also the Committee on the Global Financial System (2005) indicates that a number of the investors interviewed by their Working Committee "claim to rely almost exclusively on the rating agencies' pre-sale reports and rating opinions for information on deal specifics and performance" (p. rating agencies could obviously not play on the difference between the marginal and average credit risk within a given rating class). the coarseness of ratings reflects the limited amount of detailed 4 Consistently with this.4 3. This needs to be understood by market participants" (p. Though better as a measure of default risk. the product of the probability of default and the loss given default. They also point out that.
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
loan-level data that CRAs used in their models to evaluate the risk of the underlying portfolio. As late as 2007, Moody's reported that it was about to request more detailed loan-level data from issuers, for the first time since 2002, including even data that itself considered to be "primary", such as a borrower's debt-to-income (DTI) level, the appraisal type, and the identity of the lender that originated the loan. As noted by Mason and Rosner (2007), it is surprising that these data would not have been collected by them before, considering that "traditionally the loan to value ratio (LTV), FICO score and the borrowers' DTI are the three most significant measures of credit risk on a mortgage" (p. 24). At least as surprising is that the models used by CRAs neglected the identity of the lender that originated the loan, considering that this piece of information turns out to be highly significant in predicting the subsequent rating downgrades of the same asset-backed securities, as documented by Johnson, FaltinTraeger and Mayer (2009) in an empirical study of S&P ratings. Presumably, to effectively convey all this information about the risk of MBSs, CDOs and their tranches, the rating agencies would have had to produce multidimensional ratings, and also report statistics on the sensitivity of their ratings to the most crucial assumptions of their models, such as those on correlation between the defaults of the assets in the underlying portfolio. This, however, would have probably made their ratings much harder to understand and interpret for many investors, and would have limited the issuance of structured debt, contradicting the role that rating agencies saw for themselves in the development of this market. Indeed, as wittily pointed out by Partnoy (2006), "with respect to these new instruments, the agencies have become more like 'gateopeners' than gatekeepers; in particular, their rating methodologies for collateralized debt obligations (CDOs) have created and sustained that multi-trillion-dollar market" (p. 60). This drawback of disclosure is captured by the model of Pagano and Volpin (2008), where issuers may not wish to release complex information about their structured bonds, because only few potential buyers are sophisticated enough to understand the pricing implications of such information. Therefore, releasing it would create a winner's curse problem for unsophisticated investors, and would limit the size and liquidity of their primary market. The point that disclosing information about securitized assets may hinder their liquidity is also made intuitively by Woodward (2003) and Holmstrom (2008). The latter draws a parallel with the sale of wholesale diamonds, which de Beers sells in pre-arranged packets at non-negotiable prices, and argues that this selling method is aimed at eliminating the adverse selection costs that would arise if buyers were allowed to negotiate a price contingent on the packets' content.6 This prediction is supported by the suppression of mortgage loan location information in the securitizations carried out by the U.S. public agencies. In 1970, when the Government National Mortgage Association (GNMA or Ginnie Mae) pioneered the securitization of loans insured by the Federal Housing Administration (FHA), its management declared that no information other than the coupon rate would be dis6 Milgrom and Roberts (1992, pages 75-76), who describe this example in detail, suggest however a somewhat different rationale for de Beer's selling method: they see it as intended to save bargaining costs, that is, the direct costs of haggling over each diamond and the attendant information costs for both the buyers and the seller.
Credit Ratings Failures: Causes and Policy Options
Figure 2 Current Coupon Yield Differential between Fannie Mae 30 Year MBS and Freddie Mac 30 Year Gold PC
Source: Data kindly provided by Susan Woodward, Sand Hill Econometrics.
closed about the underlying loan pools. The reason that they gave for this decision was that prepayments, though mainly related to coupon, are also to some extent related to the geographical composition of the loan pool. GNMA suppresses the information about geography, and thus reduced investors' ability to evaluate prepayment risk (the only relevant risk in this case, as these loans are insured against default). This policy was inherited by the other two U.S. public agencies that securitize mortgage loans and guarantee them against default risk: the Federal Home Loan Mortgage Corporation (FHLMC, widely known as Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae). However, in the 1990s Freddie Mac gave in to pressure to reveal more information about its loan pools, and it regularly discloses geographical information about them. Thereafter, as shown in Figure 2, the Freddie Mac pools have traded at consistently higher yields than Fannie Mae's comparable loan pools over the 1998-2008 period, in spite of the fact that Freddie Mac's securities even pay a couple of days earlier (so they should pay lower yields). The differential has been 3.05 basis points over the whole decade, up to 4.8 basis points in the most recent and turbulent period (July 2007-October 2008).7 So here we have an example of almost identical securities, which differ mainly in the detail of price relevant information provided by the issuer: the market clearly values more the securities with less information, for which sophisticated investors can extract less trading and arbitrage profits at the expense of less sophisticated ones.8 But while suppressing price relevant information enhances liquidity in the primary market, it may reduce liquidity in the secondary market or even cause it to freeze. This is because the information undisclosed at the issue stage may still be uncovered by sophisticated investors later on, especially if it confers them the ability to earn
7 Both of these averages are significantly different from zero at the 5 percent confidence level. 8 We owe information and data about this example to Susan Woodward (Sand Hill Econometrics).
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
large rents in secondary market trading.9 So limiting transparency at the issue stage shifts the adverse selection problem onto the secondary market. In choosing the degree of rating transparency, issuers effectively face a trade-off between primary and secondary market liquidity. As shown by Pagano and Volpin (2008), the choice of transparency made by the issuers will depend precisely on the trade-off between primary market and secondary market liquidity: as just argued, coarse information enhances the first but endangers the second. The key parameters in this trade-off are the value that investors place on secondary market liquidity, as well the severity of the adverse selection problem in the primary market. If secondary market liquidity is very valuable and/or adverse selection would not greatly damage primary market liquidity, then issuers will choose ratings to be transparent and informative, even at the cost of reducing primary market liquidity. Conversely, if investors care little about secondary market liquidity and/or adverse selection would greatly impair primary market liquidity, then issuers will go for coarse and uninformative ratings. But the degree of ratings transparency chosen by issuers falls short of the socially optimal one whenever secondary market illiquidity is more costly for society at large than it is for issuers of securitized assets. This may be the case if, for instance, a secondary market freeze were to trigger a cumulative process of defaults and premature liquidation of assets in the economy, for instance because banks' interlocking debt and credit positions create a gridlock effect. Then the degree of ratings transparency that is optimal for society exceeds that chosen by issuers of structured bonds. This creates a rationale for regulation imposing a certain degree of transparency on issuers of these securities. Nevertheless, it must be recognized that such regulation will have a cost in terms of reduced liquidity or market size at the issue stage. In other words, imposing greater disclosure on the MBS market will most likely reduce its magnitude compared with the pre-crisis record, and will most likely induce investors to require higher yields even after market conditions will have gone back to normality, as exemplified by the Freddie Mac and Fannie Mae comparative experience.
4. Possible policy interventions
In the discussion above, we have identified rating inflation and coarse ratings as the main targets for policy interventions. The obvious solution to address them is to change the incentives of rating agencies and increase disclosure. But, what are the specific policy reforms to implement? In what follows we outline two possible courses of action. The first, which we regard as the preferred policy, is quite drastic, in that it requires not simply an adjustment of existing rules but a complete reorientation of regulation
9 That sophisticated investors engage in such activity is witnessed by the evidence collected by the Committee on the Global Financial System: "Interviews with large institutional investors in structured finance instruments suggest that they do not rely on ratings as the sole source of information for their investment decisions […] Indeed, the relatively coarse filter a summary rating provides is seen, by some, as an opportunity to trade finer distinctions of risk within a given rating band" (p. 3, emphasis added).
not issuers . as also underlined by Richardson and White (2009). If rating agencies tend to please issuers by inflating their credit ratings and/or by choosing excessively coarse ratings.1 Preferred policy (1) Credit rating companies should be paid by investors and not by issuers. it is crucial to eliminate (or at least reduce as far as possible) this conflict by addressing the issue of "who pays". But it is hard to imagine that such large investors may wield sufficient power as to distort the ratings of all the competing agencies. spanning from the sale of price and transaction data by trading platforms and newspapers to the sale of advice by financial analysts and of economic forecasts by econometric consultancies. A 10 While in most cases analysts are paid by investors ("sell-side analysts"). they may also end up affecting ratings . it will be essential to prevent indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. but is likely to be far less effective in addressing the problems illustrated in this paper. it is expected to require a considerable increase in an already hypertrophic regulation. in contrast with the preferred policy.10 It should be recognized that even this arrangement is not completely free from incentive problems. as indeed was the case before the 1970s. How would such a system work? Not too differently from the market for other forms of financial information. Kirk (2008) documents that paid-for analysts issue relatively less accurate forecasts and more optimistic recommendations than sell-side analysts.for instance. More importantly. and (ii) investors and rating agencies should be given free and complete access to all information about the portfolios underlying structured debt securities. 4. then the most appropriate solution is to have investors . and presumably other investors will try to patronize rating agencies that have shown no such tendency to shade their ratings so as to please their large customers. Furthermore. switching from the "issuer pays" to the "investors pay" model may be difficult to implement in practice in a situation where delegation by banking and securities regulations has conferred a tremendous power to a select group of rating agencies over issuers. Therefore. Since both rating inflation and the tendency to issue coarse ratings arise from the conflict of interest between rating agencies and investors. if some investors are large enough (or manage to set up cooperative arrangements to purchase ratings).Credit Ratings Failures: Causes and Policy Options according to two new guiding principles: (i) ratings should be paid by investors. they may try to induce CRAs to avoid or delay rating downgrades for securities in which they have invested heavily. Financial analysts are perhaps the most fitting comparison: their analysis and recommendations are either sold to investors on a standalone basis or are packaged together with financial services by large banks or securities companies. which we regard as a second-best one. which is consistent with the idea that the former are more exposed to a conflict of interest than the latter.pay them for their services. companies can also hire a feebased research firm to prepare one or many reports ("paid-for analysts"). The second policy. as well as about the design of their tranches. imposes milder changes to the current market model. 143 . Interestingly.
in July. It is also worth highlighting that imposing disclosure requirements on the issuers is far better than imposing them on the rating agencies themselves. Moreover. We believe that the disclosure of nothing less than the entire set of data available to the arrangers and servicers should be required. thereby providing healthy competition to CRAs. SEC (2008) indicates that CRAs should disclose all information used to determine ratings for structured products. But at least the market would be placed on safer foundations than it was at that time. This will weaken the unhealthy bond that now exists between issuers and CRAs. It is important to notice that this form of disclosure reduces both the risk of secondary market freezes (as all available information is given to all investors) and the possibility of collusion between issuer and rating agency. It should be clear from the discussion in Section 2 that currently prospectuses do not contain enough information to allow investor to assess the risk of default of a specific product and the change in risk characteristics over time. Although this policy would make CRAs more accountable to the public. S&P was so transparent about its CDO Evaluator Manual that issuers could predict perfectly the rating they would get. issuers will have less of an incentive to circumvent the "investors pay" principle. In fact. and tries to remedy the coarseness of ratings by prescribing a minimal informational detail to issuers and credit agencies. specialized information processors will enter and provide financial advice to investors. as was proposed by the Securities Exchange Commission. With these data. transparency about rating models could lead to greater collusion with issuers: as seen above. (2) Arrangers and servicers should disclose the complete data on the individual loans (or bonds) underlying the structured finance products. in comparison with the pre-crisis period. The information on individual loans currently available (for many but non for all securities) through expensive data providers like Loan Performance should become available for free to all investors. when the information becomes available on the market. 144 .Macroeconomic Stability and Financial Regulation: Key Issues for the G20 more direct (and consequential) way to deal with the problem would be to eliminate the many regulations that delegate powers to rating agencies: once the rents that these regulations confer to these agencies are gone. buyside investors may be able to form their own assessment of the risk characteristics of the product. but tries to restrain the conflict of interest with investors by limiting the way in which agencies contract with issuers and are paid by them. 4. it would also reduce their incentives to invest in improving their risk models. the policy being proposed here should be expected to reduce the price at which securitized assets can be sold at the issue stage and therefore the size of the market for structured debt securities. and thus structure deals so as to just get an AAA rating! As already highlighted in the previous section.2 Second-best policy This alternative policy retains the current principle that rating agencies are paid by issuers.
provide clearer information on the frequency of their updates. Restricting the compensation contracts for rating agencies may instead be less effective. beside estimates of the probability of default and of the loss given default. Even if issuers must pay an upfront fee and cannot engage in explicit rating shopping. and especially reduce the coarseness of their ratings by producing additional measures of the risk properties of the structured finance products. One may add yet more indications: for instance. and better documentation about their models and the sensitivity of ratings to the assumptions made in their models. This is the policy suggested by the Committee on the Global Financial System (2008). this requirement needs to be supplemented with the ban of rating shopping for it to be effective. that the agency should provide statistics that measure the systematic risk of the loan pool and of individual tranches. for instance because they know the models that each agency is going to use to evaluate their securities. (2008). Finally. In the same spirit. which recommends that CRAs present their ratings so as to facilitate comparison within and across classes of different structured finance products." named after NY Attorney General Andrew Cuomo. this prescriptive approach places considerable burdens and risks on the shoulders of regulators. the Financial Economists Roundtable (2008) suggested that ratings should be complemented by an estimate of their margin of error. implicit collusion may still be sustainable: they may systematically patronize the rating agencies that offer them the best ratings. However. for instance with new ways of designing structured debt securities. It requires that regulator indentifies which pieces of information and which statistics rating agencies should provide. As a result. it may induce investors to forgo once more an independent evaluation of the risk characteristics of these securities (for instance by turning to additional data sources or other information processors). the conflict of interest may persist. It also exposes regulation to the danger of failing to keep pace with financial innovation.Credit Ratings Failures: Causes and Policy Options (1) Credit rating companies should be paid an upfront fee irrespective of the rating issued and credit shopping (and paid advice by rating agencies to issuers) should be banned. As noted by Bolton et al. The requirement of an upfront fee is the so-called "Cuomo plan. trusting that the rating agency has provided all the information required by regulators. (2) Enhance transparency by determining the information that issuers and rating agencies must disseminate to the investing public. some of which may even be induced by regulation itself. 145 . 5. This rule would require mandating a more complete format for the information to be disseminated by rating agencies. which can be very costly in the presence of very diverse financial products. Conclusion What has been the role of CRAs in the subprime crisis? This paper focus on two aspects that contributed to the boom and bust of the market for asset-backed securities: rating inflation and coarse information disclosure. SEC (2008) goes some way in the direction of banning the rating shopping. Its plan is to prohibit CRAs to act as both a rater and a paid advisor for a tranched securitization.
market participants realized that the detailed information required to identify "toxic assets" in the maze of structured debt securities had simply been lost in the process of securitization. Adam B. Patrick. Becker. 7. forthcoming. Brennan." unpublished manuscript. by making them palatable also to investors who could not easily process more complex information than coarse ratings. and Jenifer Dlugosz. Markus K. 2008. 8 February. Bolton. After house prices stopped rising and defaults started on subprime mortgages started to increase. and sharpen the investors' awareness that they must not place blind faith in ratings alone. "The Credit Rating Game." unpublished manuscript. and Til Schuermann. Bo. 2009. What can be done to mitigate these problems in the future? Our preferred policy option is to move towards a system where credit ratings are paid by investors." Bank for International Settlements. Lloyd. Blankfein. 146 . Committee on the Global Financial System. "Do not destroy the essential catalyst of risk. which can still prove a valuable tool to enlarge financial markets and transfer risk from lenders to investors." Federal Reserve Bank of New York Staff Report no. 2008. so that buy-side investors may feed them into their own models so as to assess their (changing) risk characteristics. Michael J." Journal of Economic Perspectives. 318. and Joel Shapiro. Julia Hein and Ser-Huang Poon.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Ratings inflation coupled with naïve investment decisions led to a massive mispricing of risk. Xavier Freixas." unpublished manuscript. "The Alchemy of CDO Ratings.. "Reputation and Competition: Evidence from the Credit Rating Industry. "The Role of Ratings in Structured Finance: Issues and Implications. 2008. 2005.. and therefore their interest is more aligned with the issuers than with the investing public. These reforms will also create opportunities for specialized information processors providing healthy competition to CRAs. and Todd Milbourn. they will restore investors' confidence in the securitization process. The coarseness of ratings is one of the main reasons for the illiquidity that has plagued securities markets since the crisis broke out. Benmelech. Efraim. 2008. Brunnermeier. 2008. and that ratings provided an insufficient guidance to identify them. "Tranching and Rating. whose correction has been the trigger of the crisis. 2008.." unpublished manuscript. References Ashcraft. The likely motive for the inflation of credit ratings is an incentive problem: CRAs are paid by the issuers of the securities being rated." Financial Times. and where arrangers and servicers disclose for free the complete data on the individual loans underlying the structured finance products. "Deciphering the 2007-08 Liquidity and Credit Crunch. January. Although these reforms will also limit the liquidity and size of the primary market for structured finance securities in comparison with the pre-crisis period. We argue that the reason why coarse (and uninformative) ratings had been produced was to expand the primary market of these securities. "Understanding the Securitization of Subprime Mortgage Credit.
Bengt. "Credit-Rating Shopping. International Monetary Fund. "Re-Examining the Role of Rating Agencies: Lesson from Structured Finance.C. Frank. "Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies. 2009." CEPR Discussion Paper no. New York University Stern School of Business." unpublished manuscript. Jurek. University of Oxford. Global Financial Stability Report. Jakub W. Coval. John Wiley & Sons. "The Panic of 2007. 1992." 7 April. in Restoring Financial Stability: How to Repair a Failed System. Partnoy. Oliver Faltin-Traeger and Christopher Mayer. "How and Why Credit Rating Agencies Are Not Like Other Gatekeepers. "Did Securization Lead to Lax Screening? Evidence from Subprime Loans.com/abstract=1265709. New Jersey: Prentice Hall. Tanmoy Mukherjee. Marco. Chester. Matthew. Francesco Sangiorgi and Jonathan Sokobin. Holmstrom. Economics. 2007. 2008. "Can Companies Buy Credible Analyst Research?" working paper available at SSRN: http://ssrn. Keys. 2008." unpublished manuscript. "Explaining Launch Spreads on Structured Bonds" Discussion Paper. 147 . 2008. Joseph R. 7105. Financial Economists Roundtable." unpublished manuscript. 2007." work in progress. 2008. Gorton. Security Exchange Commission. Spatt.. Bank for International Settlements. Litan editors. 32. "Securitization. July. Mason." Chapter 3 in Financial Gatekeepers: Can they Protect Investors?. 2006. Kirk. 2008. Firla-Cuchra Maciej T. 2009. "Rating Shopping and Asset Complexity: A theory of Ratings Inflation. 2008. Nomura Institute of Capital Markets Research: Tokyo. Milgrom Paul.Credit Ratings Failures: Causes and Policy Options Committee on the Global Financial System.. Columbia Business School." unpublished manuscript. Inside the Ratings: What Credit Ratings Mean. and Vikrant Vig." unpublished manuscript. "Ratings in Structured Finance: What Went Wrong and What Can Be Done to Address Shortcomings?" CGFS Paper No. December. Richardson. Englewood Cliffs. Benjamin. 2008. and Joshua Rosner. Johnson. and Lawrence White. Washington. and John Roberts." unpublished manuscript. 2008. Selection and the Equilibrium Structure of Ratings. Financial Stability Forum. forthcoming. Organization and Management. 2008. Vasiliki and Laura Veldkamp." July. "Rating Agencies: More Regulation or Less?". and Paolo Volpin." unpublished manuscript. Gary. 2008. "Discussion of 'The Panic of 2007' by Gary Gorton. Amit Seru. Kathleen. April. 2008. "Securitizers and Bond Performance. Skreta." unpublished manuscript. Pagano. Chapter 3 in Viral Acharya and Matthew Richardson editors. 2008. 2005. Joshua D. February. Yasuyuki Fuchita and Robert E. "Reforming the Role of SROs in the Securitization Process. Marcus. "Report on Enhancing Market and Institutional Resilience. Fitch Ratings. and Erik Stafford. Transparency. "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions. and Brooking Institution Press: Washington. and Liquidity. D.. 2008.
2003. 2007." Wall Street Journal." Ratings Direct Research. 148 .Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Standard & Poor's. "Principles-Based Rating Methodology for Global Structured Finance Securities. Woodward. Susan. 2 January. "Is More Information Better?.
The Treatment of Distressed Banks
Mathias Dewatripont and Jean-Charles Rochet Solvay Brussels School of Economics and Management, ECARES, Université Libre de Bruxelles and CEPR; Toulouse School of Economics and CEPR
Introduction and recommendations
The current financial crisis is extremely severe. It is also multidimensional, and it has already led to many analyses and policy-oriented documents.1 This contribution is academic, and therefore stresses principles rather than detailed implementation. Moreover, our focus is on the treatment of distressed banks, a key element of the regulatory architecture which has however attracted insufficient attention so far. The treatment of distressed banks can however not be treated independently of other dimensions of this architecture, which some of our recommendations will therefore indirectly address. This paper has been prepared ahead of the April 2009 G20 meeting meant to deal with the world financial architecture. As far as the treatment of distressed banks is concerned, we can think of G20 actions as pursuing two potential objectives:
1. The harmonization of the treatment of distressed banks across countries in order to ensure a level-playing field while promoting global financial stability; it is useful in this respect to distinguish individual bank distress and systemic distress. 2. The promotion of cooperation between countries in the treatment of crossborder distressed banks.
This paper discusses these issues in turn. A key idea that underlies the analysis is that the current regulatory system is fragile because it has not dealt in an explicit fashion with the harmonization of the treatment of distressed banks. This stands in contrast with the efforts in terms of harmonization of capital ratios under Basel I and II. Of course, this harmonization has several significant flaws which have to be addressed too. But the idea that we need harmonized capital ratios is a sound one, and it should be extended to the treatment of distressed banks. This is very important because of 'political economy' considerations: whether in good or bad times, supervisors always face pressure from lobbies and from politicians that undermine the proper functioning and stability of the financial system. There is therefore a cost in leaving things vaguely specified or unspecified and therefore at the discretion of supervisors. They
Authors' note: We thank Janet Mitchell and Peter Praet for useful comments
1 See for example Brunnermeier et al. (2009), Tirole (2008) or the Group of Thirty Report (2009) for excellent wide-ranging analyses.
Macroeconomic Stability and Financial Regulation: Key Issues for the G20
need to be protected ex ante through a system of transparent rules. Of course, there is always a potential cost of such rules in terms of loss of flexibility. However, the current system has clearly erred in the other direction. The paper offers a number of recommendations to try and move closer to a rule-based system that maintains enough flexibility. Specifically, our set of recommendations is as follows: First, as far as dealing with individual banks is concerned:
• A harmonized special bankruptcy regime should be established for banks involving 'prompt corrective action', i.e. giving to the supervisory agency powers to limit the freedom of bank managers (and possibly remove them) and shareholders (and possibly expropriate them) before the bank is technically insolvent. • Supervisors should have the independence, resources and expertise to fulfill their mission properly. If public authorities are unwilling to raise supervisory budgets, this pleads, ceteris paribus, for a simplification of the regulatory regime. Basel II did go in the wrong direction here, with big banks being allowed to compute risks themselves through complex internal models, a task where they had a clear conflict of interest and which proved too difficult for proper oversight by supervisors. • In terms of the structure of regulation, one should not allow banks to 'play one regulator against the other' (as has been the case in the US with OCC and OTS). Beyond this, while consolidated supervision – bundling ex-ante monitoring and ex-post intervention – allows for cost savings and simpler coordination, it may reduce accountability. Guarding against this can be achieved through reduced discretion in terms of intervention by the supervisors (as in the US FDICIA). • One should think of the signals triggering intervention as admittedly crude indicators of the risk of potential problems. Therefore, simplicity is crucial, because it reduces manipulability and enhances transparency and credibility. • A single capital requirement, even when it is very complex, is not enough to limit risk taking by banks. Therefore, a battery of indicators have to be designed by regulators, in order to provide simple signals of the various dimensions of banking risks (including liquidity and transformation risks, risks of large losses, exposure to macroeconomic shocks, …) and used simultaneously to determine whether supervisory corrective action is needed. • Other dimensions of regulatory control are to be explored to explicitly curb the incentives of bank managers for excessive risk taking: top managers' remunerations, shareholder representation, and internal risk management systems. This cannot remain as vaguely defined as in pillar 2 of Basel II.
Second, as far as banking crises are concerned:
• Public authorities should expect crises to happen. They should put in place a mechanism that allows a crisis to be formally declared (an event which will allow the release of public funds). This means formalizing ex ante cooperation between the relevant actors (Central Bank, supervisor, Treasury) with this contingency in mind. • Ex-post crisis management should keep in mind that undercapitalized banks do
The Treatment of Distressed Banks
not function well. One should go for 'real' recapitalization, even if it is costly. There are several options – temporary nationalization, insuring bank loans or parking toxic assets in bad banks – that are possible. The objective should be to get lending going again without delay by properly capitalized banks, without excessively burdening taxpayers.
• Under current regulation, maintaining adequate capitalization in bad times has procyclical effects. Avoiding this calls for introducing 'automatic stabilizers' into the regulatory system, such as higher capital ratios in good times, dynamic provisioning, capital insurance (privately or publicly provided), or procyclical deposit insurance premia.
Finally, as far as international cooperation in crisis management is concerned:
• In economic areas which are meant to be very integrated, like the EU, one should move towards a centralized supervisor and a centralized deposit insurer. • If one wants to keep integrating the world banking market, one should seriously consider partial centralization of supervision and deposit insurance at the world level. • Barring such centralization, it is important to foster best practices in establishing credible Memoranda of Understanding for cross-border banking crisis management between authorities that detail in particular the respective rights and obligations with respect to intervention thresholds and deposit insurance.
1. Reforming prudential policy for distressed banks
The regulatory/supervisory systems of most G-20 countries have been strongly influenced by the "Basel process", initiated in the 1980s by the Banking Committee on Banking Supervision (BCBS). The aims of this process were essentially two: promoting the safety and soundness of the international banking system and guaranteeing a "level playing field" by eliminating competitive distortions due to the implicit support provided by some governments to their domestic banks. Even if the Basel process has clearly contributed to the harmonization both of risk management practices by banks and regulatory requirements across countries2, and was still undergoing important reforms (Basel II) when the crisis hit, it was insufficient to contain the crisis. We suggest that Basel II should be reformed in depth, and that the objectives of regulatory/supervisory systems should be significantly reassessed.
1.1 Implementing a special bankruptcy regime for banks
Several episodes of the crisis have revealed that banking authorities of many G-20 countries did not have sufficient legal powers to treat banking distress in a timely and efficient way. Moreover the discretion given to domestic supervisors by Basel II's pil2 The Basel accords were initially designed for internationally active banks but they have been adopted, after some modifications, by the domestic regulators of many countries.
but the bottom three categories face more and more severe restrictions on actions (e. adequately capitalized (> 8%)." A good place to start harmonizing bank insolvency procedures would be the US system put in place in 1991 under FDICIA. as put eloquently by Goodhart (2008. Therefore. Banks are not ordinary firms: partly thanks to deposit insurance.2 Putting in place strong and independent supervisory agencies A necessary complement to the reform of bankruptcy law for banks is the protection of supervisors from pressure by politicians and lobbies. The first two categories face no restrictions. and. This system has the advantage of starting to address a crisis gradually. or 'prompt corrective action' (note that Brazil put in place a system with similar features and worth looking at). Our first recommendation is therefore that: • A harmonized special bankruptcy regime should be established for banks involving PCA. and. whatever the compensation arrangement for shareholders it is bound to generate…a claim that they were robbed of their property…So the key for closure. acquisitions.3 In the absence of timely supervisory action. and there are also theoretical analyses in its favor (see for example Freixas and Parigi. Generally speaking. 1. who act under political and legal constraints that differ a lot across countries. their shareholders and managers still have considerable scope for "gambling for resurrection". in the extreme. Therefore. is a central issue. asset growth. i. which is centered around the important notion of PCA. undercapitalized (< 8%). see for example Dewatripont and Tirole (1994) for an overview of this episode. 2008). 152 . shareholders and managers still have an interest in continuing the bank's activity. and critically undercapitalized (< 2%).e. receivership). it is not really useful to harmonize regulatory requirements for banks if enforcement of these requirements is left to the discretion of domestic supervisors. and the treatment of shareholders. even under extreme solvency problems. page 353): "A key feature of any bank insolvency regime must involve some expropriation of shareholder rights. classifying banks in five categories depending on (various measures of) capital ratios: well capitalized (capital ratio > 10%). 3 This has been well-documented for example in the case of the US Savings and Loan crisis of the 1980's. since it exposed them to political pressure and threats of judicial recourse by the shareholders of distressed banks. dividend payments. 2001).Macroeconomic Stability and Financial Regulation: Key Issues for the G20 lar 2 revealed counterproductive in the management of the crisis. a first priority for restoring a level playing field for international banking and avoiding a race to the bottom in terms of enforcement of prudential policy is reforming and harmonizing bankruptcy laws for banks. The key idea is to allow the supervisor to intervene before things become too bad. giving to the supervisory agency powers to limit the freedom of bank managers (and possibly remove them) and shareholders (and possibly expropriate them) before the bank is technically insolvent. significantly capitalized (< 6%).g. typically increasing the ultimate damage to the deposit insurance fund and to the financial system as a whole. 1997. and Aggarwal and Jacques. There is broad agreement that PCA has had a beneficial effect (see for example Benston and Kaufman.
to under-regulation by the OTS. with big banks being allowed to compute risks themselves through complex internal models. it may reduce accountability.3. a task where they had a clear conflict of interest and which proved too difficult for proper oversight by supervisors. and several others. Our recommendations for the organization of supervision are that: • Supervisors should have the independence.e. Once again. resources and expertise to fulfill their mission properly. while consolidated supervision – bundling ex-ante monitoring and ex-post intervention – allows for cost savings and simpler coordination. note that there are various means of addressing the issue of political pressure and accountability. the ability for financial institutions to choose between two ex-ante supervisors – the OCC for banks and the OTS for savings and loan – an ability which has led.e. 1. The Northern Rock episodes.The Treatment of Distressed Banks This is only possible with a strong. endowing supervisors with a clear. independent.e. i. well-staffed and well-paid supervisor. A set of simple regulatory requirements. If public authorities are unwilling to raise supervisory budgets. even if it may allow for administrative cost savings. see also Dewatripont et al. complex capital ratio The Basel Committee on Banking Supervision (BCBS) has put too much emphasis on its Capital Adequacy Requirement. to keep them accountable. i. Basel II did go in the wrong direction here. Consolidated supervision can however in some cases have drawbacks. Moreover. focused mission can enhance their accountability. namely by using simple. • In terms of the structure of regulation. as explained in Box A. Beyond this. What is clearly undesirable is for example the US situation. the US system is attractive. 4 See Dewatripont and Tirole (1994) for a discussion. 5 See Wilson (1989). Guarding against this can be achieved through reduced discretion in terms of intervention by the supervisors (as in the US FDICIA). for a simplification of the regulatory regime. (1999) for an incentive-theoretic perspective. 153 . i.4 This creates a potential conflict of interest between ex-ante supervision and ex-post intervention. the FDIC. Indeed. rather than a single. as shown by evidence on the behavior of public agencies. one should not allow banks to 'play one regulator against the other' as has been the case in the US with OCC and OTS. ceteris paribus. Since early detection of bank distress is not always possible. And it is likely to be easier with consolidated supervision of all governmentinsured deposit taking institutions within each country. with its distinction between the institution in charge of ex-ante supervision (the OCC for banks and the OTS for savings and loans) and the institution in charge of dealing ex post with distressed banks. In this respect. this is an advantage of the PCA doctrine of the US FDICIA. publicly observable (and thus hard to manipulate) mandatory criteria for triggering regulatory intervention. the easier it is to evaluate how well they have performed. mainly due to the fact that its budget depended on the number and size of institutions under its supervision.5 the simpler their task. However. this pleads. supervisors might be tempted to hide a bank's problems in the hope that they might disappear and therefore not reveal their failure to identify these problems early enough.
that are very difficult to estimate). Instead. (2008) point out that in June 2007 (roughly three months before the depositors run started) its regulatory capital requirement (computed on the basis of Basel II risk weights and approved by the FSA) was slightly above £ 1.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Box A OTS: weak supervision in the US The Office of Thrift Supervision in the US has behaved as a comparatively weak and excessively tolerant regulator. These are business decisions that should normally be left to the assessment of banks' managers and administrators. Allowed an institution like Countrywide Financial to leave the banking regulator OCC to join its more permissive regulatory oversight. it is not the role of supervisors to decide on the level of capital. Allowed IndyMac Bank to backdate a capital injection in order to avoid sanctions and supervision. indicators for such future distress cannot be summarized by a single capital ratio. and too complicated to be verifiable by a third party (as it requires the calibration of several parameters. 9 See Rochet (2008) for a discussion. It is only when supervisors anticipate that a bank is likely to face distress in a near future (and therefore exert negative externalities on its depositors or on the financial system as a whole) that supervisors can and must intrude. This formula is simultaneously too simple to be a good predictor of credit losses (it assumes in particular a unique macroeconomic risk factor and normality of loss distributions). i. the idea that the capital buffers needed to cover credit risks should be computed by a complex regulatory formula fed by parameters delivered by banks' internal models has revealed disastrous.9 In any case. Allowed Washington Mutual to grow fast thanks to very aggressive 'predatory lending' practices. In particular. The Internal Risk Based approach to credit risk uses a regulatory formula based on a theoretical model (the Asymptotic Single Risk Factor model). including measures of liquidity risk. more than 15 times the regulatory requirement. with particular emphasis on pushing for deregulation rather than monitoring the institutions under its supervision. 154 . In the case of Northern Rock for example.e. 8 See Washington Post (2008a). even if very complex. which led them into bankruptcy. Blundell-Wignall et al.6 2.8 have shown that a solvent bank can rapidly become distressed for lack of liquidity and that transformation risk cannot be neglected. and more generally of the risk management strategies of all commercial banks. Similarly. As the crisis has shown. just to maintain the bank afloat.7 3. 6 See Washington Post (2008a). 7 See Washington Post (2008b). as well as exposures to macroeconomic shocks.5 billion. such as the probability of default and the loss given default. while British authorities ultimately had to inject around £ 23 billion. we believe that regulatory intervention should be triggered by a whole set of relatively simple (and publicly verifiable) indicators. it has: 1. and bilateral exposures to other banks or systemic institutions.
Indeed. In the same vein. together with other indicators. more important reason why the focus on the probabilities of failure of individual banks might have been inappropriate. it is therefore necessary to regulators to find ways to penalize or at least limit the externalities that large and complex banking organizations exert on these "core infrastructures". Anticipating (rationally) that public authorities are bound to intervene if these infrastructures are in danger. rather than absolute probability of failure. The Value at Risk is probably a good indicator for banks' shareholders who are protected by limited liability. which will have to be covered by depositors or more likely by the government. based on correlation with aggregate activity. Therefore. such as some form of control of bank managers' remunerations as well as the implementation of appropriate internal governance measures and adequate risk management systems are certainly much more adapted to curb risk taking incentives by bankers. the main reason for public intervention by Central Banks and Treasuries in the current crisis was the protection of the financial system as a whole. who are concerned about the credit ratings of their institution. banks have taken insufficient risk prevention activities in relation with these "core infrastructures". However. Our recommendations in this section are that: • One should think of the signals triggering intervention as admittedly crude indicators of the risk of potential problems. Other instruments. even when it is very complex. a 1% probability of failure does not have the same consequences if it means that 1% of the banks fail every year or alternatively that the whole banking system fails every hundred years. is not enough to 155 . Finally the notion that fine tuned capital requirements could be sufficient to limit the incentives of bank managers to take excessive risk has revealed grossly incorrect. thresholds for supervisory intervention rather than recommendations for risk management policies of banks.The Treatment of Distressed Banks The emphasis on the probability of failure of individual banks (epitomized by the use of the Value at Risk criterion) by the BCBS was obviously misplaced. We find more reasonable to interpret regulatory capital requirements as defining. • A single capital requirement. which are computed on the basis of estimated probabilities of failures. To contain moral hazard. it would be necessary to impose appropriate protection measures for the participants to these central counterparties. since this criterion does not take into account the upper tail of losses. namely systemic considerations. and in particular "core infrastructures" such as large value payment and clearing and settlement systems. A possible alternative (or complement) would be to impose on these "core infrastructures" sufficient risk prevention measures so that closing down or restructuring a large and complex banking organization (previously deemed systemic) could be performed without hindering the activity of the core infrastructure. This means that new indicators of risks have to be designed. Therefore it is crucial for regulators to find ways to discourage "herding behavior" by banks. There is another. Similarly. the Value at Risk is clearly not a good indicator for public authorities. or at least to penalize an excessive exposure to the business cycle. It is also probably a good indicator for bank managers. because it reduces manipulability and enhances transparency and credibility. if central counterparties such as clearing houses are created in order to limit aggregate risk on CDSs and some OTC derivatives. simplicity if crucial.
each has access to relevant information. Big institutions always have bargaining power in 'normal times'. This means that the size of individual banks has grown tremendously. a battery of indicators have to be designed by regulators. both nationally and internationally. and the Treasury brings with it dem10 While somewhat extreme (as discussed for example by Caballero. This unavoidably raises big banks' bargaining power with supervisors in times of distress too. …) and used simultaneously to determine whether supervisory corrective action is needed. Given the overreactions that markets often display. risks of large losses. 2. through their lobbying of Governments and supervisors. it is important for the Government to step in. starting often with purely domestic ones). • Other dimensions of regulatory control are to be explored to explicitly curb the incentives of bank managers for excessive risk taking: top managers' remunerations. They are of course magnified by the 'too big to fail' syndrome. Macroeconomic and systemic considerations Recent years have witnessed staggering growth of some individual banks. or the Single Market program in the European Union for example. Indeed. the Central Bank. 156 . even if the cost of a bailout is significant and therefore politically unattractive. even the firms which have access to disintermediated finance do rely on banks for credit lines as insurance against the drying up of direct finance. in 'normal times'. Beyond this. This cannot remain as vaguely defined as in pillar 2 of Basel II. Three issues have to be discussed in this respect: (i) Who decides when we are 'in a crisis'? (ii) What should be done ex post? And (iii) How to reduce the probability and social cost of a crisis? As far as the first question is concerned. it is important to have in place explicit crisis-management mechanisms when they come. In such cases. exposure to macroeconomic shocks. and possibly to inject public funds.10 market discipline does not work any more in times of systemic crisis. and internal risk management systems. both in large countries like the US and in small countries (Iceland being only the most extreme case). Therefore. These were discussed already in section 1. with its many bank mergers.2. being replaced by destabilizing panics. This development has several consequences for the supervision of banks. Therefore. The aftermath of the Lehman Brothers bankruptcy has moreover clearly indicated that one cannot afford to let big institutions fail. the current crisis is a good example of the volatility of markets. It is for this reason for example that. This is in large part a result of regulatory changes. at national level (the elimination of restrictions against out-of-State banking in the US) and also internationally (the elimination of restrictions against activities of foreign banks in many countries. in order to provide simple signal of the various dimensions of banking risks (including liquidity and transformation risks. it is important for public authorities to face the evidence: banking crises do happen in market economies. shareholder representation. whose banks have become very large indeed relative to GDP. The first one concerns political economy considerations. it is important to involve the three main actors in the decision process. reinforcing the need for independence and expertise of supervisors stressed earlier.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 limit risk taking by banks. 2009). the supervisor and the Treasury.
something which should not be possible in normal times. a first thing to always keep in mind is that undercapitalized banks do not function well as credit providers to the economy. page 365) for the case of the UK). Some principles seem natural however: (i) at least as far as banks which are performing worse than the average of the sector are concerned. it is typically a very bad idea. the supervisor and the Treasury at highest level. that is. and (ii) It is also important that. this issue generated significant research at the time of the 'transition' from central planning to a market economy by former communist countries in the 1990s. See for example Brunnermeier et al. Finally. what about reducing ex ante the probability and social cost of a systemic crisis? This is connected to the debate on reducing the procyclicality of regulation. the goal should be to protect depositors and taxpayers (we assume that workers have access to the same safety net as workers in non-financial companies). See for example Mitchell (2001) and Aghion et al. on this. see for example Caballero (2009) and Suarez (2008) among others): partial (or full) nationalization.12 Ex-post recapitalization of individual banks by public authorities in times of crisis can take several forms (we do not consider here 'universal' intervention mechanisms meant to help all banks. ex-post crisis management. by declaring a crisis. or the purchase of 'toxic' assets to be parked in a 'bad bank'. who describe very well the bad externalities banks in trouble exert on other banks when trying to raise their capital ratios. a second principle is that speed matters too: this process should not be so slow as to trigger panics or inappropriate (lack of) lending. and if regular consultations take place between the Central Bank. Quick. achieving both objectives can only happen if a crisismanagement system has been devised ex ante. when a 'real crisis' hits. it is promptly declared. who argue that a mixture of recapitalization and the liquidation of non-performing loans can under some conditions be the optimal solutions for a Government trying to serve the interests of taxpayers while being at an informational disadvantage with respect to bank management concerning the quality of the loan portfolio. This topic has quite rightly been the subject of various analyses.11 Concerning the second issue. (2009). When thinking of the exact decision process by which a crisis can be declared. (ii) while the first principle pleads for a cost-minimizing recapitalization. This was tried in the US savings and loan crisis in the 1980s with disastrous consequences. real recapitalization has to be preferred to fudging with accounting standards to pretend that capitalization 'is OK after all' or allowing for low capital ratios in hard times.The Treatment of Distressed Banks ocratic legitimacy. the goal is to get healthy banks working as soon as possible. for example by sell- 11 Something which does not seem to happen now (see for example Davies (2008. 12 See for example Dewatripont and Tirole (1994) for an overview of this episode.13 Our feeling is that there is no consensus among academics about the best way to proceed here. Their task would be. one has to keep in mind two objectives: (i) It is important on the one hand to avoid excessive use of public funds through excessively frequent crisis declaration. so as to release needed public funds. 13 Interestingly. While there is a natural tendency for public authorities to delay action – which is fiscally costly – in the hope that things will get better. insurance provision for bank loans. Clearly. to allow for the potential release of public funds. (1999). The contrast between Scandinavia and Japan in the 1990s is good evidence of that. there is clearly no reason to protect shareholders or managers in the process. 157 .
without excessively burdening taxpayers. in order to limit the overall amount of capital banks need to have (and its associated cost). Alternatively. 1994). 158 . The objective should be to get lending going again without delay by properly capitalized banks. maintaining adequate capitalization in bad times has procyclical effects. it is conceivable to require ex ante that banks having access to Emergency Liquidity Assistance by the Central Banks pay a periodic fee for this service. ex ante. even if it is costly. This means formalizing ex ante cooperation between the relevant actors (Central Bank. one could follow Kashyap et al.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ing assets. so as to limit the vicious circle discussed by Brunnermeier et al. It is indeed important for prudential regulation to take into account economy-wide indicators and not simply individual bank solvency. banks would pay an insurance premium to institutions against a promise of capital infusion in times of crisis. is ingenious. They are confident that private institutions or investors would be willing to provide such capital insurance. Another idea that would go in the same direction would be the introduction of procyclical deposit insurance premia (an idea discussed by Dewatripont and Tirole. Treasury) with this contingency in mind. This may be too optimistic. let us here just stress once again the need to avoid the danger of bank undercapitalization in bad times. In this case. i. Procyclical capital ratios and capital insurance are two ways to introduce 'automatic stabilizers' in the regulatory system. They should put in place a mechanism that allows a crisis to be formally declared (an event which will allow the release of public funds). In terms of the subject of this paper. This is in fact what happens anyway when Governments end up recapitalizing banks in times of crisis. There are several options – temporary nationalization. • Under current regulation. an anticyclical deficit policy. dynamic provisioning. (2009). supervisor. One should go for 'real' recapitalization. One avenue. which they discuss among others. Under this system. The difference with what has happened so far is that the Government could.e. the goal is to ensure adequately capitalized banks in times of crisis while limiting the procyclical effect of regulation. • Ex-post crisis management should keep in mind that undercapitalized banks do not function well. it could also be provided by Governments. or procyclical deposit insurance premia. charge periodic insurance premia against such 'catastrophe insurance'. (2008) and their suggestion of capital insurance. Avoiding this calls for introducing 'automatic stabilizers' into the regulatory system. Reducing procyclicality could then mean aiming at 'adequate' capital ratios in bad times and higher ratios in good times. such as higher capital ratios in good times. The scheme put forward by Kashyap et al. Our recommendations in this section are that: • Public authorities should expect crises to happen. insuring bank loans or parking toxic assets in bad banks – that are possible. capital insurance (privately or publicly provided). is Spanish-style dynamic provisioning. just like we have automatic stabilizers in fiscal policy. Similarly. However.
which was ultimately 'won' by the trio RBS. but it was very much in line with the Single Market programme. was hostile and controversial (and. ex post. the Dutch authorities did take advantage of in order to reassert control over 'their' share of the bank. First. This means considering relationships between big economic areas with more limited cross-border banking links. In this respect. and its associated productivity gains. we will start with the case of the European Union. especially since national authorities see quite differently the acquisition of national firms by foreign ones than the acquisition of foreign firms by national ones. due to business mistakes or market reversals. what happened recently to the banking and insurance group Fortis is very instructive (see Box B for details). even though not of the EU) and UK authorities for example. we will analyze this issue in various steps. And the question of who should be the lead supervisor of the Belgian-Dutch Fortis was a subject of debate between the two countries. for 'strategic control' reasons or mere national pride motives. crisis which.The Treatment of Distressed Banks Section 3: International cooperation Globalization has underlined both the current limits of. by breaking up a 'Dutch jewel'.14 The 2007 takeover battle over ABN-Amro. This is particularly problematic because one has witnessed two competing policy rationales over recent years: the first one saying that the potential of the Single Market. In such circumstances. These should take as starting point the fact that national supervisors can be expected to be pressured to 14 Also instructive is the case of Icelandic banks and the relation between Iceland (a member of the European Economic Area. such adverse asymmetric reactions have to be kept under control through a credible set of legal provisions. which has been encouraged by the Single Market initiative. one can expect nationalistic reactions. The lesson of this episode is that one can expect competition to be at times 'controversial'.1. and need for improvements in. In this section. but also the case of emerging economies where foreign banks have become very significant. is very significant. the tension between the prevalence of national regulators and the emergence of cross-border banks. international cooperation in the treatment of distressed banks. There is indeed a tension between the tendency to favor the growth of international banks (through global or regional pro-trade and pro-capital mobility policies) and the reliance on national (whether 'home' or 'host' country) supervisors. The case of the European Union In the European Union. since it accelerated cross-border banking ties. and the second one worrying that it is important for Member States to retain national ownership of their big banks. Santander and Fortis. We will then take a more global view. especially when things go sour ex post. could only be realized through synergies resulting from cross-border mergers. it is fair to say. it was definitely not popular in the Netherlands. an operation that turned out to be much too expensive for the acquirers). This did not facilitate cooperation between public authorities when the crisis came in September 2008. where 'cross-border banks' have been very actively encouraged. Just like with protectionism in general. 3. However. 159 .
…). relying on national supervisors (which is currently the case. 3. it is important to stress the crucial need for much stronger coordinated mechanisms of enforcement than exist now whenever two territories face significant cross-border banking relationships. and therefore the emergence of European and not just national banks. the current practices are not reassuring in this respect. We understand this is not an obvious goal (see the CEPS Task Force Report (2008) for example on some obstacles on the way to centralization.2. like the EU. page 371. especially since these emerging countries have more limited means of effectively guaranteeing deposits.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 pursue national objectives. the pursuit of the interests of the banking group as a whole. Note that this statement is related to the Single Market. Note that the Fortis crisis happened just after the introduction of the European 'Memorandum of Understanding'. involvement of all interested parties. that is. Indeed. which was meant to promote cooperation in financial stability and crisis management! While this MoU is full of good intentions (on information exchanges. International coordination in general The European Union is in a sense an 'extreme' case of economic integration. but we think it is necessary. which would involve several players. since there would be an asymmetry between Central Banking. 'similar' countries! The problem is less severe for intercontinental relations involving large rich or emerging economies. by triggering bank runs on other. this is a view also shared by the CEPS Task Force Report. an objective it subscribes to). 'equity'. We understand that this complicates things. However. While it is certainly possible to beef up such MoU's and make them more binding. and (ii) they have more limited cross-banking relations. and EU-wide supervisor and deposit insurer. There too the need for coordination in times of crisis – and in particular 'who takes care of depositors' – is crucial. because: (i) they have more ammunition to tackle crises. However. one should simultaneously favor the emergence of a European supervisor and of a European deposit insurer. as the Fortis example demonstrates. 2008). however. just like public supervisors can be expected to face lobbying by national industry. The case for Euro-area supervisor and deposit insurer seems therefore stronger. with consolidated oversight by the home country supervisor supplemented by domestic oversight by the host country supervisor). A crisis in one such country where depositors would fail to be protected could have devastating effects. Our recommendation in this section is that: • In economic areas which are meant to be very integrated. applies to the entire European Union and not just the Euro area. requires coordination and cooperation that is going to be tested in times of crisis. even though these have been grow- 160 . not enforceable' as stressed by Praet and Nguyen (2008. one should move towards a centralized supervisor and a centralized deposit insurer. Note however that many emerging economies face very significant foreign bank presences. its problem is that it is 'a flexible tool that is. one has to face the facts: If one really wants to promote the Single Market in banking (which makes sense if one wants to pursue the Single Market in non-financial sectors).
went on Dutch TV boasting that 'they had managed to buy the better part of Fortis. Since Fortis was faced with staggering liquidity needs (dozens of billions of Euros by September 29). This offer involved the splitting of ABN-Amro's activities between the three banks. Fortis' weakness proved fatal after the Lehman Brothers failure and subsequent market meltdown. for a combined total of 16.8 billion Euros. interbank lending to Fortis had collapsed and significant deposit withdrawals were starting to take place. the BelgoDutch banking and insurance group Fortis bought ABN-Amro for a record 71 billion Euros. Court opposition by Fortis shareholders (unhappy about the consequences of the deal on the price of Fortis Holding shares) casts a shadow on the future of this operation. Wouter Bos. This immediately led to a sharp drop of the stock price. the deal was risky. A second round of negotiations then followed. For Fortis. with the Dutch side buying on October 3 the Dutch activities of Fortis as well as its ABN-Amro activities. where the trio won against ABN-Amro-top-management-supported Barclays Bank. Luxembourg and the Netherlands agreed to a concerted recapitalization (against equity stakes) on September 28. which 'disappointed' the Dutch public authorities. while the market capitalization of Fortis was around 40 billion Euros at the time. the Belgian Government has attempted to sell most of the remainder of Fortis activities to BNP-Paribas. Fortis Luxembourg and Fortis Netherlands. was however overwhelmingly approved by Fortis' shareholders in August 2007. together with a 13 billion Euro equity issue. since it meant buying the Dutch activities of ABNAmro as well as its private banking and asset management operations more generally. By September 24. leaving the worse one to the Belgians'. 161 . thanks to a bid which has higher than the equity offer of Barclays and moreover included 80% of cash.0 billion Euros they had promised on September 28.The Treatment of Distressed Banks Box B The Fortis case: Limits to international cooperation in rescue efforts15 In May 2007. despite the importance of the growth in Dutch activities that the acquisition of the ABN-Amro business implied. This agreement failed however to calm the markets. The deal.7. in terms of oversight. the Governments of Belgium. 2.0 billion Euros in Fortis Belgium. After the departure of the Dutch part of Fortis. for a price of 24 billion Euros. 15 See for example van de Woestyne and van Caloen (2009). It is to be noted that. in July 2008. both in contradiction with earlier promises. committing respectively 4. with the announcement of a new equity issue and the cancellation of dividend payments. The Dutch Finance Minister. together with the Royal Bank of Scotland and Santander. This was the result of a hostile takeover battle.9 and 4. obliging the National Bank of Belgium to keep providing massive Emergency Liquidity Assistance to Fortis in the next days. Belgium was and remained lead regulator of Fortis.Difficulties surfaced openly in June 2008. as well as the resignation of the CEO. Jean-Paul Votron. It was also revealed later on that the Dutch side had never paid the 4.
especially with the opening up of banking markets and the spread of risks through securitization. it remains true that harmonization still has not taken place concerning the treatment of banks in distress. deposit insurance rarely extends beyond a country's borders: "Under most national deposit insurance systems. unfortunately. page 3) stresses: "To protect banks and banking systems against the risk of international financial contagion. can go for subsidiaries – which then have legal personality in that country and become national firms – or simply branches. if at all. there is the issue of when public intervention can take place and what are the public intervention powers.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ing over time. as stated for example by Krimminger (2008. Indeed. Let is simply stress the two most important ones: First. 162 . deposits of domestic branches are insured by the domestic deposit insurance system and deposits in a host country are insured. Second. especially since we have to keep in mind that crisis management has to take place with under great time pressure. Note that banks." There are therefore clear potential incentive problems facing the home supervisor in terms of consolidated supervision. the regulatory and supervisory safeguards have been raised to match these evolutions. even for branches. was a good idea. this can lead to a host of problems. by the host country's deposit insurance scheme. depositors in foreign branches of a US bank are not insured under the FDIC's deposit insurance and are subordinated to uninsured depositors of the US branches in the distribution of the proceeds from the sale of the bank's assets. Clearly. While a global supervisor and deposit insurer may be beyond reach. as a result. Under US law. bank regulators around the world have embarked on an extensive program of harmonizing prudential banking standards among countries and fostering closer cooperation between national bank regulators. and most importantly. We have stressed earlier that the US system establishes by FDICIA. let us stress again that. making such prompt action unavailable in other countries. the principal licensing and prudential requirements written into national banking laws have reached a high degree of uniformity. One of the reasons for this success is that it has been comparatively easy to identify best practices for these requirements. it has to be considered seriously if one really wants to integrate further the banking market. with PCA. Depositors in foreign branches of US banks are covered by FDIC deposit insurance only if the deposit is payable in the US in addition to the foreign branch. This can be really dangerous in terms of contagion. which remain an integral part of the bank. with the risk of being pressured to 'limit damages' and leaving part of the mess to foreign countries. However. page 384). is the question of depositor protection. when setting up operations in a foreign country. little international uniformity of law or practice exists in the area of banking regulation governing the treatment of banks in distress. In contrast. However. … It is fair to say that. we can highlight a couple of general principles: 1. While it is beyond this short paper to analyze in detail the way forward in terms of cooperation in crisis management. but this system is definitely not generalized. as Asser (2001." While of course recent history has shown that the 'success' of harmonized capital ratios should not be exaggerated (see our discussion in Section 1).
" Journal of Banking and Finance 25: 1139-1160. R. between the various countries about how to share supervisory and deposit-insurance responsibilities. "FDICIA After Five Years. Shin (2009).. "The Current Financial Crisis: Causes and Policy Issues. M. Concretely. and K. Fries (1999).T. References Aggarwal. the decision of whether to 'save' the bank. it is important to foster best practices in establishing credible Memoranda of Understanding for cross-border banking crisis management between authorities that detail in particular the respective rights and obligations with respect to intervention thresholds and deposit insurance. to a Single World Market. and at which conditions. Our recommendations in this section are that: • If one wants to keep integrating the world banking market. Lee. P. 2. what is required is an ex-ante credible agreement. Aghion. OECD.H. Asser. Washington. "A Global Perspective on the Great Financial Insurance Run: 163 . P. Atkinson and S. Crockett. and G." Journal of Economic Perspectives 11: 139-158. Blundell-Wignall. D. T. "Optimal design of Bank Bailouts: The Case of Transition Economies.C. in the absence of a supranational supervisor. If one thinks that centralization is either impossible or undesirable. The two goals of avoiding contagion and avoiding regulatory arbitrage by banks should be kept in mind. Persaud and H. Moreover.The Treatment of Distressed Banks What applies to the EU Single Market applies.J. P. Caballero. Goodhart.C. following and idea like PCA. "The Impact of FDICIA and Prompt Corrective Action on Bank Capital and Risk: Estimates Using a Simultaneous Equations Model. (2009). R." Journal of Institutional and Theoretical Economics 155: 5170. whatever the legal form of cross-border banking relationships. Indeed. should in fact be taken jointly by the various authorities. The Geneva Report on the World Economy 11. London: CEPR. C. Jacques (2001). The Fundamental Principles of Financial Regulation.M. Once again. Such a MoU should be as explicit as possible in order to have a chance of functioning in times of crisis. A. Brunnermeier. A. if one keeps the idea of domestic deposit insurance." Financial Market Trends. or MoU.G. A.: International Monetary Fund. and therefore fully protect all its depositors. Bolton and S. 2008.. one should seriously consider partial centralization of supervision and deposit insurance at the world level.. one could give real powers to a supranational authority like the Basel Committee on Banking Supervision. Legal Aspects of Regulatory Treatment of Banks in Distress. there should be standardization of such MoU's to spread best practices. Kaufman (1997). • Barring such centralization. Benston. More generally. mutatis mutandis. J. We have already stressed the need to harmonize intervention thresholds. it is crucial to think of a more even-handed approach between home-country and host-country supervision. (2001). one should at least get serious about joint crisis management.
Concrete Steps Towards More Integrated Financial Oversight – The EU's Policy Response to the Crisis. Cambridge. (2008).org. and Solutions (Parts 1 and 2). (2008). H. Praet. "Rethinking Capital Regulation. "The Regulatory Response to the Financial Crisis. Tirole (1999). and B.A. J. Fortis." Journal of Financial Stability 4: 368-375. The Prudential Regulation of Banks." Journal of Financial Stability 4: 376-390. MA: MIT Press." Journal of Financial Stability 4: 351-358. van Caloen (2009). Jewitt and J." VoxEU. Group of Thirty (2009). (2008). M. 10:127. and J. J. "The Economics of Career Concerns. Bureaucracy: What Government Agencies Do and Why They Do It. Wilson. Krimminger." TSE note number 1. Suarez.Q. Part II: Application to Missions and Accountability of Government Agencies". December 23. November 23. (2001). Dexia … Le Séisme. R. Goodhart. Brussels: Ed.-C. Parigi (2008). "Panel Comments. F. I. Stein (2008). "Overview of Recent Policy Initiatives in Response to the Crisis. "The Need for an emergency Bank Debt Insurance Mechanism. Washington Post (2008b). "Banking Regulation and Prompt Corrective Action. 164 . (2008). J. (2008). Tirole (1994). Nguyen (2008). (1989).G. J. Consequences. "Regulator Let IndyMac Bank Falsify Report: Agency Didn't Enforce Its Rules. van de Woestyne.. M. "Banking Regulator Played Advocate Over Enforcer: Agency Let Lenders Grow Out of Control. P." CEPR Policy Insight number 19. CEPS Task Force Report (2008). Freixas. "Leçons d'une Crise. and A. January 23. Davies. J. Mitchell. "Le Futur de la Réglementation Bancaire. Dewatripont.E. Washington Post (2008a). Rochet. Financial Reform: A Framework for Financial Stability.." TSE note number 2." Journal of Financial Intermediation. (2008)." Journal of Financial Stability 4: 364-367. C. Tirole. A.C. M. Then Fail".Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Causes.M. and G. "Bad Debts and the Cleaning of Banks' Balance Sheets: An Application to Economies in Transition.H. Review of Economic Studies 66: 199-217." mimeo. X. New York: Basic Books. Dewatripont. "The Resolution of Cross-Border Banks: Issues for Deposit Insurers and Proposals for Cooperation. Kashyap. Inquiry Finds". Rajan and J." mimeo. Luc Pire.
It is unclear who is a culprit and who is a victim. Governance at the firm level did not take into account the financial stability implications of selling Author's note: I thank Patrick Bolton. empire building. ECARES. There were no financial stability problems associated with these scandals. The current crisis originated in developed markets. conflicts of interest. There are robust banks and distressed banks with similar corporate governance characteristics. with European and Asian markets taking away "market share" from New York. The Principles did not prevent the corporate scandals of 2002 in the United States and Europe showing that major corporate governance failures could also occur in developed markets. 165 . an alleged lack of enforcement outside the United States and shifting capital market competitiveness. Banks with weak governance have collapsed in one country. weaknesses in internal controls. these corporate governance failures have not followed a simple pattern. The view expressed here are those of the author and not those of the European Corporate Governance Institute (ECGI) or the CEPR. The OECD and the World Bank were entrusted with improving emerging market standards and today the OECD Principles of Corporate Governance are one of the twelve keys standards of the Financial Stability Forum. misaligned or perverse incentives. Julian Franks and Mathias Dewatripont for discussions. To complicate matters further it is likely that even with perfect governance at the level of individual institutions. at banks with a large shareholder and at banks controlled by the state. systemic failure would have occurred. G20 and other countries adopted their own measures. Equally there is no simple pattern across countries. Université Libre de Bruxelles. it has caused financial instability. incompetence and fraud. It has brought to light classic examples of board failure on strategy and oversight. Banks have collapsed in countries with weak shareholder rights and in countries with strong shareholder rights. ECGI and CEPR Introduction and recommendations The East Asia/Russia/Brazil crisis of 1998 first highlighted the link between weak corporate governance.Corporate Governance and the Credit Crisis Marco Becht Solvay Brussels School of Economics and Management. it involves contagion and has spilled over into the real economy. The international debate focused on the international incompatibility of the reforms. There have been problems at widely held banks. weak institutional infrastructure in emerging markets and financial stability. However. but banks with equally weak governance did not collapse in other countries. The OECD Principles were revised. The United States adopted the SarbanesOxley Act and other reforms.
with the consent of the buyout targets' shareholders and of their own investors. At the micro-level it appeared that risk could be insured and lending expanded profitably. nationalized or reprivatized. on the corporate governance of individual institutions: • Encourage or force banks to follow the example of Union Bank of Switzerland (UBS) and conduct a detailed investigation of the sources of their write-downs and propose measure for their future avoidance to shareholders and regulators. It will take many more months before we have conclusive empirical analysis on what so far are casual empiricist observations. Competitive pressure from non-banks drove banks to engage in new riskier activities and to increase total remuneration. • Recognize that banks need to recruit individuals of outstanding competence and integrity to run them. which has traditionally focused on banks. Corporate governance was never designed to internalize contributions to systemic risk. Independent academic research has not yet caught up with events. Regulation must become more fault-tolerant and corporate governance has a potential role to play. Study the governance and regulatory failures associated with the current crisis for each institution and formulate. The most likely explanation of these facts is varying combinations of corporate governance failure with regulatory failure and herding. Contracts should be modified to take into account the lessons of the 166 . These developments pose new challenges for prudential regulation. Corporate governance was no-fail stop device for regulatory failure. Pension funds and asset managers of all sorts purchased what turned out to be "toxic assets". many non-bank institutions on the periphery of prudential regulation have contributed to the leveraging of the world economy. especially once they are recapitalized. It would also explain why some countries have avoided major bank failures while others could not. This would explain why some banks within the same countries failed and others did not. Specific recommendations are: First. Make the system more robust by creating advocates of financial stability and financial stability incentives that can be built into the governance of financial institutions. Ensure the international compatibility of regulation and corporate governance reforms and thus avoid the problems experienced after Enron. Moving forward the global rescue of financial institutions has amplified moral hazard at all levels. either directly or by purchasing shares in institutions that did. Finally. encourage or force necessary change. Central gatekeepers like credit rating agencies and analysts did not raise the red flag. 2. Private equity firms drove up leverage in the corporate sector. Shareholders and boards encouraged executives to expand and leverage. In many cases there was no agency problem at the firm level.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 or purchasing certain financial services. The G20 should pursue three basic policy objectives on corporate governance and the prevention of a future credit crisis : 1. The inability of individual banks to incorporate systemic risk into their corporate governance and incentive contracts amplified these problems. 3.
Second. Bolton. 1.1 The FSF would fill a gap in shareholder monitoring of banks. political or media pressure. • Recognize that uniform restrictions on bonuses and total remuneration at distressed banks often affect the wrong people and can create perverse incentives. The Fund would devote more resources to shareholder monitoring than a private or public sector pension fund. The Fund would provide a natural home for bail-out equity stakes in times of crisis. securities regulation and other corporate governance provisions applicable to the banks it invests in. and thus protected from political interference. The FSF would be broadly autonomous. BBR survey five alternative mechanisms that may mitigate the conflict between managers and dispersed equity holders: (i) partial concentration of own- 1 The international fund could also take the form of a group of regional funds tied together in a college of stability funds at the G20 level. The FSF would seek a dialogue with these investors. The FSF would be accountable to its sponsoring governments and the general public. It would hold influential equity positions in all financial institutions and internalize financial stability concerns.Corporate Governance and the Credit Crisis crisis. which should be preferable to inflexible." The corporate governance literature has traditionally focused on the problems associated with dispersed equity holding and the collective action problem among equity investors. The FSF would also monitor the corporate laws. on building financial stability into corporate governance: • Consider the creation of an international Financial Stability Fund (FSF) that takes common share and preference share equity positions in the financial institutions of participating countries. like the European Central Bank or the Bank of England. If governments wish to claw back excessive bonuses and salaries paid out during the run-up to the crisis they can attempt to do so through the tax system. The staff of the Fund would be free to find institution specific solutions to meet its brief. Private institutional shareholders would monitor the Fund." (Becht. uniform and potentially inappropriate legislation at the national level. It would be largely immune to capture by the banks it invests in. The Fund could be given broad guidelines on the governance and lending practices it should promote. but this should be based on rigorous analysis of the facts and not on intuition. 167 . In general a corporate governance problem arises whenever an "outside investor wishes to exercise control differently from the manager in charge of the firm. Did corporate governance failure at banks cause the current crisis? Corporate governance can be defined as "concerned with the reconciliation of conflicts of interest between various corporate claimholders and the resolution of collective action problems among dispersed investors. The Fund would be multi-national and thus void of mercantilism and/or protectionism. Roell 2005).
and (v) fiduciary duties for CEOs together with mechanisms to seek redress for past actions. As discussed already. Creditor governance in the ordinary sense failed.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 ership and control. The survey concludes that there is a fundamental tradeoff between large shareholder intervention and the prevention of large shareholder abuse. Bank executives can take wide-reaching decisions with large material consequences that take effect in hours. In practice managers and shareholders share control with creditors and potentially with other corporate constituencies. Prudential regulation can be seen as the governance mechanism for representing depositor interests and as protecting the interest of the taxpayers providing the deposit insurance (Dewatripont and Tirole 1994). not in days. Provided creditors have liquidation rights sharing control with them can provide an effective incentive scheme for management. In theory creditor governance became tougher. 1996). Dewatripont and Maskin. shares and options. (iii) delegation and concentration of control in the board of directors. Depositors tend to have no protection from covenants but because they can run and cause a banking crisis they are implicitly or explicitly insured. The growth of banks through acquisitions. and Bolton and Scharfstein. Corporate governance failure at banks? An intuitive case can be made that the collapse of major financial institutions during the current crisis has its roots in the classic governance conflict of interest between managers and dispersed shareholders. They lavishly refurbished their offices and ordered corporate jets. They took 2 Macey and O'Hara (2003) have suggested that boards should be made liable for the same purpose. (ii) hostile takeovers and shareholder activism. months or years. depositors are not directly involved in the governance of banks and insured. Banks are complex organizations and the asymmetry of information between executives. the board and shareholders makes monitoring largely ineffective. providing stronger managerial incentives (see Hart and Moore. 1995. The standard corporate governance analysis also applies to banks. They sold complex financial products at inflated prices. except that banks traditionally have depositors. Agency problems in banks are likely to be larger than in other types of corporations (Levine 2004). Dispersed creditors find it more difficult to agree on debt restructuring and hence they are more committed to liquidate. like employees. In practice short term creditors "ran" by not rolling over their loans and ex-post bank creditors were treated like depositors. 1995. Hence. 168 . They fuelled the financial bubble with reckless lending. in what follows I focus on equity governance. the increasing complexity of their asset and liabilities sides and international expansion all contributed to tilting the balance of corporate power firmly in favour of bank executives. Bank executives are said to have used this advantage to grow their institutions in size and to reward themselves richly in cash. In contrast to equity ownership creditor governance is tougher the more dispersed the debt.2 In the run-up to the credit crisis banks increasingly issued bonds and leveraged using short-term credit. (iv) alignment of managerial interests with investors through executive compensation contracts.
for example. The boards then reward them with excessively generous remuneration packages. 169 . The self-dealing hypothesis has been put forward most forcefully in the United States because pay levels are much higher on average than elsewhere and boards enjoy much greater autonomy than in most other countries. which is expensive. which bestowed them with honours. The limited downside but apparently unlimited upside in pay-performance sensitivity has raised suspicions of self-dealing by corporate managers. equity ownership plans and option plans. by Bebchuk and Fried (2004). boards and regulators were unable to stop executives from engaging in these dangerous activities. Bankers supported sports events and the arts. Both types of incentive are potentially important. This exaggerated account of the standard governance failure analysis leading to the current crisis has motivated numerous policy recommendations to be put forward in recent months. Does the governance failure view fit the facts? Executive incentives Executive contracts provide monetary and non-monetary incentives that are supposed to align the interests of senior management with those of shareholders and potentially with other constituencies.3 CEOs are alleged to control the nomination process in corporate elections and appoint their own boards. The candidate with the largest number of votes wins. This is worrisome because there is no solid empirical evidence yet that the classic agency problem between dispersed shareholders and managers has caused all the bank failures and problems we have observed. 4 In most U. particularly in the United States. Monetary incentives include base salaries. were justified by the large returns to shareholders earned before the 2003 stock market collapse. bonuses. career prospects and social prestige. Some have already been implemented or cast into parliamentary proposals. Implicit incentives include dismissal.Corporate Governance and the Credit Crisis what turned out to be wild gambles. Regulators were captured or fooled. states the default rule for corporate elections is "plurality voting". Shareholders are not allowed to vote against candidates but can only abstain. When the music stopped playing bankers had brought the World's financial system to a halt and plunged the real economy into a deep recession that might result in a depression or hyperinflation. analysts and credit rating agencies were conflicted or incompetent. Most empirical studies of executive compensation have focused on the sensitivity of pay to corporate performance and the likelihood of dismissal following poor performance. They were on best terms with the highest levels of government. Putting up rival slates of directors requires a full proxy solicitation under SEC rules. Executive remuneration became highly controversial when pay remained high after stock prices fell ("reward for failure"). Severance pay arrangements have also attracted severe criticism.4 The 3 This case has been argued.S. They enjoyed enormous social prestige. Large increases in the level of pay in the 1990s. Shareholders. Important gatekeepers like auditors.
6 Senior executives did have a large portion of their wealth invested in the shares of the institutions they managed. In each case the outcome for financial stability is the same.5 Did bank executives suffer losses as a result of the crisis? To my knowledge there is no systematic answer to this question yet. but in the most glaring cases the senior executives and/or the Chairman did have to depart. Researchers find it difficult to get access to data on executive contracts and remuneration packages outside the United Kingdom. The measures are often justified by a moral hazard argument: bankers who were responsible for bringing 5 Media and scholarly attention usually focuses on the remuneration packages of chief executives and executive directors. at least temporarily. 6 A widely cited example is Jim Cayne. If executives engaged in self-dealing active monitoring by shareholders and boards must be strengthened. Some executives even kept these shares after retiring. If the executives responsible for bringing about the crisis only suffered mild losses their incentives were not aligned with those of shareholders and they were engaged in self-dealing. G20 governments have the power to commission such an investigation. Strengthening shareholder rights and boards would not prevent a future crisis.000. It is important to find out exactly what incentive structures were in place at financial institutions prior to the credit crisis and why they failed. as many commentators have argued for the United States. Again we are still lacking global statistics. the CEO of Bear Sterns.000 on a Tuesday when they were worth $1 billion the week before. 170 . In the United Kingdom there have been petitions to revoke the "Sir" of the former chief executive of a leading failed bank. but the contract was flawed anyway because it did not prevent the crisis. Taxpayers demand an answer and reform should not be based on populist accusations and guesswork. In Europe's smaller countries some chief executives and chairmen of failed banks decided to emigrate.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 back dating of options scandal provided additional support to this view. Implicit loss is incurred from dismissal. but the corporate governance and regulatory implications are different. Pending a systematic answer we do know that there was a failure in executive remuneration. Even in the United Kingdom it is generally not possible to obtain such data for non-listed companies and below the senior executive level. If executives and shareholder jointly failed to prevent the crisis the incentive contracts for both groups must be redesigned. This might well be true. Moving forward it will be crucial to investigate reward structures in financial institutions below the CEO level. especially if the executives left the firm prior to the credit crisis. who sold his shares for $61. but press reports suggest that some losses were substantial. If the executives did suffer large losses comparable to those of shareholders their incentives were aligned. The current policy response in several G20 countries has been to impose general limits on the total remuneration of executives at institutions that have received capital injections or other financial help from the government. Proponents of the self-dealing hypothesis will argue that despite the losses the cash remuneration received over the working life of these executives is more than sufficient to retire comfortably. In financial institutions the pay structure for employees throughout the organization is important.
like partnerships limited by shares. New forms of remuneration will be invented that have the sole purpose of avoiding government regulation. finance experience and management experience of board members. Bebchuk (2009) discusses specific incentive problems arising from TARP II. State control is also negatively correlated to quantitative measures of educational background. Many of the executives who led their banks into the crisis have already departed with their bonuses. Three. As I agued above a conclusive analysis is still pending but preliminary evidence suggests that the problems are complex and often institution specific. 7 "Iceland's biggest listed bank ponders London switch". The largest remaining Icelandic bank has a Chairman who owns a controlling block. Again. 171 . It is true that most of the spectacular failures occurred at widely held banks. Large shareholders A powerful approach to mitigating the collective action problem of dispersed shareholders is the presence of a large shareholder with a strong economic interest and voting rights. Financial Times.7 On the other hand casual inspection of the New York Times (2009) bailout list shows that two of the banks with the highest reported ratio of nonperforming loans to cash on hand (the "Texas ratio) are run by blockholders owning more than 30% of the equity capital. bank executives might be discouraged from applying for required capital injections because they do not want to become subjected to the associated constraints. further investigation is needed. The same is true for other "exotic" forms of ownership. Blockholder controlled banks in other countries too have incurred substantial losses. 27 January 2009. general remuneration restrictions across banks are likely to have perverse effects. Two. Four. Banks with concentrated state ownership in other G20 countries. If governments have the desire to claw back excessive salaries and bonuses paid out during the credit expansion they could use the tax system to this effect. it is not clear that blockholder controlled banks have been systematically more prudent. It is also true that there are examples of blockholder controlled banks that have been particularly resilient. Yet it would be incorrect to conclude that state control of banks is always bad. The research shows that running up to the third quarter of 2008 state controlled banks incurred larger losses than private banks. moving forward uniform restrictions are unlikely to cure potential incentive problems at banks. Pending systematic analysis. in terms of moral hazard the remuneration restrictions tend to affect the wrong individuals.Corporate Governance and the Credit Crisis about the current crisis should not be rewarded with taxpayer money after their institutions have failed. have made fewer losses during the crisis than their peers. Very recent evidence from Germany on the state as the concentrated owner of banks is not encouraging (Hau and Thum 2008). Through the board the blockholder also has the ability to appoint or remove the management. More perplexingly in some countries ownerless banks like cooperatives have shown themselves to be extremely robust. This argument is seductive but has several faults: One. as was frequently pointed out in Germany. and some in Germany itself. This blockholder has an interest in monitoring the board and through the board the management.
A second source of activism is specialist funds that purchase share blocks in target companies with the intention of bringing about change. There is extensive empirical research on corporate boards that has been surveyed several times (Romano 1996. In practice the role. structure. composition and size of boards differ substantially across countries and organizations. Directors generally prefer to assume an advisory role than to be confrontational. Franks and Grant 2008). to monitor management and to approve important decisions. Their most common objective is corporate restructuring (Becht. Activism takes two different forms. They also find it hard to justify to their beneficiaries or clients why they should spend large amounts of money on monitoring portfolio companies when they only internalize a small portion of the benefits. Judging from these and other examples it is not clear either that specialized activist funds are particularly well suited to act as anchors of prudence. The Board Most reform efforts in corporate governance have focused on the board and for good reasons. Boards are often not independent from the CEO and even when they are CEOs have superior information. HSBC and UBS.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Shareholder activism Shareholder activism is a potential alternative to permanently concentrated ownership. 8 In the United States there is also significant resistance to giving traditional shareholder activism a bigger role because many of the most active funds are trade union pension funds. In general it is the mission of the board to select the CEO. Bhagat and Black 1999 and Hermalin and Weisbach 2003). There is also consensus that large boards do not function well. In practice the chairman of the board assumes a leading role. Even large public pension funds find it hard to justify significant expenditure on active monitoring. Large institutional investors increasingly monitor their equity portfolios for underperformance. In practice even the largest institutional investors hold relatively small stakes in large financial institutions. Directors generally have a limited financial interest in the corporation and when they do they are no longer considered independent. They meet with portfolio companies and regularly vote their shares. Prominent examples of interventions by such funds in banks included ABN Amro. as we have just observed. 172 . There are many reasons why boards can be ineffective. These funds have the advantage of internalizing a larger proportion of their activist activity. Traditional activism was unable to prevent bank failures. Traditionally their influence over boards and management has been limited for legal reasons in the United States and for reasons of tradition in continental Europe and Asia. Boards become crucial in times of crisis. institutional investors are well organized and the legal system grants them great influence over corporate boards through corporate elections. provided they are successful. The bulk of this research has focused on the relationship between board independence and corporate performance concluding that there is little or no measurable relationship. functioning. beyond the exercising of votes and regular due diligence (Table 1). even in the United Kingdom.8 Traditional activism is most developed in the United Kingdom where institutional holdings are relatively concentrated.
173 . Corporate Acquisitions The finance literature has documented that corporate acquisitions programmes are extremely hazardous for the shareholders of the acquiring companies. However. the role of boards in the period leading up to the credit crisis and the role of boards during the crisis needs to be investigated thoroughly. Many of the largest corporate scandals 2002 were related to aggressive acquisitions programs that failed. Again. this is an area that deserves more detailed investigation.7 Postal Savings Canada Pension Employees Provident Fund Central Provident Fund Fondo de Reserva Seguridad FFR Public Institute / Social Security National Social Security Employees' Provident Local Government Pensions National Pensions Reserve Fund Future Fund New Zealand Superannuation Government Pension Fund AuM ($bn) 936 286 203 178 135 128 100 82 70 47 41 40 36 32 29 25 14 10 9 Note: Sovereign Pension Funds in the ranking of the 300 largest pension funds in the world by assets under management at the end of 2006. However.2.3. Based on all we know one should not hope that boards can prevent the next financial crisis. In the United States shareholders in most states have indeed no direct say on corporate acquisitions. Mergers and acquisitions also lie at the heart of some of the largest bank failures we have observed during the current crisis.4. we do know that board failure can result in disaster and continued attention must be paid to ensuring that the boards of financial institutions meet the highest management science standards. It is tempting to blame poor acquisitions on a lack of shareholder rights. Source: Watson Wyatt Worldwide (2008) The research on German banks (Hau and Thum 2008) appears to be the first to relate financial losses at banks to board composition and director qualifications. shareholders did approve the most damaging acquisitions made by banks in the United Kingdom and in Belgium. As discussed already losses are negatively correlated with director qualifications. Again.Corporate Governance and the Credit Crisis Table 1 Sovereign Pension Funds : By Assets Under Management Ranking 1 2 3 4 5 5 7 8 9 10 11 12 13 14 15 16 17 18 19 Country Japan Norway Korea South Africa Sweden Taiwan Canada Malaysia Singapore Spain France Kuwait China India Finland Ireland Australia New Zealand Thailand Pension Fund Government Pension Fund Government Pension Fund National Pension GEPF AP Fonden 1.
distressed debt-fund specialist. Example 2: TCI intervened at ABN-Amro. ABN-Amro shareholders received an advance payment of the expected restructuring gains in the form of a large takeover premium.S.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 2. in this case a Japanese bank and a U. From a corporate governance perspective TCI's intervention shook up an underperforming bank and forced corporate restructuring through a takeover. The managements negotiating the buyout deals were fully aware of the details and were given high-powered incentives for generating cash-flow. From the perspective of the activist funds and the banks' shareholders these interventions were positive. As a result the bank sold off non-performing debt before the credit crisis took hold (Becht. It did not help financial stability because the bad loans were simply passed on to someone else in the system. The corporate governance problem at ABN-Amro had been solved but a new problem had 174 . Target shareholders received substantial premia and willingly sold their shares. which induced traders to take on too much risk. For example. Example 1: A well known activist fund engaged with a medium sized mortgage bank in continental Europe. The same was true at the macrolevel. there were no obvious corporate governance problems in large leveraged buyouts. Mispricing of risk The UBS (2008a) report on the causes of its sub-prime write-downs states that the risk on mortgage-back securities was mispriced inside the bank. Ex-post the problems of ABN-Amro were passed on to the United Kingdom and Belgium. Even if the incentive schemes for traders applied the correct formula. Yet. The engagement reduced the agency problem between the management and the shareholders of the bank. Contributions of individual leveraging to systemic risk were not priced in and as a result many institutions took on too much risk. This is a new problem that the corporate governance literature has not addressed. Systemic failure Corporate governance and regulatory failures at individual institutions were amplified by the fact that the parties did not internalize the effects of their actions on the rest of the financial system. This failure also applies to institutions that did not suffer a corporate governance problem in the classic sense. Passing on problems Shareholder activism increased substantially in the run-up to the crisis and resolved a number of agency problems between widely held bank shareholders and the bank's management. they could not work with incorrect prices. From a financial stability perspective the interventions only passed on problems instead of solving them at the root. these buyouts contributed substantially to credit expansion in the corporate sector. at least prior to the crisis. Franks and Grant 2008). The providers of leveraged finance received extensive documentation and undertook due diligence.
There are no existing institutions one can think of that could play this role. Typically they do not serve the interest of national governments but of their pension beneficiaries. TCI incurred substantial losses from in other financial stocks in its portfolio induced by the financial crisis. provided the owner has the proper monitoring incentives and no major conflicts of interest. In times of crisis the fund could seamlessly provide additional equity capital to a bank.9 Banco Santander apparently secured the best part in the deal. Its influence over the bank would increase with the size of its stake. A financial stability fund? The ideal monitor could be a newly created Financial Stability Fund (FSF) that takes significant equity positions in all financial institutions of participating countries that contribute to systemic risk. It would be beneficial to have a second line of defense and to build financial stability into corporate governance at the level of individual institutions. but it also suffered from the financial instability caused by the subsequent problems at RBS and Fortis. Private institutional investors like company pension funds or insurance companies cannot play the role of a financial stability monitor. In normal times the fund would have the task of monitoring financial institutions as a large shareholder. They internalize bad debt by one institution sold to another and individual contributions to increases in global risk. sectors or companies. A Financial Stability Monitor Going forward the current bailout programmes will amplify systemic moral hazard problems. However. To solve the systemic problem emphasized here the monitor must also internalize global financial stability. 175 . All participants clearly failed to internalize the negative financial stability externality emanating from an individually rational deal. 3. individually the funds are too small to hold significant stakes in large financial institutions. The fund 9 It is debatable whether there was a corporate governance problem associated with the acquisition at RBS and Fortis. These funds are so large and diversified that they "own the World". They are subject to competitive pressure and would find it hard to find beneficiaries who want to pay for upholding the financial stability public good. Equally it must be willing to devote significant resources to monitoring the banks and ensuring that they comply with financial stability criteria. Prudential regulation and supervision was not sufficient to prevent the current crisis. but in both cases the acquiring banks' shareholders approved the acquisition.Corporate Governance and the Credit Crisis been created at the Royal Bank of Scotland and Fortis. Ex-post both banks paid too. The relevant institution must be large enough to hold significant stakes in all banks. They can also decide to divest from certain asset classes. regions. The closest we have to the ideal financial stability monitor are large public pension funds (Table 1). Existing research suggests that the most robust corporate governance device at the micro-level is semi-concentrated ownership.
176 . Political interference has been a cause of substantial losses at state controlled banks in some G20 countries. but has a different purpose. The Fund could be given broad guidelines on the governance and lending practices it should promote. The FSF would prevent small countries hosting banks that take excessive risks. 7. It is unlikely that any one bank or group of banks could capture the fund. for example by giving guarantees intended to attract private lenders or equity investment. upon request. The staff of the Fund would be free to find institution specific solutions to meet its brief. The FSF would invest in many banks in several countries. uniform and potentially inappropriate legislation at the national level. which should be preferable to inflexible. Autonomous. 4. international taxpayers would have a share in the upside of the financial system. The SoFFin does not become involved in the governance of banks on a case-by-case basis. The Fund would devote more resources to shareholder monitoring than a private or public sector pension fund. The FSF would be broadly autonomous. The FSF would offer a coherent approach to administering the bail-out equity stakes governments have acquired during the crisis. instead of insuring it with no residual control or claim.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 would complement the role of prudential supervisors. Shareholder monitor. It is designed to deal with the current crisis and is limited in time. Instead it imposes restrictions. approval of acquisitions and other important shareholder decisions. Principle based. The fund would work with other long-term investors and deal with issues prudential supervisors are badly equipped to deal with. Bank executives have an incentive to avoid getting help from the TARP because of the restrictions it imposes (Bebchuk 2009). The German Finanzmarktstabilisierungsanstalt (SoFFin) contains elements of the envisaged FSF (see Box 1). Bank executives would be monitored by the FSF at all times. The Fund only assists German banks. and thus protected from political interference. Bail-out stakes. It is likely that governments will be holding these stakes for many years. The TARP II programme in the United States is similar to the SoFFin. The FSF would avoid this problem by taking equity positions in all banks on a permanent basis. Beggar-thy-neighbor. The FSF would also allow small countries from hosting large international financial institutions they could not recapitalize on their own. Capture. National stability funds like the SoFFin lend themselves to solving the problems of local banks at the expense of neighboring countries. The FSF would be invested in all banks and have no interest in pursuing such policies. 10 The SoFFin and TARP II have been criticized for imposing restrictions on banks that create perverse incentives. 2.10 The Financial Stability Fund would provide a long-term response to the financial crisis and resolve many problems of the current response: 1. In addition to having an active shareholder monitor at the banks looking after their interests. 5. 6. 3. for example the appointment of boards. The fund does not invest in all banks but only in distressed banks. Small countries. like the European Central Bank or the Bank of England. in particular on executive remuneration and payout policy.
Financial institutions can apply to the fund for three types of help : guarantees. Hence the fund is also referred to as the "Sonderfonds Finanzmarktstabilisierung (SoFFin)" (Special Fund Financial Market Stabilization).com/abstract=387561 Bebchuk. 18 February 2009 Becht. Patrick Bolton and Ailsa Roell. The FSF would also monitor the corporate laws. Business Lawyer 54. M. Public sector oversight. References Adams. The FSF would seek a dialogue with these investors. mimeo Bhagat.A. The Prudential Regulation of Banks. 10. Private sector oversight. Pay without Performance. We want compensation tied to performance. Elsevier. Dewatripont. MA. It was created to deal with an emergency situation and is supposed to be wound down once the crisis has been dealt with. Marco. Tirole (1994). Available at SSRN: http://ssrn. Harvard University Press. Private institutional shareholders would monitor the Fund's activities. Box 1: SoFFin – A national financial stabilization fund limited in time The Finanzmarktstabilisierungsfonds (Financial Market Stabilization Fund) was created as part of the German Financial Market Stabilization Act (Finanzmarktstabilisierungsgesetz) on 17 October 2008. M. Company law monitor. "Have a Quiet Word? The Returns to Private and Public Shareholder Activism". "Corporate Law and Governance". Wall Street Journal. Is Corporate Governance Different for Bank Holding Companies? (March 2003). Bebchuk. North-Holland Becht. capital injections and/or the transfer (sale) of "toxic" assets acquired prior to 13 October 2008. Dewatripont. "Credit and Efficiency in Centralized and 177 . Fried.A. Maskin (1995). Chapter 12. 9. Marco. Cambridge. Cambridge. 921-963. and E. (2004). MA: MIT Press. The FSF would be accountable to its sponsoring governments and the general public.. In the case of capital injections and assumption of risk positions these include restrictions on remuneration and the prohibition of severance and dividend payments. (2009). L. securities regulation and other corporate governance provisions applicable to the banks it invests in. It is managed by the Finanzmarktstabilisierungsanstalt (Financial Market Stabilization Agency). Volume 2. Handbook of Law and Economics.S. "The uncertain relationship between board composition and firm performance". L.The fund has the purpose of stabilizing the financial system.M.Financial institutions receiving help from the fund become subject to certain conditions. Hamid.. J. Julian Franks and Jeremy Grant (2009). Renee B. S. and J. and Mehran. B.Corporate Governance and the Credit Crisis 8. (1999). Black. Congress Gets Punitive on Executive Pay.
php). Ross. 62. and O'Hara.541-555. Brussels.. 277-339.. M. American Economic Review 85. 9 September 2008 (http://www. Romano. Jonathan R. J. 1. Available at SSRN: http://ssrn. World Bank Policy Research Working Paper No. "Debt and seniority: an analysis of the role of hard claims in constraining management". Shareholder Report on UBS's Write-Downs.com/creditcrisis/recipients/table Billion Bailout. October. Weisbach. Paolo (2008). R. Zurich Union Bank of Switzerland (2008b). O. Maureen. 7-26. Available at SSRN: http://ssrn. The Corporate Governance of Banks. pp. Presentation at the Transatlantic Corporate Governance Dialogue Conference on "Corporate Governance and Financial Stability".nytimes. Economic Policy Review. "Boards of directors as an endogenously determined institution: a survey of the economic literature". Hart. mimeo Hermalin. B. 567-585. Harald and Marcel Thum (2008). April 2003. The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence (September 2004).org/tcgd/2008/presentations.com/abstract=795548 New York Times.S.E. Industrial and Corporate Change 5 (2). Review of Economic Studies.com/abstract=625281 Macey. 178 . (1996). Zurich Volpin.Macroeconomic Stability and Financial Regulation: Key Issues for the G20 Decentralized Economies". Tracking the $700 http://projects. Union Bank of Switzerland (2008a). 9. "Corporate law and corporate governance". No.ecgi. Public Banks in Germany. The Corporate Governance of Financial Institutions. Federal Reserve Bank of New York Economic Policy Review 9. 3404. Levine. Vol. Moore. (1995). Subprime-Related Losses and Board (In)Competence: Private vs. Report on Remediation of Causes of Sub-Prime Losses. Hau. (2003).
so that they internalise the effective demand externalities of the stimulus while reflecting each country's 'fiscal spare capacity'.org . • Force greater disclosure of information about the underlying pool of securities for structured instruments. and by accelerating the development of financial systems in emerging markets. The G20 process and the London Summit process offer the prospect of concrete. The essays in this e-book. and solutions must involve reciprocal commitments and actions. • Sever the link between credit rating agencies (CRAs) and issuers. • Establish a harmonized bankruptcy regime for banks. Prohibit indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. implementable results that can restore confidence and lead the way to recovery. giving the supervisor strong powers over bank managers and shareholders before the bank is technically insolvent. • Mitigate procyclicality by adjusting the Basel II capital requirements using a multiplier based on macroeconomic conditions. • Consider eliminating the 'hard wiring' of the CRAs in the regulatory system . • Use macroeconomic policy to meet any threat of deflation promptly. • Create a centralized clearing counterparty for CDS trades without further delay.less rather than more regulation here.cepr. but global: it involves the advanced countries. and poor countries. based on US-style 'prompt corrective action'. analyze a range of reform proposals: • Address global imbalances by creating insurance mechanisms for countries that forego reserve accumulation and stimulate domestic expansion. and an inflation target to avoid expectations of deflation. first presented at a seminar with the G20 Deputies on 31 January. so that a CRA's rating cannot be influenced by the prospect of future business with the issuer. There is no decoupling. emerging market countries.The current crisis is not only systemic. Centre for Economic Policy Research 53-56 GREAT SUTTON STREET • LONDON EC1V 0DG • TEL: +44 (0)20 7183 8801 • FAX: +44 (0)20 7183 8820 • EMAIL: CEPR@CEPR. • Consider the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities. • Design fiscal stimuli cooperatively.ORG www. Consider requiring that CDS be exchange-traded and prohibiting naked CDS. in particular local currency bond markets and foreign currency hedging instruments. with a zero interest rate policy and quantitative easing.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.