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J ournal of Regulation & Risk

North Asia
In association with

Volume III, Issue I – Spring 2011

Articles & Papers


After effects of 2008 financial crisis will last decades Prof. Carmen M. Reinhart & Vincent R. Reinhart

Awkward things, even ugly facts can be useful William R. White

Central bankers need to be more, not less, proactive Adam S. Posen

Macroprudential policy perspectives: Emerging markets Ramon Moreno

European crosshairs focus on short selling, OTC derivatives Carlos Tavares

Economists’ hubris: The case of equity asset management Shahin Shojai, George Feiger & Prof. Rajesh Kumar

Can the yuan ever become an international reserve currency? John H. Makin

How Spain can avoid a repetition of the Irish error Prof. Charles W. Calomiris & Desmond Lachman

The European Union debt crisis: Worrisome delusions Prof. Charles Wyplosz

Fiscal policy in the US and European Union ‘misguided’ Nobel Laureate Prof. Paul Krugman

Reliance on financial models risks repeat of 2008 fiasco Dr. Jon Danielsson

The economic consequences of naked credit default swaps Dr. Rajiv Sethi & Dr.Yeon-Koo Chi

Collateralised debt obligation detox for the European Union Satyajit Das

Capital in large financial institutions can’t be measured Steve Waldman

Lambs to the slaughter: Real causes of the financial crisis Peter J. Wallison

Sarbanes Oxley regulation in current financial markets Gavin Sudhakar

Integrating China’s economy into global capital markets Terry Tse & Gene Guill
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Publisher & Editor-in-Chief
Christopher Rogers
Editor Emeritus
Dr. John C. Pattison
Editor
Ian Watson
Chief Sub Editor
Fiona Plani
Editorial Contributors
Prof. Lawrence Baxter, Xavier Bellouard, Prof. William Black, Prof. Charles L.
Calomiris, Dr. Yeon-Koo Chi, Prof. Jon Danielsson, Satyajit Das, George Feiger,
Ian Fraser, Dr. Gene Guill, Andrew G. Haldane, Prof. Laurence J. Kotlikoff, Dr.
Brett King, Prof. Paul Krugman, Prof. Rajesh Kumar, Desmond Lachman, John
H. Makin, Ramon Moreno, Adam S. Posen, Robert Pringle, Prof. Carmen M.
Reinhart, Vincent Reinhart, Dr. Rajiv Sethi, Benjamin Shobert, Shahin Shojai,
Gavin Sudhakar, Prof. Jennifer S. Taub, Carlos Tavares, Terry Tse, Adair Turner,
Steve Randy Waldman, Peter J. Wallison, William R. White, Prof. Charles Wyplosz.
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JRRNA is published quarterly and registered as a Hong Kong journal. It is


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© Copyright 2011 Journal of Regulation & Risk – North Asia
Material in this publication may not be reproduced in any form or in any way
without the express permission of the Editor or Publisher.

Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.

Journal of Regulation & Risk North Asia 1


Volume III, Issue I – Spring 2011

JOURNAL OF REGULATION & RISK


NORTH ASIA
Contents
Q&A – Andrew G. Haldane 9
Debate – Adair Turner 19
Debate – Prof. Laurence J. Kotlikoff 35
Opinion – Prof. Lawrence Baxter 41
Opinion – Prof. Jennifer S. Taub 45
Book review – Benjamin Shobert 49
Book review – Satyajit Das 53
Comment – Ian Fraser 57
Comment – William Black 61
Comment – Xavier Bellouard 65
Comment – Dr. Brett King 67

Articles
After effects of 2008 financial crisis will last decades 73
Prof. Carmen M. Reinhart & Vincent R. Reinhart
Awkward things, even ugly facts can be useful 105
William R. White
Central bankers need to be more, not less, proactive 115
Adam S. Posen
Macroprudential policy perspectives: Emerging markets 141
Ramon Moreno
European crosshairs focus on short selling, OTC derivatives 159
Carlos Tavares
Economists’ hubris: The case of equity asset management 163
Shahin Shojai, George Feiger & Prof. Rajesh Kumar
Can the yuan ever become an international reserve currency? 177
John H. Makin
How Spain can avoid a repetition of the Irish error 185
Prof. Charles W. Calomiris & Desmond Lachman
The European Union debt crisis: Worrisome delusions 189
Prof. Charles Wyplosz

2 Journal of Regulation & Risk North Asia


Articles (continued)
Fiscal policy in the US and European Union ‘misguided’ 193
Prof. Paul Krugman
Reliance on financial models risks repeat of 2008 fiasco 197
Dr. Jon Danielsson
The economic consequences of naked credit default swaps 201
Dr. Rajiv Sethi & Dr.Yeon-Koo Chi
Collateralised debt obligation detox for the European Union 207
Satyajit Das
Capital in large financial institutions can’t be measured 215
Steve Waldman
Lambs to the slaughter: Real causes of the financial crisis 221
Peter J. Wallison
Sarbanes Oxley regulation in current financial markets 233
Gavin Sudhakar
Integrating China’s economy into global capital markets 243
Terry Tse & Gene Guill

Journal of Regulation & Risk North Asia 3


Foreword
The Journal, its staff and contributors associated with this publication wish to
extend their deepest sympathy to all individuals, their families and colleagues
bereaved or greatly affected by the March 11 earthquake and tsunami in Japan.
Further, we commend all those who have shown great stoicism and made valiant
efforts in dealing with the traumatic aftermath and nuclear crisis in Fukushima.
We, like people everywhere, trust that the Japanese nation will swiftly recover from
this catastrophe and apply the valuable lessons learnt to lessen the impact of any
future natural disaster in one of the world’s foremost economies.

In this, our first publication of 2011, we hope as ever to provide our readership with
valuable insights, opinion and comment on issues of importance to those dealing with
governance, risk management and compliance within northeast Asia’s financial services
sector. As usual, the Journal presents an eclectic mix of papers and articles from some of
the world’s foremost authorities on monetary policy, foreign exchange, regulation, com-
pliance, accounting and risk modelling – much of this informed by both the financial
crisis of 2007-8 and regulatory efforts, or lack thereof, to prevent another crisis in future.

This author, in league with many other authorities – among them the Bank of England,
Bank of Switzerland, UK Financial Services Authority, Swiss Financial Market Supervi-
sory Authority and numerous other voices – remains sceptical that Dodd-Frank’s and
Basel III have addressed adequately the causes that contributed to the financial melt-
down. As such, our attention now focuses on regulatory reforms expected to be imple-
mented by the European Union and United Kingdom during the remainder of this year
as politicians, central bankers and regulators balance the requirements of the financial
services sector with those of the electorate and a sound banking infrastructure able to
withstand another ‘black swan’ event without recourse to massive state bailouts.

The Journal remains committed to advancing a profitable financial services sector


that benefits the economic wellbeing of nations worldwide as well as the global economy.
We are in no doubt that banking and finance are of central importance to all developed
economies and that a well ordered and regulated financial services sector benefits all seg-
ments of society. As ever, we are opposed to onerous knee-jerk regulations that benefit no
one and will continue to present both sides of this ongoing debate throughout the year.

Christopher Rogers
Publisher & Editor-in-Chief

Journal of Regulation & Risk North Asia 5


Acknowledgments
THE editorial management of the Journal of Regulation and Risk – North Asia would
like to extend its gratitude to SWIFT Asia Pacific and Dow Jones for enabling the
Journal to publish and distribute this edition of the JRRNA. Further, the Journal
extends its thanks to those organisations and individuals that co-operated with,
contributed to, or authorised publication of content in this issue.

  A full list of those who kindly assisted with this, the Spring 2011 issue of the
Journal is not possible, but the Publisher and Editor would like to thank the fol-
lowing organisations for their generous assistance and support: The Federal
Reserve Bank of Kansas City; the Bank of England; the Bank for International
Settlements; CAPCO; Quartet FS; Financial Services Authority; Deutsche Bank;
Peterson Institute for International Economics; American Enterprise Institute;
Pareto Commons; VoxEU; economics21.org; Interfluidity, and Wiley Publications
for their kind permission to reproduce material from their respective publica-
tions and websites.

Detailed comments and advice on the text and scope of contents from Prof.
William Black, Dr John C. Pattison, Prof. Lawrence Baxter, Prof. Laurence Kot-
likoff, Satyajit Das, Steve Randy Waldman, Terry Tse and Prof. Jennifer Taub were
invaluable; we are also grateful to Ian Watson and Fiona Plani of Edit24.com for
their due diligence in setting out, editing and correcting the text.

  Further thanks must also go to the China Banking Regulatory Commission,
Beijing & Shanghai Chapters of the Professional Risk Managers International As-
sociation, and the Hong Kong Chapter of the Global Association of Risk Pro-
fessionals for their kind assistance in helping to distribute the Journal to their
respective memberships in Greater China, Japan and Korea.

Journal of Regulation & Risk North Asia 7


Q&A

Banking crisis of ‘07-’08 result


of a collective breakdown
Central Banking Publications’ Robert
Pringle puts some challenging questions to
the Bank of England’s Andrew Haldane.

Robert Pringle: As you are aware, the way tipping point dynamics of a financial system
the authorities reacted to events in 2007-8 under stress. In combination, these three
has been criticised. My own criticism, which I failures carry an important generic implica-
expressed at the time, is that they failed to make tion for crisis management, and that is the
clear until it was too late that they stood four- importance of keeping policy one step ahead
square behind the British banking system. Also of market expectations. Not to do so risks
official talk about the banks’ need for capital expectations becoming unanchored at times
rattled markets. How would you respond and, of uncertainty. Unanchored expectations
more generally, what lessons have been learnt cause asset prices to detach from fundamen-
for crisis management? tals. That manifests itself in large risk premia,
which during the crisis reached heights last
Andrew Haldane: There are a great many seen during the Great Depression.
lessons. And these lessons apply every bit
as much to the authorities and academics Fear of the unknown
as bankers. There was a collective failure to This was probably as much a reflection of
predict fully the crisis and its consequences. uncertainty, in the Knightian sense, as risk.
This failure had three elements. In part it was Everyone feared the unknown. In these
cognitive – disastermyopia was rife, with the situations, theory is turned on its head.
collective risk senses of the regulators and Pessimistic expectations drive asset prices
the regulated dulled by the period of appar- lower which in turn lowers spending: the
ently extraordinary stability that has become reverse of conventional asset price models,
known as the Great Moderation. in which fundamentals drive asset prices
In part, it owed to risk management – rather than vice versa. That is one reason
the failure to differentiate idiosyncratic from risk models failed to cope with the crisis.
systemic risks, and in turn manage them By generating bad fundamentals, spiralling
appropriately. And in part it was analytical expectations and asset prices became a self-
– there was insufficient appreciation of the fulfilling equilibrium.

Journal of Regulation & Risk North Asia 9


Robert Pringle: Turning to macroprudential Lehman’s failure brought the entire globe
policy, what tools does the Bank have to make down to earth with a bump at precisely the
the market pay due attention to its views – e.g. to same time. Given this interconnectivity, the
cool a future asset price boom? probability of simultaneous financial earth-
quakes is many times greater than if you
Andrew Haldane: The past is informative simply multiplied their individual probabili-
here. Pre-crisis, many central banks, includ- ties together.
ing the Bank of England, did have an instru- Cumulative pre-crisis losses of many
ment in their back pocket. That instrument of these financial earthquakes would have
was voice. It found expression in Financial been life-threatening for the world’s banking
Stability Reports, which proliferated over the system. For UK banks at the end of 2006, the
past decade. Looking back over those pre- Bank’s Financial Stability Report stress tests
crisis reports, the Bank (and other central estimated total losses in the region £100 bil-
banks) did a reasonable job of identifying the lion [approx. $162 billion]. We had the analy-
key financial fault lines. sis, and even the numbers, roughly right.
At the Bank we even tried to quan- But pre-crisis, they were viewed through too
tify the impact of those fault lines using, rose-tinted a lens.
at the time, a relatively untested approach
– aggregate, system-wide stress tests. The Barking dogs
estimated losses were large enough to chew Second, even if we had had the right lens,
up a chunk of the banking system’s capital. this would probably not have altered the
But, individually, those fault lines did not course of the crisis. The Bank, and others,
appear to be life-threatening for the global spoke with increasing forcefulness about
financial system. potential stresses in the system from 2003
onwards. We were dogs barking at the pass-
Robert Pringle: So what went wrong? ing traffic. As the cars drove past at increas-
ing speed, these barks grew louder. The
Andrew Haldane: Two things. First, the drivers of some of the cars took notice, but
authorities perhaps discounted too eas- they did not slow down.
ily the possibility of these fault lines being Why? Because they knew the dog’s bark
exposed if not simultaneously then at least was worse than its bite. What was needed
sequentially. In the financial system, eve- in this situation was someone to slow the
rything and everyone is connected. Those traffic, all of the traffic, for the game being
holding subprime securities also had expo- played was a collective mania. These manias
sures to various financial vehicles: struc- are founded on a desire to keep one step
tured investment vehicles, collateralised ahead of the opposition. This results in a
debt obligations, monolines and various race to bottom which, although individually
other nasties. rational, is collectively calamitous. It is a clas-
This interconnection across assets, sic co-ordination failure and so requires a co-
institutions and countries is one reason ordination solution.

10 Journal of Regulation & Risk North Asia


The solution? A watchdog with teeth. But there are good grounds for opti-
That is one vital element of macropruden- mism. First, we are hopefully some years
tial policy, being able to reinforce the words away from the next financial storm, cer-
with action. The typical macroprudential tainly of the severity just witnessed. This will
tools to lean against such cycles are likely give the new crew some time to practice
to be regulatory ones – for example, capital manoeuvring the vessel in calmish waters.
and liquidity ratios. By varying them coun- Second, the impact of policy on lenders’
ter-cyclically, banks’ cost of capital can help expectations may be the key transmission
moderate the credit cycle. Moderate but not channel. To see why, recall that the origins of
eliminate. Elimination of the credit cycle many past credit cycles are unco-ordinated
through macroprudential policy is infeasible, lending expectations. So the key is to find a
and possibly undesirable. means of co-ordinating expectations.
Changes in regulatory requirements
Radical departure have the potential to do so. The brakes are
So microprudential tools will serve macro- applied to everyone in the race. Lenders
prudential ends. This sounds fairly simple. know that if the initial policy signal is not
It will be anything but. It is a radical depar- heeded, tightening will continue until it is.
ture. And this policy experiment will be tak- Knowing that, there will be strong incentives
ing place pretty much simultaneously all to slow or stop provided policy is credible.
around the world – for example, in Britain Knowledge of the precise impact of changes
through the Bank’s new Financial Policy in regulatory ratios on lending behaviour,
Committee (FPC), across the euro-area therefore, may be less important than the
through the new European Systemic Risk credibility of policy announcements when
Board (ESRB), in the United States through made. This underscores the importance of
the new Financial Stability Oversight clear communications. It also suggests the
Council (FSoc). need to keep the macroprudential regime
relatively simple, especially at the outset.
Robert Pringle: How does this compare with
the early days of monetary policymaking? Robert Pringle: How does the macropruden-
tial objective and toolkit fit into the monetary
Andrew Haldane: Technically, this policy policymaking process? In particular do you
experiment will be no less daunting than- expect monetary policy – interest rate setting – to
when monetary policy first began to operate be more influenced by macroprudential concerns
actively. As then, knowledge of the trans- than in the past?
mission mechanism is scant. The authorities
will be sailing in largely uncharted waters in Andrew Haldane: Recent announcements
a new boat with a new crew. Against that in Britain signal a significant change in the
backdrop, it is perhaps understandable that Bank’s policy armoury. This will in future
some pessimists have predicted an immi- comprise three elements: microprudential,
nent shipwreck. macroprudential and monetary policy. And

Journal of Regulation & Risk North Asia 11


these three responsibilities will be executed Robert Pringle: More generally has the rela-
by three, three-letter acronyms: the PRA tionship between financial stability and mon-
(Prudential Regulatory Authority), the FPC etary policy changed?
and the MPC.
These three arms are complementary. Andrew Haldane: This relationship is, of
Micro and macroprudential policy will draw course, long-established. Both are about
on some similar information (for example, on preserving faith in money – whether central
banks’resilience) and will deploy some simi- bank or commercial bank money. History
lar instruments (for example, capital ratios). tells us it is impossible to deliver monetary
And macroprudential and monetary stability without financial stability, and
policy will likewise draw on some similar vice-versa.
information (for example, on credit condi-
tions) and both will have the effect of moder- ‘One spanner short’ risk
ating aggregate cycles in the macroeconomy It is not difficult to see why monetary and
(credit and business cycles respectively). financial stability have an umbilical link.
Housing these three policy levers under The crisis has underlined the importance
one roof helps ensure the necessary infor- of recognising the join between the two.
mation is made available to all who might Macroprudential policy is intended to com-
need it as smoothly as possible. It also helps plete that join. It fills the policy gap down
internalise any potential spillovers between which the authorities have sometimes fallen
the three, lowering the risk of institutional in the past. It reduces the risk of the authori-
arm-wrestling. ties being one spanner short of a full toolkit.
More than that, if well executed the
three levers ought to be mutually support- Robert Pringle: Are you satisfied that you will
ive. Consider the evolution of the financial have access in timely fashion to the data you
system between 2000 and 2007. In Britain, require, and how are you going to analyse it to
nominal spending was growing roughly at pinpoint emerging risks?
trend, at around five to six per cent a year. But
bank balance sheets were growing at three Andrew Haldane: Out of crisis springs
times that rate. opportunity as well as threat. The experience
of the Great Depression is salutary in this
Missing link respect, as out of it sprang a three-pronged
Had monetary policy aimed to check that revolution in macroeconomics. A revolu-
growth, the pain would have been felt by the tion in macroeconomic theory through the
non-financial sector. Prudential policy could IS/LM model which, with a few knobs and
have more effectively tackled those financial whistles, remains the mainstay of macro
excesses at source. It was the missing link in theory today.
the monetary/financial stability chain. With A revolution in macroeconomic
the introduction of the FPC, that link will policy – the dawn of activist monetary
now be forged. and fiscal policy. And a revolution in

12 Journal of Regulation & Risk North Asia


macroeconomic data, with the introduc- themselves went largely unanalysed until it
tion of the National Accounts. was too late. We need to avoid falling into
Although the least heralded, the third of that same trap.
these was every bit as significant as the first
two. In responding to the current crisis, it is Robert Pringle: Federal Reserve historian
possible we need a data initiative every bit Allan Meltzer and others have argued that all
as radical as followed the Great Depression. the regulation and restructuring in the world will
Data gaps have emerged and have ampli- not produce financial stability unless and until
fied stress at every stage in the crisis. Perhaps individual responsibility for avoiding excessive
most dramatically, a lack of knowledge of risk is brought back. Do you agree and if so how
network connections and counterparty can this be brought about?
exposures helped contribute to the seizure in
financial markets that followed the collapse Andrew Haldane: I am doubtful it would
of Lehman Brothers. be sufficient, but greater market discipline
Things are changing for the better. is a necessary ingredient in taming future
Initiatives are underway internationally, excesses. Perverse incentives contributed
including through the Financial Stability significantly to the crisis. The pay-off sched-
Board, to identify and plug data gaps. And ules facing staff and shareholders in financial
some of the policy initiatives in train will firms were option-like, with liability limited
deliver much better data on financial risks on the downside but returns unlimited on
and transactions. In future, a much larger the upside.
number of financial instruments will be
traded on exchanges and cleared on central Incentives to gamble
counterparties or transactions recorded in This generated inevitable incentives to gam-
trade repositories. ble. With taxpayers having further cush-
ioned the downside during the crisis, these
Potential goldmine incentives have been further distorted. It
These changes will generate a potential data is not difficult to conceive of contractual
goldmine for policymakers panning for nug- means of altering the pay-off schedules fac-
gets of systemic risk. It’s not foolproof. The ing shareholders and staff. Paying them in
key will be to ensure the authorities and equity, perhaps with a minimum vesting
market participants put these data to work period, would help.
systematically to help spot problems. The But Lehman Brothers and Bear Stearns
Bank for International Settlements interna- demonstrated that it is no panacea. Indeed, it
tional banking data were introduced as a could actually increase incentives to gamble
direct response to crisis – the less-developed for resurrection when firms are on the brink.
countries’debt problems of the 1980s. It may also reduce incentives to issue new
And they quickly demonstrated their equity for fear of diluting existing sharehold-
usefulness, signalling clearly debt problems ers and staff.
in the run-up to the Asian crisis.Yet the data Such was the Lehman story.

Journal of Regulation & Risk North Asia 13


Robert Pringle: So what’s the solution? Finance: A Systems View of the Credit Scrunch,
have suggested a move to confidence
Andrew Haldane: An alternative, recently accounting – placing confidence intervals
proposed by Jeffrey Gordon, a law profes- around banks’ asset valuations. This has par-
sor at Columbia University, is to distribute allels with publishing fan charts for macro-
to shareholders and staff in convertible debt economic variables in the Bank’s Inflation
rather than equity. That would preserve, Report. Fan charts signal the extent of
indeed heighten, incentives to keep out of underlying economic uncertainty, as a better
the tail, for at that point conversion of debt basis for planning and pricing. The self-same
into equity would crystallise losses. rationale applies to confidence accounting.

Capital cushion Robert Pringle: From a systemic risk per-


These same instruments would, through spective over what period should Basel III be
convertibility, provide an additional capital phased in?
cushion for a bank should it fall from heaven.
Measures such as these could help re-boot Andrew Haldane: Few people are anticipat-
the financial system with market discipline. ing the imminent return of a rampant hunt for
They probably need to be accompanied by risk. Balance sheets still need to be repaired.
greater transparency about the risks banks Memories of the recent crisis remain strong.
are taking. Financial bruises are still visible. And market
Transparency has been one of the true nervousness is still pervasive.
casualties of the crisis. Confidence in banks’
accounts had been badly damaged by the Overcooked claims
crisis even before the Repo 105 revelations This febrile environment gives us some
at Lehman Brothers. A rethink of disclo- breathing space. There have been a num-
sure practices is needed. It is easy to be criti- ber of recent private sector studies of the
cal of the accountancy profession. In some impact of hasty regulatory reform. They
respects, the judgments they are required to suggest the damage to growth from enact-
make when auditing bank balance sheets ing regulatory reform could be very signifi-
are next to impossible. cant.Having looked closely at these studies,
At times of acute uncertainty, it is unre- these claims seem to me to be overcooked,
alistic to expect accountants to reach a true often dramatically so. But there is some tail
and fair view of asset valuations when mar- risk of a drag on the real economy from the
ket participants themselves have no clue. regulatory agenda – a possibility rather than
In situations like these, bank balance sheet a probability.
uncertainty is intrinsic. This intrinsic uncer- In the face of these uncertainties, it
tainty might usefully be better recognised in makes sense for the authorities to tread care-
accountancy practices. fully. Put more formally, uncertainty calls for
For example, Michael Mainelli and Bob a minimax strategy, where you minimise the
Giffords in their book, The Road to Long chance of an awful outcome. This speaks to

14 Journal of Regulation & Risk North Asia


smoothing the transition to a new regula- outside of established policy frameworks,
tory regime. as agents internalise the possibility of the
The G20 endorsed that position at their authorities blinking again next time.
meeting in Toronto in June 2010. This was The key is, then, to design policy frame-
recognition that countries’ cycles and bank- works which are time consistent in the face
ing systems were in different phases and of tail events. This means striking a balance
states of health. It was also recognition that, between the credibility of the framework
if the regulatory regime is to be flexed, this on the one hand and its flexibility on the
is better done through the transition path other. The evolution in policy frameworks
than end-point. Against that backdrop, a during the crisis has taken us somewhat in
multi-year transition timetable for reform that direction. Say on liquidity provision, the
would be tolerable, provided the end-point Bank’s new framework provides a Discount
remains credible. Window Facility and longer-term repos
against a wider set of collateral to achieve a
Robert Pringle: Turning to longer-term issues, credible framework with built-in flexibility.
the crisis forced central banks and governments
in many countries to take unprecedented actions. Rainbow coalition
Some people including some central bankers On the regulatory front, the architecture of
think these have damaged central banks’ cred- capital rules is also moving in this direction.
ibility. What is your perception? Historically, regulatory capital was usable in
death but not life. The new capital regime
Andrew Haldane: No one’s credibility has aims to add a buffer that is intended to be
escaped unscathed. The focus of the pub- usable in life as well as death, rising when
lic’s ire has predictably been the banks and, the good times roll and falling when the bad
to lesser extent, the authorities. But the eco- times rumble. This will introduce a much
nomics and finance profession has not had greater degree of flexibility into the regula-
a good war. And nor should borrowers be tory regime – a rainbow coalition of conserv-
excused from blame. Both sides need to be ative minimum and liberal buffers.
more disciplined if future credit cycles are to
be tamed. Robert Pringle: When you and I took part in
a seminar in Hong Kong last March – organised
Keynes’ dictum by the Journal of Regulation & Risk - North Asia
For the authorities, elements of pre-crisis – where you gave the speech entitled the “$100
policy framework, in the teeth of the worst billion question” and I listened as you estimated
crisis in a half-century, were flexed. That is the scale of the massive annual subsidies to
not something to apologise for. When the banks from taxpayers, I could not help wonder-
facts changed, policymakers changed their ing whether the game is worth the candle.
minds. Keynes’ dictum was followed. The The price in terms (for example) of costs to
world would have been a worse place had taxpayers and of growing inequality as banks
it not. But there are costs from having acted hold society to ransom, seems unacceptable;

Journal of Regulation & Risk North Asia 15


anything would be better, even the nationalisa- There seems to me to be a lot of resist-
tion of the financial system. What conclusions do ance among members of the banking com-
you draw from your analysis? munity to structural reform. Structure is a
bogeyman for much of the financial industry.
Andrew Haldane: Now is as good a time Part of the problem is semantic. The struc-
as any to rethink the industrial organisa- ture debate too easily attracts labels – Glass-
tion of banking. Given a clean slate, the Steagall this, McFadden that. But the debate
existing structure of finance is not where need be neither narrow nor name-specific. It
you would start. should embrace reform of financial structure
The financial system is large (perhaps too in a general sense – the structure of finan-
large), concentrated (possibly too concen- cial contracts and infrastructures, as well as
trated), risky (probably too risky) and com- financial institutions.
plex (almost certainly too complex). Events
since the crisis have, if anything, amplified Altered topology
some of these trends. That is why the work On the last of these, a fairly radical set of
of the new Banking Commission set up by reforms are underway to improve market
the new government is so important. infrastructure, including through central
Regulatory reform is seeking to lean trading and clearing of financial instruments.
against these trends. But it has obvious lim- That will alter fundamentally the topology of
its. After each crisis the lament has been the the financial network. The financial system
same – ‘more of the same, but better’. To will go from resembling a ball of wool to a
date, the same path of reform has been fol- bicycle wheel. This rewiring ought to make
lowed: more capital and liquidity – only this the system less prone to short-circuit when
time it will be better quality; more regulators next a fuse blows.
– only this time they will be smarter.
The ‘same but better’ ideology has not Hidden complexities
served us especially well to date. That is why On financial contracts, many contracts writ-
policy may need to refocus its sights on a dif- ten ahead of the crisis amplified stress rather
ferent objective – regulating structure as well than moderating it. Many had hidden com-
as behaviour. plexities which confused investors or hidden
options which crippled them. AsYale econo-
Structural ‘bogeyman’ mist Robert Shiller has discussed, it is not
There are good theoretical reasons for doing difficult to design contracts which automati-
so. Structural (or mechanism) design is an cally hedge risk – state-contingent contracts.
effective way of shaping incentives in a way Contingent capital is one topical exam-
which is robust to uncertainty and arbitrage. ple. GDP bonds issued by sovereigns are
There are also some good practical reasons another. Asset-price-indexed secured debt
for seeking structural reform; it reduces the would be a third.
need for an encyclopaedic regulatory rule On financial institutions, there is an
book and an omniscient regulator. ongoing debate about separating retail and

16 Journal of Regulation & Risk North Asia


investment banking, the casino from the The regulatory authorities played their
utility. In reality, banking does not neatly part in encouraging both. This lack of diver-
divide in quite this way. Some retail banking sity increased the system’s brittleness when
is race-track betting and some investment the sunlight was eclipsed.
banking is utilitarian. This is a finding other disciplines have
long recognised. There are literally thou-
Hedging the risks sands of years of empirical evidence from
In engineering structural reform, the key natural ecosystems on the link between
instead is to better align the risk character- species diversity and system-wide robust-
istics of the assets banks hold and the liabili- ness. In environmental ecosystems, diversity
ties funding them. Consider retail deposits. If prevents disease spread and strengthens the
retail deposits are to be riskless, as customers immune system.
demand, the assets backing these safe liabili-
ties need to be similarly safe. Systemic diversity
Equally, if risky assets are to be held, And in decision-making ecosystems, diver-
then to align risk characteristics these sity of opinion makes, on average, for better
assets need to be funded with loss- decisions. All of this is reassuring at a time
absorbing liabilities, either equity or when new committees on systemic risk are
convertible debt. By restructuring in this springing up all over the world. In making
way, risks to banks’ balance sheets are future macroprudential decisions, diversity
hedged without resort to the taxpayer or of the system should be given prominence
the chainsaw. as a public policy objective – not because it
There is risk ring-fencing. That ring- is politically correct, but because it is analyti-
fencing can be done within a group structure cally compelling. •
or outside of one.
Editors Note: The Journal of Regulation &
Robert Pringle: The major centres are setting Risk – North Asia would like to extend its
up systemic risk regulators, with central banks gratitute to the Chairman of Central Banking
having important roles. Can these avoid being Publications, Robert Pringle, and the Bank of
procyclical? Shouldn’t we be encouraging diver- England’s Executive Director for Financial
sity of regulatory system? Stability, Andrew Haldane, for taking time
out from busy schedules prior to the New
Andrew Haldane: The diversity issue is an Year to participate in the Journal’s regular
important one. Homogeneity hallmarked Q&A section.
the run-up to crisis: homogeneity of busi- We would also like to instruct readers of
ness strategies by banks, as they collectively the Journal that this interview – arranged by
grew towards the newest source of sun- the JRRNA – first appeared in the autumn
light; and homogeneity of the risk man- edition of Central Banking and has been
agement systems intended to keep this modified slightly for the purposes of this
behaviour in check. publication.

Journal of Regulation & Risk North Asia 17


Debate

Remove excess credit if you


wish to mitigate against crisis
Adair Turner, Chairman of the UK’s
Financial Services Authority, weighs up a
myriad of problems associated with banking.

In this section of the Journal, we cover the period 1970 to 2010 from the mid-20th
ongoing debate and dialogues con- century, is that the complexity of finance and
cerning major issues of the day. In this, its scale relative to the real economy has dra-
the first part of our debate section, the matically increased. Debt to GDP ratios have
Journal publishes an abridged version increased dramatically in the household and
of a speech delivered by the head of the corporate sectors, but even more so within
UK’s FSA in the autumn of 2010 which the financial sector.
drew considerable criticism from Prof.
Laurence Kotlikoff, author of the criti- Increased complexity
cally acclaimed book: Jimmy Stewart The value of trading activities – whether
is Dead – Ending the World’s Financial in foreign exchange or debt, or equities, or
Plague with Limited Purpose Banking. commodities, has increased hugely relative
to related real economy variables. And the
What do banks do: Why do credit booms and complexity of the wholesale financial mar-
busts occur and what can public policy do kets has greatly increased, with the emer-
about it? In this paper, we attempt to answer gence of interest rate and credit derivatives,
this vexed question as the global economy and structured credit products, which did
begins returning to some semblance of nor- not even exist 30 years ago.
mality following the 2007/8 financial crisis – a After a mid-20th century of relative
tumultuous series of events that precipitated financial repression – a reduction in the rel-
the largest downturn in global GDP since ative role in finance – we have seen finan-
the Great Depression of the early 1930s. cial deepening and increased complexity.
Finance plays a crucial role within a mar- And the predominant pre-crisis conven-
ket economy, but that role has continually tional wisdom was that this deepening and
evolved during the 200-year history of mod- increased complexity had been beneficial,
ern economics. And one striking thing about increasing both allocative efficiency and
the past 40 years, which clearly distinguishes system stability.

Journal of Regulation & Risk North Asia 19


Financial deepening and liberalisation • Over-reliance on apparently sophisti-
were seen as an integral part of the package cated mathematical models to measure
of ‘structural reform’ which would deliver and manage risk;
improved economic performance. But these • Poor corporate governance and risk
confident assertions are not clearly sup- management processes;
ported by the facts. • And the explosion of uncleared coun-
It is not clear that financial deepening terparty exposures, which created a cat’s
beyond that already achieved in the devel- cradle of non-transparent relationships
oped world 30 years ago has significantly between multiple financial institutions.
increased allocative efficiency and growth.
Looking at the highest level, at overall cor- Fundamental questions
relations of financial intensity and GDP Fixing these and other obvious deficiencies
growth, there is no clear relationship. in our financial system must form an impor-
The period of relative financial repres- tant part of the new regulatory agenda. But
sion from 1935 through to 1970 delivered fixing these problems will not be a sufficient
growth almost as substantial as the subse- response. And we will not design a sufficient
quent 40 years of financial deepening and response unless we ask relatively fundamen-
liberalisation. It may be true that specific tal questions about what a financial system
elements of increased financial intensity does and what it should do, and about why
and sophistication in certain circumstances financial markets and institutions, in particu-
deliver increased allocative efficiency. lar banks, are so vulnerable to instability.
However, that must of necessity be illus- And what that fundamental analysis
trated at the specific level; it is not proved by shows is that the roots of instability lie not,
high-level correlations. or not just, in specific faulty features of the
current system – in bad incentives, poor risk
Financial dustbowl management, over-complex products or
As for the claims of increased stability – over-reliance on ratings – but in too much
clearly they have turned to dust in the finan- credit, too easily available at too low a price,
cial crisis of 2007/8. And in the wake of that with the fundamental problem being that
crisis, it is easy to identify numerous specific bank lending, financial markets and prop-
features of the new financial system which erty markets interact in ways which drive
created greater risk, such as: destabilising credit and asset-price cycles.
• Overly complex structured credit
products, with deeply embedded Careful management
options which many investors did not Our regulatory response will not there-
properly understand; fore be effective unless: in the long run it
• Bonus structures which created incen- reduces leverage in the financial system and
tives for excessive risk-taking; constrains it in the real economy; and, puts
• Conflicts of interest and poor practices in in place new policy tools to take away the
credit rating agencies; punchbowl of excessive credit and property

20 Journal of Regulation & Risk North Asia


price inflation before the party gets out of unmatched assets and liabilities, so that the
hand. The transition to that sounder system provider of funds can hold an asset which
needs to be managed with care – too rapid looks different in risk, return and maturity
a progress to higher capital and liquid- from the liability the fund users owes.
ity standards could slow recovery – but we
need to be clear that long-term reform of the Four functions
financial system will have at its core changes This is achieved by four transforma-
that mean that credit is not as easily available tion functions: Pooling – which enables a
as in the pre-crisis years. householder, for instance, to hold an indi-
Financial systems and markets in aggre- rect claim on many different SME loans,
gate perform four functions. They provide rather than be exposed to a specific risky
payment services; they provide insurance SME; Maturity transformation, which
services; they create markets in immediate can be delivered in two different ways:
and short-term futures contracts, such as in – contractually on bank balance sheet, with
foreign exchange or commodities; and they householders holding on-demand depos-
intermediate between providers of funds its but borrowing 20-year mortgages; or
and users of funds, savers and borrowers, via liquid traded markets, with individuals
and as a result play a crucial role in the allo- able to hold equities for a day, even though
cation of capital within an economy. the fund user enjoys perpetual equity
finance. And finally risk/return tranching,
Greatest risks with moderately risky bank loans funded
There are risks involved in all of these func- with a mix of very low-risk deposits and
tions. But it is primarily in the fourth func- high-risk bank equity.
tion, and sometimes in the third function,
that the greatest risks to financial stability Inherent vulnerability
arise and therefore deserve greater attention. The remainder of this article explores the
The financial intermediation function links value added which these transformations
providers of funds to users of funds. deliver and the risks they create. It identifies
Sometimes the link is a ‘matched’ one five interacting factors which help explain
with, for instance, a householder directly why banking crises occur and cause harm,
buying the equity or bond of a business or and why the latest was so severe:
a government so that the asset the fund First, the fact that all financial markets
provider owns looks exactly the same as are inherently vulnerable to divergence
the liability the fund user owes. And the from equilibrium values and that as a
financial system helps lubricate that pro- result increased financial trading activity
cess through market-making, and through creates increased risks, even if it delivers
research and distribution. some benefits.
But the really crucial intermedia- Second, that credit contracts introduce
tion activities, and those which introduce very specific vulnerabilities in our econo-
the greatest risk, are those which create mies, and that the greater the role of credit

Journal of Regulation & Risk North Asia 21


contracts, i.e. the greater the level of leverage tools, which lean against the wind of exces-
in the real economy and in the financial sys- sive credit creation and of asset-price cycles.
tem itself, the more vulnerable the system is It is now necessary to look at what are
to shocks and self-reinforcing cycles. the key arguments of each of the five points
Third, that fractional reserve banks raised thus far and then explore policy impli-
introduce specific vulnerabilities into the cations associated with these points.
economy because of their specific ability to
create credit and money and because of their Key driver
maturity transformation function. We begin with the premise that liquid finan-
Fourth, that different types of credits cial markets are inherently vulnerable to
perform quite different functions within instability. One key driver of potential insta-
the economy, with credit extended to bility is that financial markets are inherently
finance existing assets, in particular to susceptible to momentum and herd effects;
finance property, quite different in nature to over-shoots; to self-reinforcing ‘irrational
from credit extended to finance new invest- exuberance’, and then irrational despair.
ments, and peculiarly susceptible to volatile Charles Mackay’s classic work on the
supply and pricing. Madness of Crowds, Charles Kindleberger’s
Fifth, that the growth of securitised credit, on Manias, Panics and Crashes – have docu-
while theoretically having the potential to mented that inherent susceptibility, from the
disperse and reduce risks, in fact interacted Dutch tulip mania of 1635-37 to the Wall
with the specific risk characteristics of banks Street boom of the 1920s. And we have an
to make the whole system less stable. increasingly rich theoretical understanding
of why these overshoots occur.
Crucial interactions The behavioural economics of Daniel
The essence of why the financial system Kahneman and others provide explanations
proved so unstable, and why the latest from psychology and evolutionary biology,
financial crisis was so great, lies therefore, I with people acting in instinctive or emo-
argue, in the interaction between the specific tional ways which, even at the individual
characteristics of credit contracts, of banks, level, might reasonably be described as irra-
of real estate finance, and of liquid traded tional, with ‘animal spirits’ sometimes a key
markets. The regulatory reform agenda must driver of market dynamics.
therefore address these interactions. At its
core should be two elements: much higher ‘Irrational boom’
capital and liquidity requirements across the But theories of imperfect principal/agent
banking system and, in particular, for large relationships and decision-making under
systemically important banks, addressing conditions of imperfect information and
the ‘Too Big to Fail’ (TBTF) conundrum but inherent irreducible uncertainty, also explain
not believing that fixing TBTF is sufficient in how even the most rational of people might
itself to make the system more stable; and participate in a collectively irrational boom,
the development of macro-prudential policy calculating that they will be among those

22 Journal of Regulation & Risk North Asia


clever enough to get out just in time – a crises lies in the specific character of credit
matter Paul Woolley touched upon recently contracts. Four features are important: speci-
when detailing principal/agent relationships ficity of tenor, specificity of nominal value,
and their implications. the irreversibility and rigidities of default and
But while all liquid financial markets bankruptcy, and the credit/asset price cycle.
are susceptible to unstable divergence from
equilibrium values, it is clear that some Continuous credit supply
booms and busts matter more than others, We shall come back to the credit/asset price
and that, in particular, booms and busts in cycle later in this paper; for now, a brief com-
credit pricing and credit supply are far more ment on the first three features:
important than those in specific commodi- Specificity of tenor: The fact that a debt
ties or in equities. The internet boom and contract has to be repaid at a particular
bust of 1998-2001 was large enough to move date, and that at any time there are large
equity indexes in a dramatic fashion and to debt repayments due next month or next
create wealth gains and losses which were year, means that a continual supply of
significant relative to US GDP, but the bust new credit is essential to the working of
had only a slight impact on US or global the economy in a way which is not true of
growth. The fall of corporate bond spreads to equity finance. Equity prices can collapse,
a low point in spring 2007 followed by huge and firms may be unable to raise new
rises in 2007-09, by contrast, reflected a credit equity, but they are not also required to
boom and bust which tipped the whole repay existing equity; and economies could
developed world into severe recession. operate for sustained periods of time with
no new primary equity issues: they cannot
Volatility the culprit operate without new lending to refinance
And throughout modern economic history, old. Credit is different because if the finan-
in the 19th century banking crises and in the cial machine suddenly stops lending, the
many banking collapses of the 1930s, and economy can go into reverse.
in the numerous crises of the past 30 years,
it was volatility in credit supply within the Deflation hazard
economy, surges and sudden stops of credit Specificity of nominal value: Debt contracts
– whether to governments, to other banks, or in nominal value money terms – is an equally
to the non-bank private sector, which have important feature, harmless as long as gen-
had a peculiar ability to cause real economic eralised inflation is maintained at a relatively
harm. A banking crisis, as the IMF notes, is stable and predictable level, but potentially
far more likely than other financial crises to destructive in the face of unanticipated infla-
cause severe recessions. tion or deflation.
Turning our attention to the second of Unanticipated inflation and hyper-infla-
our raised points, that is, credit contracts tion can destroy financial wealth and social
introduce specific vulnerabilities. The expla- cohesion, but it is unanticipated deflation,
nation for the greater impact of credit-related such as that of 1930-33 in the US, which has

Journal of Regulation & Risk North Asia 23


arguably even greater capacity to wreak real characteristics of credit mentioned earlier
economic harm through its impact on the – specificity of tenor and nominal value,
real value of debt, via the mechanisms which the rigidities and irreversibilities of default
Irving Fisher set out in his classic article on and bankruptcy, and the potential for credit
Debt Deflation. driven asset price cycles – apply to non-bank
credit securities as well as to bank intermedi-
Direct contradictions ated credit – and indeed one crucial issue to
Irreversibility and rigidities of default and which we return later is whether a non-bank
bankruptcy: which generate economic system of credit extension introduces some
costs even in the absence of debt-deflation specific drivers of instability which are not
or financial crisis, but which if combined present to the same extent in a bank-based
with either debt-deflation or banking crisis credit system. But it is certainly the converse
(banks as well as corporates going bankrupt) case that bank credit intermediation intro-
can have an enormously destructive effect. duces specific risks not present in the non-
As Ben Bernanke points out in one of bank case.
his Essays on the Great Depression, the
existence of debt default and bankruptcy Different combinations
are direct contradictions of any theory of Essentially, what leveraged fractional reserve
smoothly adjusting economic relationships. banks do is to increase the range of poten-
‘In a complete markets world, bankruptcy tial contracts available to both users and
would never be observed’, Bernanke notes suppliers of funds, by making it possible
‘because complete state contingent loan for suppliers to hold assets with different
agreements would uniquely define each combinations of risk, return and maturity
party’s obligations in all possible circum- from those which users of funds face in their
stances. As firms approach default, eco- liabilities: they maturity transform – enabling
nomic rationality and perfect information providers of funds to hold deposits of much
would dictate a smoothly operating write- shorter tenor than the maturity of the loans
down of debt claims or translation of debt advanced to users of funds; and they tranche
claims to equity claims. by risk and return so that moderately risky
loan assets are funded with a mix of close to
Destructive credit crunches zero risk deposits, moderately risky senior
The fact that instead we have large legal debt, and high risk equity.
and administrative costs, and fire sales of Those transformation functions appear
assets, illustrates how far from the ‘Arrow- to deliver significant economic benefits, at
Debreu nirvana’ of complete markets our least at some stages of economic develop-
real world economy actually is, and it makes ment. Economic historians of 19th century
credit crunches hugely disruptive. Fractional Britain have often argued that Britain’s
reserve banks introduce further specific more developed banking system was one
risks, but it is not just credit which is differ- of the factors driving superior economic
ent: bank credit is even more specific. The performance, facilitating the mobilisation of

24 Journal of Regulation & Risk North Asia


savings which would have been more dif- safe through the combined effect of capital
ficult if savers had been linked to users of and liquidity regulation and central bank
funds through untransformed contracts, in liquidity insurance. Finally, banks have a par-
which the risk, return and maturity of the ticular ability to drive credit and asset price
issuers’ liabilities had to match precisely the cycles – the fourth specific feature of credit
aggregate risk, return and maturity of the instruments to which I will now turn within
savers’assets. a consideration of the different economic
functions of different credit categories.
‘Borrowable money’ Turning our attention to the fourth
Walter Bagehot certainly believed so, argu- point I raised previously, this being dif-
ing in Lombard Street that Britain enjoyed ferent categories of credit deliver different
an economic advantage over France value and create different risks. Over the
because the UK’s more advanced banking past 40 years, household and corporate
system fostered the productive investment sector sterling denominated debt in the UK
of savings rather than leaving them ‘dor- has grown from about 22 per cent to 125
mant’. ‘Much more cash’ he wrote, ‘exists per cent of GDP.
out of banks in France and Germany and
in the non-banking countries than can be Self-reinforcing
found in England or Scotland, where bank- The vast majority of this debt has been lent by
ing is developed. But this money is not . . banks, and has been largely matched, though
. attainable . . . the English money is “bor- not entirely, by the growth of bank deposits,
rowable money.” with bank credit and bank money created in
But these benefits of leveraged and frac- a self-reinforcing fashion. Banks have thus
tional reserve banks also bring with them delivered more leverage to the real economy.
very significant risks. Banks facilitate greater But with two thirds of the loan assets long-
leverage in the real economy and they are term mortgages, and with deposits primarily
leveraged themselves, increasing the dan- short term, they have also delivered much
gers that arise from the specific characteris- more maturity transformation.
tics of credit rather than equity contracts. Both increased leverage and increased
maturity transformation create risks for
Risky institutions the economy, but can also deliver benefits.
And they introduce maturity transformation The challenge for prudential regulation is
risks, and related confidence and contagion to preserve the benefits while constraining
risks, rooted in the simple fact that banks risks to an acceptable level. In many debates
create a set of contractual liabilities which about credit extension, and about the impact
legally have a right to simultaneous execu- of new prudential regulations which may
tion, but which banks could never simulta- restrict it, it is assumed that credit contracts
neously honour, given the contractual tenor primarily perform the function of linking
of their assets. Banks are therefore inherently savers with businesses investing in produc-
risky institutions, which can only be made tive assets.

Journal of Regulation & Risk North Asia 25


More credit supply and cheaper credit loans, only to a limited extent, finance new
supply is assumed to be good for business productive investment: rather they are pri-
investment, enabling more investment pro- marily used to finance the tax advantaged
jects to exceed the cost of capital. Capital and purchase of already existing assets in the
liquidity regulations, which restrict credit expectation of future capital gain.
supply or increase its price, are therefore Policies to ensure financial stability there-
often assumed to produce harmful effects on fore need to recognise the central impor-
growth through their impact on investment. tance of real-estate finance in the banking
and wider credit markets of the UK and
Household deposits many other developed countries, and the
It is certainly essential in our assessment of way in which credit supply and asset prices
capital and liquidity rules that we consider can become linked in self-reinforcing cycles
such possible effects and balance any such of the sort described by Hyman Minsky.
adverse impacts, whether in the long term or These credit and asset price cycles are inher-
over the transition period, against the bene- ent potential risks in any system of fractional
fits of reduced instability, which higher capi- reserve banks, and are the key drivers of
tal and liquidity requirements would deliver. financial and economic instability which
But it is also important to understand prudential regulation needs to address.
that only a minority of credit extension in
the UK and other rich developed econo- Interest rate elasticity
mies now performs this economic function. It is therefore essential that our assessment
Whereas in 1964 a mental model in which of the impact of prudential regulation recog-
the UK banks took household deposits and nises the very different economic functions
lent them on to business captured much of of different categories of credit. It also needs
the reality, over the past 40 years, loans to the to recognise that the interest rate elastic-
household sector, and in particular residen- ity of different categories of credit is likely
tial mortgages, have become dominant. to be highly variable, particularly in boom
times. The interest rate increase required to
Socially useful slow down a commercial real estate boom,
This intermediation from household depos- fuelled by expectations of future capital
its to household mortgages is socially useful, gain, may be so high that it causes severe
but its social value is only to a limited extent harm to the flow of credit to finance new
related to new physical investment in the productive investment.
housing stock, instead primarily delivering The appropriate policy response may
value to the extent that it enables more effec- therefore need to include quantitative levers
tive life-cycle consumption smoothing and which directly address credit supply, and
inter-generational resource transfer. their variation by sector of the economy.
Loans to the corporate sector, mean- Andrew Smithers and Andrew Large con-
while, are increasingly dominated by loans sider the options for such macro-prudential
to finance commercial real estate. These tools in their contribution to this book.

26 Journal of Regulation & Risk North Asia


Turning to my fifth and final point, It seemed to deliver an array of benefits.
namely, that securitisation was supposed It enabled investors to select assets more
to reduce the risks, but instead created new precisely tailored to their own specific risk
ones. In the confident pre-crisis conven- return preferences. Therefore, it was argued,
tional wisdom, securitised and structured it facilitated increased credit extension – per-
credit and related credit derivatives were haps a true but also an ambivalent benefit
lauded as a new financial technology, which to which I will return later. And it enabled
was both increasing allocative efficiency and banks to better diversify risk: originating
reducing risks. loans but then distributing some of them
to end investors, so that banks no longer
Inherent danger needed to hold portfolios determined by
But while in theory securitised credit could their own specific regional or client base. As
have achieved risk reduction, its particular a result, it was believed, securitisation made
implementation undermined that potential possible a more stable financial system.
and it simultaneously created a new and
dangerous source of instability. Undelivered ‘benefits’
Simple credit securities – government And in theory it should have been more sta-
or single name corporate bonds – have ble, because it appeared to remove from the
existed for almost as long as bank loans, credit extension system the particular risky
and continue to play a major role in the features which come with bank balance
credit extension system, linking investors sheets. It should result in assets being held by
to users of funds in ‘matched’, non-trans- end investors rather than by leveraged bank
formed, credit relationships. But from the intermediaries. And it should remove the
1970s pooling was used to create credit contractual maturity transformation of bank
securities out of multiple small credits, and balance sheets, substituting instead liquid-
tranching was used to create securities tai- ity through marketability. Part of what went
lored to the risk return preferences of dif- wrong, however, was that neither of these
ferent investor groups. supposed benefits was actually delivered.
When the music stopped in 2008, a large
Array of benefits share of credit securities turned out to be
Essentially, securitisation achieves the same held on the trading books of banks – banks
risk tranching function performed by a which had originated and distributed credit
bank balance sheet, but without overt bal- with one hand, then bought back other
ance sheet based maturity transformation. banks’ credit securities with the other hand,
By the early 21st century securitised credit encouraged to so by utterly inadequate
had grown to account for over 50 per cent capital requirements against trading assets.
of all US home mortgages, 25 per cent of And shadow bank maturity transforma-
US commercial mortgages and consumer tion – SIVs and conduits and mutual funds
credit, and in the UK over 20 per cent of holding long-term assets against short-term
home mortgages. liabilities and relying on market liquidity to

Journal of Regulation & Risk North Asia 27


allow sales to meet redemptions – turned noting with approval that credit derivatives
out to be quite as risky as the contractual on ‘enhance the transparency of the markets
balance sheet variety. collective view of credit . . . [and thus] . . . pro-
These specific faults in the system vide valuable information about broad credit
can be addressed by better regulation – conditions and increasingly set the marginal
though as a result, much of the demand price of credit’.
for securitised credit instruments may But setting the marginal price of credit
never return, the faults being essential to by reference to the market’s collective view
their apparent attractions. of credit risk is allocatively efficient and risk
reducing only if the markets collective view
Exuberance, despair of risk is sound. If instead, CDS spreads for
But the wider development of securitised the major banks fell dramatically, as they did
credit and credit derivatives also created a from 2002 to reach a historical low in spring
new category of risk – a risk which takes us 2007, just before the financial crisis broke,
back to the first of my five points, that all liq- and providing no early warning whatsoever
uid financial markets are vulnerable to herd of the increased risks, then the greater use
and momentum effects, to surges of collec- of market credit prices to inform risk assess-
tive irrational exuberance and then despair. ment can accentuate still further the risks
At the core of these effects are self-refer- inherent in credit contracts and fractional
ential rather than fundamental assessments reserve banks.
of risk and price – equity pricing in Keynes’
words being like a ‘pick the prettiest face’ Accentuated risks
competition in which ‘we devote our intel- The development of securitised credit with
ligence to anticipating what average opinion transparent and potentially self-referential
xpects the average opinion to be’. prices, and combined with mark-to-market
As trading of securitised credit and credit accounting, as a result played a role in accen-
derivatives grew in importance, it became tuating the risks of credit and asset price
easier for such self-referential approaches to cycles always present in systems of bank
be applied to credit markets – with not only credit extension.
non-bank credit investors, but also banks Overall, therefore, the explanation
themselves using the price of credit to infer of why the latest financial crisis was so
risk, rather than using fundamental risk severe seems likely to lie in the interaction
assessment to determine the appropriate between different sources of instability.
price of credit. Excessive bank lending to finance assets
which increase in value as a result of the
‘Enhanced transparency’ credit extended, had caused multiple past
A trend which the conventional wisdom crises long before securitised credit and
of efficient market theory not only noted, credit derivatives had been created.
but positively welcomed, the IMF Global And liquid financial markets are inher-
Financial Stability Review of April 2006 ently vulnerable to momentum and herd

28 Journal of Regulation & Risk North Asia


effects which drive divergence from equilib- forces which drive credit and asset price
rium values, but booms and busts in equity booms and busts. The importance of credit
prices are not always hugely harmful at the was indeed recognised as a central issue
macro level. by the cheerleaders of financial liberalisa-
tion and deepening, but with the simplis-
Classic cycle tic assumption that more credit was, by
What was especially toxic about the financial definition, good.
system in the run-up to the crisis, however, Thus as mentioned earlier, one of the
was the intensity of interaction between arguments for securitisation and credit
maturity transforming banks, real estate derivatives was that they ‘facilitated credit
markets, new and complex forms of credit extension’. And in the debates about the
extension and non-bank maturity trans- Basel II capital regime, one of the overt aims
formation, and liquid financial markets in of the reformers was to introduce advanced
which credit risk assessment and pricing risk assessment techniques which would
became self-referential. This interaction allow banks to operate with less capital than
drove an extreme version of the classic credit before, thus making possible higher bank
and asset price cycle, more complex and and real economy leverage.
more global in reach.
I began this article by referring to some Rising inequality
obvious things that went wrong with The rapid growth of credit in the pre-crisis
finance before the crisis and some obvious years, particularly in the United States,
and very important things we need to put was not therefore an accidental by-prod-
right. Large bank bonuses for selling over- uct of financial liberalisation, but a delib-
complex and risky products of little real use erate aim. And as Raghuram Rajan points
to humanity were a major problem, and we out in his recently published book, Fault
need remuneration practices and regulations Lines, rapid credit growth served a useful
which make excessive risk taking less likely political purpose, enabling low-income
in future. Americans to maintain consumption even
when real incomes stagnated in the face
Fundamental issues of rising inequality.
Whilst it is right to focus regulatory reform But much of this credit turned out to be
on the key issues I’ve thus far raised, the unsustainable: the resulting high levels of
reform process also needs to address more leverage produced increased the vulnerabil-
fundamental issues. If we only address ity of the economy to shocks; and its rapid
banker bonuses and not the fundamental growth linked to property prices, followed
drivers of credit supply instability, we will by inevitable bust, was the major driver of
not adequately reduce the probability of a instability. Regulatory reform cannot there-
repeat performance. fore avoid questions relating to the optimal
The central issue is the availability of level of credit within an economy and to
credit, and in particular the pro-cyclical the management of credit growth linked to

Journal of Regulation & Risk North Asia 29


asset prices. In assessing proposals for radi- and at too low prices – especially to real
cal structural reform of the financial system, estate and construction sectors – and then
we therefore need to focus on whether such restricted. This has two implications:
proposals address the fundamental drivers The first is that when we say that in future
of volatile credit supply and pricing. all banks, however big, must be allowed to
‘fail’, the objective should not be to put them
‘Ex-ante’ expectations into insolvency and wind-up, since that will
Four specific structural options merit con- produce a sudden contraction of lending, but
sideration. The first of these is fixing ‘Too instead to ensure that we can impose losses
Big to Fail’: on subordinated debt holders and senior
The‘Too Big to Fail’agenda is undoubtedly creditors sufficient to ensure that the bank
important and a key focus for the Financial can maintain operations, under new man-
Stability Board’s Standing Committee on agement, without taxpayer support.
Supervisory and Regulatory Cooperation. The second is that the multiple failure
It is not acceptable that tax- payers have to of small banks could be as harmful to the
bail out large failing banks, and the ‘ex-ante’ real economy as the failure of one large
expectation that they will undermines mar- bank, even if all such banks failed at no tax
ket discipline. payer cost, and even if the market knew
A range of policy responses are possible; ‘ex-ante’ that no tax payer support would
these include capital surcharges, impaired be forthcoming.
resolution processes, and changes in legal
structure – increased use of separate subsidi- Insufficient response
aries. It is important to understand, however, The American banking crisis of 1930-33 was
that in the latest crisis, as in previous ones, primarily a crisis of multiple relatively small
direct taxpayer costs of bank rescue are likely banks. Fixing ‘Too Big to Fail’ is therefore a
to account for only a very small proportion of necessary but not a sufficient response.
the total economic costs. Separating commercial from invest-
ment banking: Limiting the involvement of
Too liberal, too low commercial lending banks in risky propri-
IMF estimates suggest they are unlikely etary trading is also undoubtedly desirable.
to exceed two to three per cent of GDP in Losses incurred in trading activities can gen-
the developed economies most affected by erate confidence collapses, which constrain
the crisis, and they may turn out signifi- credit supply and in extremis necessitate
cantly less once bank equity stakes are sold. public rescue.
But public debt burdens in the developed The interaction between trading activ-
economies are likely, as a result of this crisis, ity and classic investment banking played a
to increase by something like 50 per cent crucial role in the origins of the latest crisis:
of GDP. These much larger costs derive indeed, the thesis of this chapter is that it was
from our essential problem, from volatility precisely the interaction of maturity trans-
in credit supply, first extended too liberally forming banks and of self-referential credit

30 Journal of Regulation & Risk North Asia


securities markets, which drove the peculiar in the beginning of this century, could be
severity of this latest crisis. But legislated driven by the combination of commercial
separation of commercial and investment banks originating and distributing credit and
banking will not prove a straightforward or non-banks buying and trading it, the two
sufficient solution for three reasons: together generating a self-referential cycle of
First, because in a world where securi- optimistic credit assessment and loan pric-
tised credit is likely to continue to play a sig- ing, even if the functions were performed by
nificant role, drawing a legislative distinction separate institutions.
between ‘proprietary trading’ and ‘customer ‘Volcker Rules’ are in principle desirable,
facilitation’is close to impossible. and there may well be merit in writing the
principle into legislation, but are not a suf-
Key lever ficient response. What about separating
For that reason indeed the ‘Volcker rule’ deposit taking from commercial banking, an
clauses of the US legislation make the dis- idea favoured by Prof. John Kay in numer-
tinction in principle, but leave it to regulators ous economic papers and the Financial Times.
to apply it in practice. One of our key levers
in doing that will be appropriate capital Gilts backing
requirements for trading activity, to prevent This is quite different from Paul Volcker’s.
banks holding credit securities in trading Rather than splitting commercial from
books with the inadequate capital support investment banking, it would separate
allowed before the crisis. insured deposit-taking from lending. All
Second, because while large integrated insured retail deposits would be backed 100
commercial and investment banks (such as per cent by government gilts, while lending
Citi, RBS and UBS) played a major role in the banks would be funded by uninsured retail
crisis, so too did large or mid-sized commer- or commercial deposits or by wholesale
cial banks (such as HBOS, Northern Rock, funds, and would compete in a free, unregu-
and IndyMac) which were not extensively lated and unsupervised market. As Prof. Kay
involved in the proprietary trading activities well knows, I disagree with his argument
which a‘Volcker Rule’would constrain. that this would create a more stable system.
The underlying assumption is that the
Self-referential cycle existing system is unstable only because
And third, that even if proprietary trading explicit deposit insurance and implicit prom-
of credit securities was largely conducted ises of future rescue undermine the market
by institutions separate from commercial discipline which would otherwise produce
banks, important and potentially destabi- efficient and stable results. If instead we
lising interactions could still exist between believe that financial markets, maturity
maturity transforming banks and credit transforming banks, and credit extension
securities trading. against assets which can increase in value, are
A credit supply and real estate price inherently susceptible to instabilities which
boom, as witnessed both in the US and UK cannot be overcome by identifying and

Journal of Regulation & Risk North Asia 31


removing some specific market imperfec- valuations were on an upswing and then to
tion, then Prof. Kay’s proposal fails to address ‘run’ when valuations and confidence fell,
the fundamental issues. It would create safe creating credit booms and busts potentially
retail deposit banks which would never need as severe as in past bank-based crises.
to be rescued, but it could leave credit supply
and pricing as volatile, pro-cyclical and self- Essential challenge
referential as it was pre-crisis. The essential challenge indeed is that the
Abolishing banks – 100 per cent equity tranching and maturity transformation
support for loans: Professor Kotlikoff’s functions which banks perform do deliver
proposal, in contrast, suggests a truly radi- economic benefit, and that if they are not
cal reform of the institutional structure for delivered by banks, customer demand for
credit extension. Lending banks would these functions will seek fulfilment in other
become mutual loan funds, with investors forms. We need to find safer ways of meet-
sharing month-by-month (or even day-by- ing these demands, and to constrain the sat-
day) in the economic performance of the isfaction of this demand to safe levels, but we
underlying loans. cannot abolish these demands entirely.
There is therefore a danger that if radi-
Pooling, not tranching calism is defined exclusively in structural
This is equivalent to making banks 100 per terms – small banks, narrow banks, or the
cent equity funded, performing a pooling replacement of banks with mutual loan
but not a tranching function. And it would funds – that we will fail to be truly radical in
clearly exclude the possibility of publicly our analysis of the financial system and to
funded rescue: if the price of loan fund understand how deep-rooted are the driv-
assets fell, the investors would immediately ers of financial instability.
suffer the loss. But it is not clear that such a
model would generate a more stable credit Thrusts of reform
supply. As stated previously, a system of The core drivers of instability lie in the
securitised credit combined with mark-to- credit asset price cycle and in the interaction
market accounting can generate self-refer- between banks, credit securities markets and
ential cycles of over- and under-confidence. real estate markets. There are two thrusts of
regulatory reform which could address this.
Pro-cyclicality The first, much higher bank capital and
And while Kotlikoff’s loan funds might seem liquidity requirements, will create a more
to abolish the maturity transforming bank, resilient banking system less likely to suffer
with investors enjoying short-term access crisis and bank failure. But these changes
but not capital certainty, investors would be will also, by constraining but not eliminating
likely in the upswing to consider their invest- the extent to which the banking system can
ments as safe as bank deposits. Investments perform its tranching and maturity transfor-
in loan funds would therefore be likely mation functions, constrain total leverage in
to grow in a pro-cyclical fashion when the real economy and thereby reduce the

32 Journal of Regulation & Risk North Asia


vulnerability which derives from the rigidi- investment and economic growth does not
ties of credit contracts. mean that it has no value; the functions
And by reducing the likelihood of bank of life-cycle consumption smoothing and
failure, they will reduce the danger that con- intergenerational resources transfer, which I
fidence collapse leads to sudden constraints identified earlier as the primary functions of
on credit supply. Even if not varied through the credit system, are socially valuable.
the cycle, higher bank capital and liquidity
requirements will therefore tend to reduce Striking a balance
the procyclicality inherent in banking sys- Society therefore faces a trade-off. We can
tems and credit markets. make the finance system more stable via
The crucial question is, therefore, are how significantly higher capital and liquidity
much higher these requirements should requirements without hitting long-term
be and how we transition from today’s less growth but at the expense of less easy access
demanding level. to credit. We need to strike a balance, hon-
estly recognising that the benefits of finan-
Lower leveraging cial stability have a cost in terms of customer
To think straight, we need to consider these choice. In light of the severe economic harm
two questions separately; it is quite possible caused by the financial crisis, a significant
that an economy significantly less leveraged shift in the balance towards stability and
than today would be optimal, but also that resilience makes sense.
transition from high leverage to low lever- But we also need to manage the tran-
age will have a depressive effect on short to sition with care, and the FSA and global
medium term growth. authorities are therefore also using eco-
On the long-term issue, one striking fact is nomic modelling to consider carefully how
that in the past we have had banking systems increases in capital and liquidity standards
which operated with far higher levels of capi- will impact short and medium-term growth.
tal and liquidity than today, but were still able
to serve the financial needs of growing econ- Transitional cost
omies. And macroeconomic analysis con- The analysis suggests that, with appropriate
ducted to inform global regulatory decisions, off-setting, monetary policy and long imple-
suggests that lower levels of bank and real mentation periods, the cost of transition can
economy leverage have no necessary impact be small. But it cannot be nil: de-leveraging
on long-term steady state growth rates. is difficult to achieve without some growth
penalty, even if the increase in leverage deliv-
Factually out of line ered no permanent growth improvement – a
This should not surprise us, given that the strong argument for designing a future sys-
mental model in which all credit is essen- tem less likely to create excessive leverage in
tial to drive investment and growth is, as I the first place.
suggested earlier, out of line with the facts. Higher capital and liquidity stand-
But the fact that much credit does not drive ards, applicable throughout the cycle, will

Journal of Regulation & Risk North Asia 33


themselves create a financial system less response of different categories of credit to
vulnerable to shocks. both interest rate and regulatory levers.
But we cannot remove the dangers of
bank failure entirely without moving to Leaning against the wind
a Larry Kotlikoff style abolition of banks, The details of what policy levers should
which as argued earlier, would still leave be available and how they should be
important other risks in the financial sys- deployed have been written about exten-
tem. Moreover, the risk tranching and sively by Andrew Large and Andrew
maturity transformation functions which Smithers. And the UK is now commit-
banks perform do deliver value, even if the ted to creating a new Financial Policy
scale on which they perform them needs to Committee, chaired by the Governor of
be constrained. the Bank of England, and drawing on
the analyses and insights of both central
Vulnerability bankers and prudential regulators, and
Levels of capital and liquidity requirement responsible for considering the overall
which leave banks able to perform their evolution of credit supply, and for tak-
useful functions will still therefore leave the ing appropriate action to lean against the
economy vulnerable to destabilising up- wind of excessive credit creation.
swings in credit supply and asset prices, This is a vital response to the previous
deriving from the interaction between gap in our regulatory system, to the underlap
maturity transforming banks, credit securi- which previously existed between a central
ties markets, and self-reinforcing credit and bank focused on monetary policy alone, and
asset price cycles. a regulator focused on micro rather than
In addition to higher capital and macro issues.
liquidity requirements, therefore, the
regulatory response needs to involve the Credit supply constraint
deployment of counter cyclical macro- But to be effective, the new body will need
prudential tools, which directly address to be willing to take away the punchbowl
aggregate credit supply. of excessive credit when everybody else –
property developers, householders, and
Broad category the government as recipient of the tax rev-
These could include automatic or discretion- enue generated – is thoroughly enjoying
ary variation of capital or liquidity require- the party.
ments across the cycle, or constraints, such as Creating a safer financial system
LTV limits, which directly address borrowers requires not just action to prevent over-
rather than lenders. Such policy levers may paid bankers from selling overly complex
moreover need to be varied by broad cat- financial products and, in doing so, tak-
egory of credit (e.g. distinguishing between ing undue risks; it also requires constrain-
commercial real estate and other corporate ing a credit supply which, in the upswing,
lending) given the very different elasticity of it seemed that we all rather enjoyed. •

34 Journal of Regulation & Risk North Asia


Debate

Limited Purpose Banking:


more than an idyllic dream
Boston University’s L.J. Kotlikoff, rattled
by Adair Turner’s assault on his proposed
remedy for banking sector ills, hits back.

In this, the second part of the current In the US, mutual fund companies
Journal’s debate section, Prof. Laurence already constitute one third of the finan-
Kotlikoff takes issue with Adair Turner’s cial system and facilitate/intermediate a
rather dismissive tone relating to Limited very large volume of lending to companies,
Purpose Banking (LPB) and its ability to governments and homebuyers. So “truly
make the financial services sector a less radical”is a bit strong for my taste. Also, indi-
riskier and more robust enterprise for the vidual mutual funds are, except for the letters
long-suffering taxpayer, as well as gov- used in their name, banks. The difference is
ernment, regulators and investors alike. that they are safe banks or, if you like, utility
banks, which that “truly radical” economist
In your masterful and much publicised Mevryn King has advocated.
speech on the Future of Finance delivered
in London recently, you raised some very No leverage
strong concerns about Limited Purpose They are safe insofar as they are never
Banking that are, I believe, misleading, leveraged in any state of nature. I chose
misdirected, and rather surprising since the word “banking” in Limited Purpose
LPB delivers precisely the reforms you Banking to convey the point that we need
advocate in your numerous speeches and banks, but ones that stick to their legiti-
published papers. mate purpose – financial intermediation,
Let me respond to the specifics (in not gambling with the taxpayers’ chips and
quotes) of what you wrote (the italic text) the economy’s performance.
and then indicate why LPB does what you The fact that mutual fund companies
say you want. were exempted, to my knowledge, from any
“Abolishing banks: 100 per cent equity additional regulation under Dodd-Frank
support for loans. Prof Kotlikoff‘s proposal, in means that the US Congress views mutual
contrast, suggests a truly radical reform of the funds as a safer banking system. Their
institutional structure for credit extension.” expansion relative to traditional banks is

Journal of Regulation & Risk North Asia 35


surely fostered by this bill. (This, and the cre- fund) permit the mutual fund shareholders
ation of the Consumer Financial Protection to leverage each other. So tranching is defi-
Agency, are the two features of Dodd-Frank nitely part of what I’m proposing provided
that I like.) the sharing rules among the parties are very
This is not to say that mutual funds in simple and clear and there is no liability to
their current form are what I advocate. As any parties beyond the mutual fund owners.
I’ve written, no mutual fund, except cash “And it would clearly exclude the pos-
mutual funds, which hold only cash, would sibility of publicly funded rescue: if the price
be backed to the buck. Open-end funds of loan fund assets fell, the investors would
would have automatic in-kind redemp- immediately suffer the loss.”
tion or closed-end conversion triggers in I disagree. As I say in the book, under
the face of redemption runs. I’m strongly LPB the government, if it so chooses, can
opposed to the government’s guaranteeing intervene directly to lower interest rates to
the buck of any mutual fund besides cash particular borrowers by buying shares of the
mutual funds, where there is no need for mutual funds purchasing their paper. The
the guarantee since the cash is in the vault, mutual funds, themselves, would never need
physically or electronically. to be publicly rescued, but I believe you are
“Lending banks would become mutual referring to the government rescuing partic-
loan funds, with investors sharing month ular borrowers who might not otherwise get
by month (or even day by day) in the eco- funded at“reasonable”interest rates.
nomic performance of the underlying loans. The most common reason the price of
This is equivalent to making banks 100% a loan fund falls is that market interest rates
equity funded, performing a pooling but not a rise. But a rise in market interest rates lowers
tranching function.” the market price of outstanding bank debt.
This is not a real difference with the And, for that matter, it lowers the implicit
current system. Under the existing system, market value of deposits to the extent that
investors in banks, be they stockholders they are going to be withdrawn in the future
or creditors, are sharing, day by day, in the as opposed to immediately.
performance of the banks’ underlying loans.
Citigroup bonds, for example, float on the Back door risk
market. While it’s true that deposits don’t You appear to think that the current finan-
explicitly float, they do implicitly insofar as cial system is delivering safety for the com-
when banks fail, taxpayers have to cover mon man because he has the assurance that
the insured deposits. Hence, every day that his checking account is safe. Under Limited
the performance of a standard bank’s loans Purpose Banking, the common man can
change, the value of the contingent liability invest in cash mutual funds or short-term
facing taxpayers changes. government bond funds, so he can get this
Also, as I discuss in Jimmy Stewart Is same type of safety.
Dead, mutual funds with clearly defined But, with all due respect, you seem to
sharing rules (a CDO is such a mutual be missing the fact that risk is hitting the

36 Journal of Regulation & Risk North Asia


common man through the back door – via under-confidence, it is the bankers, not the
the potential for job loss, loss of retirement individual investors, who are, it seems to me,
assets, tax hikes and future inflation. alternatively gunning the system and run-
“But it is not clear that such a model ning it down. You want bankers to manage
would generate a more stable credit supply.” financial risk for individuals and the econ-
The stability of the supply of credit is, omy. They aren’t to be trusted in this role. I
from my reading of the current and prior don’t want our children’s economic futures
credit crises, very closed tied to the stability in the hands of the salesmen and lawyers
of the financial system. When major finan- who end up at the top of financial behe-
cial companies fail, the spectre of this flips moths. Jimmy Stewart, in short, is dead.
the economy to a bad equilibrium (co-ordi- But the main factor I feel you overlook
nation failure) of the type described by Peter in referencing self-referential cycles is the
Diamond and others in which firms expect lack of transparency. Your 86-page paper
and, then, collectively create bad times. mentions this word only three times and
the word disclosure only once. I think the
Equity financed primary reason the crash of 2008 hit with
In addition, the credit market flips to a such force was not the fact that housing
bad equilibrium of the type described by prices had risen too much due to irrational
Stiglitz and Weiss in which lenders expect exuberance (indeed, they fell much less than
only bad borrowers and, then, set rates stock prices), nor that too much credit, per se,
high enough to produce that outcome. was extended, but that too much fraud was
LPB ensures that there will never again involved in the extension of credit.
be financial failures on a small scale, let
alone a large scale. As you know, Limited If only . . .
Purpose Banks can’t go bankrupt since Had Lehman Brothers, Bear Stearns, Merrill
they are 100 per cent equity financed. Lynch, Countrywide … been forced to send
“As Section 4 argued, a system of securi- their mortgage applications to the Federal
tised credit combined with mark-to-market Financial Authority (the sole regulator I pro-
accounting can generate self-referential cycles posed under LPB) to have the applicant’s
of over and under confidence.” past income verified (via income tax returns),
Regardless of the accounting rules and have the applicant’s current job and earnings
disclosure, the market is going to mark verified, have the applicant’s credit rating
assets to market. Lehman’s chief, Dick verified, have the applicant’s proposed col-
Fuld, said his assets were very safe and far lateral (the home to be purchased) indepen-
exceeded his liabilities, but the market said dently appraised, and have the applicant’s
otherwise. So limiting mark-to-market application (his mortgage) independently
accounting is not really feasible and ques- rated, and had all this been posted on the
tioning it (which I’m not sure you mean to) web in real time, trillions of dollars in toxic
is shooting the messenger. loans would never have been originated.
As for self-referential cycles of over- and It’s the systematic production of

Journal of Regulation & Risk North Asia 37


fraudulent securities that’s at the heart of the mutual fund companies to reference
what happened. Your speech mentions the them as short-term commercial paper funds
word fraud not once. and make every shareholder sign a one-sen-
This is not to claim that self-referential tence statement in giant letters - “I under-
cycles can’t arise. As we both know from stand that this is not a cash mutual fund, that
the work of Samuelson, Cass, Shell, Calvo, it is risky, that it can break the buck, and that I
Farmer, and many others, models with may, therefore, lose the money I invest.”
rational agents (what I’d call neoclassi- “Investments in loan funds would there-
cal models) can exhibit multiple equilibria fore be likely to grow in a pro-cyclical fashion
paths of asset prices, even absent any of the when valuations were on an upswing and
information/co-ordination issues referenced then to run when valuations and confidence
above. LPB – a perfectly safe banking system fell, creating credit booms and busts poten-
in which all securities purchased, held, and tially as severe as in past bank-based crises.”
sold by the financial intermediaries are inde- The picture being drawn here is of the
pendently vetted and disclosed – won’t keep public purchasers of mutual funds seeing
asset prices from moving in what seem to be returns on fixed income going up and bor-
crazy ways (just consider today’s long-term rowing on their homes to invest more in
US Treasury bond prices), but it will stop these funds in a craze to make a few more
bubbles spread by lies and crashes spread by basis points. But what we know is that
panic over fraud. households tend to buy and hold, while
bankers tend to churn their portfolios. I just
Whistle blower don’t see this as a valid objection to LPB rela-
Under LPB, Madoff’s valuation would never tive to the current system.
have hit US$60 billion. It wouldn’t have hit The essential challenge indeed is that
two cents since Madoff’s fund would have the tranching and maturity transformation
been a mutual fund subject to third party functions that banks perform do deliver eco-
custody and the custodian would have nomic benefit, and that if they are not deliv-
blown the whistle. ered by banks, customer demand for these
“And while Kotlikoff‘s loan funds might functions will seek fulfilment in other forms.
seem to abolish the maturity transforming As previously indicated, tranching (some
bank, with investors enjoying short term investors taking more risk than others within
access but not capital certainty, investors a fund) is part of limited purpose bank-
would be likely in the upswing to consider ing. Indeed, CDOs are, to repeat, effectively
their investments as safe as bank deposits.” mutual funds with this property. The fact
There are thousands of fixed-income that so many CDOs invested in toxic loans
mutual funds whose prices fluctuate by the is because the loans were fraudulent, not
minute. The owners of these funds don’t because the loans were risky. We don’t say
view them as safe as bank deposits. And that stocks are toxic, even though the stock
under LPB, money market funds would market has fluctuated dramatically since its
clearly break the buck. Indeed, I would force peak. We say mortgage-backed securities

38 Journal of Regulation & Risk North Asia


are toxic because borrowers’ incomes were radicalism is defined exclusively in struc-
misstated, collateral values were mis- tural terms – small banks, narrow banks, or
stated, and credit worthiness was misstated. the replacement of banks with mutual loan
Furthermore, tranching is just one way for funds – that we will fail to be truly radical
some people to take more risk than others. A in our analysis of the financial system and to
simpler way is for more risk-averse people to understand how deep-rooted are the drivers of
simply invest in mutual funds that purchase financial instability.”
safer asset; i.e. tranching is not the end all The truly deep root of financial instability
and be all of risk allocation in the economy. is the use of the claim of proprietary infor-
mation to conceal the production and sale of
Avoiding bank runs fraudulent securities. The assets we call toxic
As for maturity transformation, the liquid- today have that title for a reason.
ity risk-sharing featured in the Diamond- “An exclusive focus on structural change
Dybvig model can be achieved by options, indeed, reflects a confidence that if
households simply holding a portfolio of only we can identify and remove the specific
mutual funds, some of which specialise in market imperfections, which prevent market
short-term bonds and others that invest disciplines from being effective, then at last
in long-term bonds, i.e. a model with such we will obtain the Arrow-Debreu nirvana of
investments provides the same risk sharing complete and self-equilibrating markets.”
as their model. But it does so without the risk This is the last thing I believe. I don’t
of a bank run. The Diamond-Dybvig paper believe we’ll achieve any Arrow-Debreu
claims that governments can insure deposits nirvana. LPB will fix some huge problems
to avoid the bank runs associated with their and restore the rule of law to the financial
mechanism of having banks return deposits system. It will do great good. It is worth tak-
on demand. However, their paper assumes ing very seriously.
real deposit insurance when only nominal In the words of George Shultz, Limited
deposit insurance exists in the real world and Purpose Banking is“simple, clear, and, most
it girds this assumption with the assumption of all, effective.” In the words of George
that the output of the economy is unaffected Akerlof, LPB “offers an amazingly sim-
by bank runs, which is clearly not the case. ple financial fix to prevent an even worse
“We need to find safer ways of meeting crash.” In the words of Edmund Phelps,
these demands and to constrain the satisfac- LPB“is one of the best visions to surface so
tion of this demand to safe levels, but we can- far.” In the words of Simon Johnson, LPB
not abolish these demands entirely.” “is beyond appealing; it is compelling.” In
Again, LPB permits tranching within any the words of Niall Ferguson, LPB“is clearly
given mutual fund and liquidity risk-sharing the best available remedy.” In the words
(the raison d’être of maturity transformation) of Kenneth Rogoff, LPB “is a blueprint for
via diversified holding of short- and long- how to fix it (the financial system) from the
term fixed income mutual funds. ground up.”In the words of Jeff Sachs, LPB
“There is therefore a danger that if is“a powerful reform that stops banks from

Journal of Regulation & Risk North Asia 39


gambling and restricts them to their legiti- rating. Limited Purpose Banking provides
mate purpose.”And in the words of Martin non-conflicted credit rating, appraisals,
Wolf, in endorsing LPB,“cautious reform is third-party custody, income and employ-
the risky option.” ment verification, etc.
None of these and other prominent You advocate higher capital requirements.
economists who have stuck out their necks LPB has 100 per cent capital requirements.
in extremely strong support of LPB are naïve You want credit originators to have skin
or believe that it would produce Arrow- in the game. Under LPB the investors have
Debreu nirvana. all the skin in the game. And they get to see
“If instead we believe that liquid finan- on the web in real time precisely where this
cial markets are subject for inherent reasons skin is invested.
to herd and momentum effects, that credit You say the market wants simple, trans-
and asset price cycles are centrally impor- parent structures. LPB provides the simplest
tant phenomena, that maturity-transform- and most transparent structure.
ing banks perform economically valuable You want firewalls so that one financial
but inherently risky functions, and that the intermediary doesn’t bring down another.
widespread trading of credit securities can LPB has a firewall around each mutual fund.
increase the pro-cyclicality of credit risk Losses of any mutual fund have no impact
assessment and pricing, then we have chal- on any other mutual fund.
lenges which cannot be overcome by any one You want securitisation, but simpler
structural solution.” securities. Mutual funds are, themselves,
I also believe each of these things and a very simple securitisations. And since the
lot of other things about the current system. Federal Financial Authority would rate com-
That said, LPB combines a large number of plex securities as more risky, they would
structural solutions in one simple system. likely disappear form the market.
What I don’t believe is that this statement You want financial stability. LPB offers
and the one about Arrow-Debreu nirvana financial intermediaries who cannot fail.
are serious critiques of LPB. That is, it puts a definitive end to the banking
crises that have plagued global economies
In conclusion for hundreds of years.
Adair, let me conclude by connecting what You oppose radical change. But the cur-
it seems you are advocating in your paper rent financial system is not safe at any speed.
(which I generally like very much) to LPB. Tens of millions of unemployed workers and
You raise the need for financial disclo- newly broke retirees can attest to this. They
sure. LPB provides full disclosure. are looking for real change, not maintaining
You raise concern about too big to fail. the status quo with some minor tweaks (a la
LPB has small banks (the individual mutual Dodd-Frank), which is as radical as it gets.
funds) none of which can fail. Adair, climb onto the ramparts. We
You say we need non-conflicted credit need you. •

40 Journal of Regulation & Risk North Asia


Opinion

Congressional report into


financial crisis holds out hope
Prof. Lawrence Baxter of Duke University
offers his analysis and considerations on
the recently published FCIC Report.

On January 27 this year, the US Financial many complicated issues. It is going to be


Crisis Inquiry Commission (FCIC) ensnared in adversary politics. Nevertheless,
released its long-awaited findings in The it is of very high quality.
Financial Crisis Inquiry Report: Financial
Report of the National Commission on Perplexing crises
the Causes of the Financial and Economic Together with the thoughtful Thomas dis-
Crisis in the United States). sent, the overall report provides us with
much considered insight and lessons for the
The 10-member bipartisan commis- future. It represents two different and not
sion report consists of the official findings incompatible ways to understand the 2007-8
adopted by a majority (six) of the commis- financial crisis.
sioners, including chairman Phil Angelides. In another time, these views could have
been blended into one truly outstand-
Dissenting statements ing analysis, but such is the atmosphere
There is also a dissenting statement by in America today – even after the Arizona
Republican members, Bill Thomas (vice- shootings – that we may be expecting too
chairman), Keith Hennessey and Douglas much to hope for unanimity. Indeed, juxta-
Holtz-Eakin (limited per Commission rules posed as they are, the majority and dissent-
to 26 pages, referred to as the ‘Thomas dis- ing views provide a case study in themselves
sent’), and a separate dissenting statement on the perplexity of financial crises and how
by Peter J. Wallison, also limited in length to think about them.
(referred to as the ‘Wallison dissent’). Mr.
Wallison supplemented his statement with Closed-door ‘railroading’
a much longer version, separately available. But first let me say a few words about the
Hereafter, I will refer to the 408 pages plus Wallison dissent.
the 13-page summary as‘the Report’. Mr Wallison believes that the Com-
Obviously a report of this length covers mission never seriously tried to understand

Journal of Regulation & Risk North Asia 41


the real cause of the crisis, that members of to do with the crisis. One cannot help but get
the commission were essentially railroaded the feeling that he does not fully appreciate
by closed-door determinations as to what how financial entities mutually interact and
questions would be asked, which hearings interconnect in many complex ways (this
to hold and who would be interviewed, and is one of the reasons sociologists call the
that the interviews were sometimes them- industry“tightly coupled”).
selves held behind closed doors. He says
that the question he has most frequently Basic misunderstanding
been asked is: “Why Congress bothered to And to excuse reckless lending by suggest-
authorise [the Commission] at all”because ing that banks were under coercion, when
Congress went ahead anyway and enacted most of the toxic lending was in fact origi-
the Dodd-Frank Act without waiting for nated not by banks but by financial entities
the report. that were not even subject to the constraints
Mr. Wallison offers as the excuse, reflects a
‘Best practices’ basic misunderstanding about how the CRA
In Mr. Wallison’s view the real cause of the applies and is implemented by banks.
crisis was the Clinton-Bush-promoted gov- The Wallison dissent also says that AIG
ernment housing policy from 1997-2007. was the“only company known to have failed
The chief miscreants were the Government because of its CDS obligations . . . and that
Sponsored Entities (GSEs), Fannie Mae and firm appears to have been an outlier.”Hence
Freddy Mac, the Community Reinvestment it rejects the claim that credit default swaps
Act (CRA), and subprime lending “best had anything to do with the crisis.
practices.” In this climate, he argues, the
GSEs and insured banks facing a CRA gun Litany of complaints
to their heads were “compelled to compete The fact that AIG was the principal player in
for mortgage borrowers who were at or the field, that almost all, if not all, the major
below the median income in the areas in investment and commercial banks were
which they lived.” dependent on AIG being able to honour its
commitments, and that the government and
Higher rate of default taxpayers ultimately had to provide more
The Report debunks this tired old shibboleth than US$180 billion in support for AIG in
by correctly noting that CRA requirements order to prevent all the others from failing, is
were minuscule in proportion to the scale of totally lost on Mr. Wallison.
lending involved, and by noting the fact that Hints at the reason for Mr. Wallison’s
private financial institution securitisation in almost obsessive focus on the Fannie/Freddy
the area led to a far, far higher rate of default alleged cause of the crisis are to be found
than that done by the GSEs (which was in a litany of complaints in the latter part
bad enough itself). Mr. Wallison asserts that of his dissent about being excluded from
“deregulation” in the form of the repeal of interviews, his friend’s American Enterprise
the Glass-Steagall Act in 1999 had nothing Institute paper not being circulated by the

42 Journal of Regulation & Risk North Asia


Commission, and having only eight days to were somehow innocent or helpless victims!
read the draft report and decide whether to Of course our housing policy was based
join it. (Has Mr. Wallison ever worked in a on unrealistic goals, and the GSE system is
busy law firm or company? The Commission badly in need of reform.
was mandated by Congress to get its work
done by a deadline and was not able to meet Much still to be fixed
the deadline as it was.) The Report acknowledges this by describing
The Report itself and the main, Thomas extensively why these policies have failed.
dissent, however, are both worthy of care- But, as Simon Johnson, a former chief econ-
ful study. Using multiple detailed, factual omist of the International Monetary Fund,
case studies, the Report works its way has recently explained, trying to blame the
through the many factors that led up to poor for the crisis is simply absurd.
the Crisis and it concludes that the Crisis The Report also rightly notes that despite
could have been avoided were it not for Dodd-Frank we have a lot left to fix: Our
clear human mistakes. financial system is, in many respects, still
unchanged from what existed on the eve of
Orgy of borrowing, fraud the crisis. Indeed, in the wake of the crisis,
Readers will be familiar with all of the sug- the U.S. financial sector is now more con-
gested reasons for the Crisis, from the orgy centrated than ever in the hands of a few
of borrowing and lending to the fraud, self- large, systemically significant institutions, as
dealing and denial on the part of many play- Neil Barofsky, the TARP Special Inspector
ers in the industry.The Report correctly places General, said in his January 26 testimony
blame on all of us: borrowers who were out to the House Committee on Oversight and
of their depth; lenders who lacked discipline Government Reform.
and sometimes honesty; corrupt and mis-
managed GSEs (Fannie and Freddy); securi- More bailouts, bad behaviour
tisers and distributors who had neither skin In other words, unless and until institutions
in the game nor any incentive to act in the currently viewed as“too big to fail”are either
long-term interest of investors, shareholders broken up so that they are no longer per-
and taxpayers; weak corporate governance; ceived to be a threat to the financial system,
and a Congress and regulators who had the or a structure is put in place that gives ade-
ability but not the fortitude to take preven- quate assurance to the market that they will
tive action. Paraphrasing Shakespeare, the be left to suffer the full consequences of their
Report declares that“the fault lies not in the own recklessness, the prospect of more bail-
stars, but in us.” outs will continue to fuel more bad behav-
And so this must be with something as iour with potentially disastrous results. Thus
systemic as a financial crisis. It is naive to try far, the Dodd-Frank Act appears not to have
to pin blame on any one group, though it is solved the perception problem.
even more naive to try to argue, as does Mr. Whether we have the fortitude to do so
Wallison, that some of the principal players remains to be seen.

Journal of Regulation & Risk North Asia 43


The Thomas dissent adds more interest explaining why a full dissent was neces-
to the overall publication. While chiding the sary (what about a qualified concurrence?),
main Report for focusing on some aspects the dissenters nevertheless make interest-
that, in the dissenters view were only minor ing and helpful distinctions between types
contributors to the crisis (e.g., CRA and the of systemic risk (“contagion” and “common
repeal of Glass-Steagall) or are simplistic shock”– actually there are more), and they
diagnoses (e.g.“deregulation”), the dissent- also rightly observe that, until the major
ers ask a number of very valid questions as financial plunge, even larger past wealth
they try to isolate the“essential”causes (many losses did not bring the global financial sys-
of which concur with the views expressed in tem to its knees.
the Report).
The dissent rightly notes widely differing Concentrated risk
conditions – political, institutional, cultural The key differences in this case were lever-
and regulatory – in Europe, where the finan- age and risk concentration. Highly correlated
cial institutions also wrought havoc. housing risk was concentrated in large and
highly leveraged institutions in the United
Insufficient answers States and much of Europe.
One might dispute that these differences Bingo!
were really significant in an increasingly The Commission was charged only with
“Americanising” and tightly coupled world investigating the causes of the Crisis, not
of finance. Nevertheless, it is important to coming up with policy solutions. We still
continue exploring these questions. We still have much work to do for the future.
don’t have enough answers. The dissent Perhaps the Commission is unduly opti-
accuses the majority of wanting to give more mistic to make the general assumption that
an account of bad events than a focused “this financial crisis was avoidable” (major-
explanation of what happened and why. ity) and that we can“avoid the next financial
When everything is important, nothing is. crisis”(Wallison).
The problem is that to understand sys-
temic crises, everything is important and it is A matter of scale
very hard to isolate single causes. Even the As with oil drilling disasters, it is doubtful
list of 10 “essential causes” enumerated by that we can ever completely avoid future
the Thomas dissent, none of which is dis- problems. What we can do is substantially
puted in the Report, is inadequate. mitigate them and make them manageable.
This means reducing potential shocks to the
Stages of the crisis financial system by reducing the scale of the
One has to understand the dynamic story, players that operate within it. On this reform
and indeed the Thomas dissent itself resorts is implicit and sometimes even explicit
to the same approach when explaining agreement among at least nine members of
the “Stages of the Crisis.” While not really the Commission. •

44 Journal of Regulation & Risk North Asia


Opinion

Basel III fails to adequately


address equity capital reserves
Professor Jennifer S. Taub of the University
of Massachusetts is underwhelmed by the
Basel Committee’s latest Capital Accord.

Our largest banks failed to build Paul Pfleiderer, authors of“Fallacies, Irrelevant
cushions to absorb losses even while Facts, and Myths in the Discussion of Capital
knowing back in 2007 that the music Regulation: Why Bank Equity is Not Expensive.”
would soon stop playing and, to mix a Duke University Law Professor Lawrence
metaphor, the debt-fuelled asset bubble Baxter recently discussed this study in his
would burst. As it happened, externalis- online blog, The Pareto Commons, in an
ing their losses worked out well for the entry entitled ”Whose risk is it? bank capital,
bankers, but not for the rest of us. It is a basel iii, and the bankers.”
mistake to repeat this cycle. And, yet we
are doomed to suffer the consequences Healthy banking goal
of others’ folly if we don’t require banks A November op-ed signed by 20 profes-
to lighten up on debt and build up their sors and published in the Financial Times as:
equity capital reserves. “Healthy banking system is the goal, not
profitable banks”, explains why equity is
While most banks resist the idea of cutting not expensive. This group included Nobel
back on their borrowing, claiming it is “too Laureate William Sharpe and Eugene Fama.
expensive,” some bankers and experts disa- “Bankers warn that increased equity require-
gree. In a recent Bloomberg story about the ments would restrict lending and impede
delay in higher capital requirements, former growth. These warnings are misplaced.
Citigroup CEO, John Reed posed the ques- “First, it is easier for better-capitalised
tion: “[Why do] we continue to listen to the banks, with fewer prior debt commit-
same people whose errors in judgment were ments hanging over them, to raise funds
central to the problem. for new loans.
“Second, removing biases created by the
Listen to the profs current risk-weighting system that favour
Better that we listen to professors Anat marketable securities would increase banks’
Admati, Peter DeMarzo, Martin Hellwig and incentives to fund traditional loans.

Journal of Regulation & Risk North Asia 45


“Third, the recent subprime-mortgage behemoths that are bloated on debt could
experience shows that some lending can be and should slim down. Even today, the
bad for welfare and growth. Lending deci- Admati op-ed explains, they are highly lev-
sions would be improved by higher and eraged and owe at least US$95 for every
more appropriate equity requirements.” $100 in assets they own. The remaining $5
in equity is hardly sufficient. With this type
‘Yogi Berra’ on leverage of balance sheet, if asset values fall by a mere
As Prof. Lawrence Baxter highlighted in a five per cent, the firm is insolvent. And, of
recent entry in the Parato Commons in a course, well before insolvency, the pressure
blog entitled “Yogi Berra on leverage,” Prof to raise capital by selling the more valuable
Admati explains: assets, will pressure others who own simi-
“The reason that high leverage lowers lar assets, driving down prices and thereby
banks’ funding costs is that the more debt pressuring other banks to also raise capital,
banks use relative to equity in their funding, the downward spiral.
the smaller is the slice the government takes
in taxes, and the higher is the value of the No debt financing
implicit or explicit guarantees the govern- How sensible is this? Is there a safer amount
ment provides to their debt.” of equity capital? Admati notes that non-
For a quick sense of what global regu- financial firms, hold much more equity capi-
lators can do right now, one can turn to tal. They borrow just about US$30 for every
Professor Admati’s January 19, 2011 op-ed $100 in assets they own. This leaves about
in the Financial Times. In “Dividends Can $70 in equity to absorb losses. And, some
Wait Until Banks Are Stronger,” she cau- firms like Apple and the Gap have virtually
tions against the Federal Reserve permitting no debt financing.
big banks to pay out increased dividends What is the ideal for financial firms?
to shareholders. Instead, in her view, they In, “Basel III: The Fatal Flaw,” Simon
should build up, not shrink their equity capi- Johnson, professor and former chief econo-
tal cushions. mist for the International Monetary Fund
suggests at least 15 per cent in“good times.”
Footing the bill This equity of 15 per cent idea was also
In other words, paying shareholders now, put forward in the November Financial Times
means wearing away the protection the letter signed by the 20 professors previously
banks have to withstand future market mentioned. The letter stated:
turmoil, thus increasing the odds they will “If a much larger fraction, at least 15 per
externalise their losses, leaving the taxpayers cent, of banks’ total, non-risk-weighted,
and other investors who suffer from a delev- assets were funded by equity, the social
eraging spiral to foot the bill. benefits would be substantial. And the
Bank holding companies that still fund social costs would be minimal, if any.”
their operations with massive debt will (emphasis added).
continue to create risk to the public.These Others argue for even more of a cushion.

46 Journal of Regulation & Risk North Asia


For example, Martin Wolf, the Financial Times group, those that the new super-regulator,
chief economics commentator and econom- the Financial Stability Oversight Council
ics professor in Basel: “The mouse that did determines to pose a “grave threat” to the
not roar,”recommends 20-30 per cent equity financial stability of the US will be required
capital to assets without risk-weighting. by the Federal Reserve to have a 15 to 1
debt to equity limit, or US$15 borrowed to
Parallel requirements finance US$16 in assets, a mere 6.25 per cent
Has the Dodd-Frank Act or the Basel III in equity. While the legislation permits regu-
accord made things better? Not much lators to impose even greater equity capital
as of yet. Under the hard-won “Collins requirements, this is not hard-wired into the
Amendment” in Dodd-Frank, for exam- law and requires willing regulators.
ple, bank holding companies must follow
at least the same requirements as insured Details ‘buried’
depository institutions (the banks where As for the Basel III accord, which does not
savers keep deposits and that are insured by have the force of law, but instead is guidance
the Federal Deposit Insurance Corporation for the participating countries, it’s not much
(FDIC) when it comes to both leverage and better. The Basel Accord would permit even
risk-based capital. less equity capital than Dodd-Frank, as low
In terms of leverage, for insured deposi- as three per cent. That’s US$97 borrowed to
tory institutions (IDIs), four per cent equity is finance $100 in assets. If you read the report,
considered “adequately capitalised,” though you might miss this newly introduced lever-
three per cent is permitted for certain IDIs. age ratio. Details are buried on page 60-61.
And, getting that imposed on bank holding And, it may be temporary, as it is only a test,
companies was the result of a fierce legisla- from January 1, 2013 to January 1, 2017.
tive battle.
Prior to that, there had been no statutory Asset discounting
limits on leverage of bank holding compa- While the Basel Accord also has a separate
nies (or the giant investment banks that series of seemingly higher capital require-
assumed the bank holding company des- ments, those measure Tier 1 capital (largely
ignation in 2008 to gain federal government equity), as well as other forms of capital rela-
support). Many were leveraged as high as 30 tive to risk-weighted assets – meaning some
to 1 or 40 to 1, or just 3.3 per cent to 2.5 per assets are not counted fully in the denomi-
cent in equity. nator. Even if a bank owns US$100 in assets
which it used $97 to borrow, it can discount
More equity capital some of those assets.
Also under Dodd-Frank, those bank hold- The discounting process is based on the
ing companies with US$50 billion in assets expected risk that the asset will lose value.
(as well as so-called systemically important Some assets are held at their full dollar value,
“nonbank financial companies”) may have others more and others less. Some assets
to hold more equity capital. Of this special could be treated as if they did not exist. if

Journal of Regulation & Risk North Asia 47


they are considered using some straight- between losses, declines in bank capital, and
forward tests and also a variety of complex contraction in credit availability.”
formulas. As an example, this could result “Therefore, the Committee agreed to
in treating the US$100 in assets like $30 in introduce a simple, transparent, non-risk
assets and thus $3 in relation to $30 looks based leverage ratio...intended to achieve the
more like 10 per cent. following objectives...constrain the build-up
Risk-weighting, of course, is not new or of leverage in the banking sector, helping
necessarily nefarious, but in practice have avoid destabilising deleveraging processes
been subject to manipulation. which can damage the broader financial
system and the economy; and...reinforce the
‘Risky pools’ risk based requirements with a simple, non-
While these weights were intended, as the risk based “backstop” measure.” However,
Economist recently described to “discourage three per cent is just not enough.
banks from lending to risky enterprises, and
to encourage the accumulation of apparently Maturity mismatch
risk-free assets,” in reality they contributed And, to be sure, limiting leverage alone is
“to the structured finance craze, as securiti- not sufficient. For example, regulators also
sation was a way to‘manufacture’apparently need to pay close attention to maturity
risk-free assets out of risky pools.” An issue mismatch (using short-term, sometimes
raised on many occasions in leading journals, overnight, funding to support long-term
perodicals and newspapers by Per Kurowski, illiquid assets). And, of course, inflated
author of the Blog, A View from the Radical asset values and assets with “embedded”
Middle, and former executive director at the leverage, and assets and liabilities “hidden”
World Bank. off balance sheet need to be addressed.
However, to dimiss the necessity of lever-
Simple leverage ratio age limits is suspect.
Recognising the limits of these risk-weighted Some contend that reducing leverage
measurements, the report wisely highlights will have no value at all, suggesting that
the importance of a simple leverage ratio: limiting debt is like limiting a person to “six
“One of the underlying features of the crisis drinks” in order to avoid drinking binges.
was the build-up of excessive on- and- off For example, commentator, Eric Falkenstein,
balance sheet leverage in the banking sys- writes, “they will switch from beer to wine,
tem. In many cases, banks built up exces- whiskey, or grain alcohol,” meaning the
sive leverage while still showing strong risk assets purchased will be of poorer quality but
based capital ratios. better yields initially.
During the most severe part of the crisis, And, of course, asset quality is impor-
the banking sector was forced by the market tant, but the author does seem to ignore the
to reduce its leverage in a manner that ampli- possibility that the banks have been drink-
fied downward pressure on asset prices, fur- ing grain alcohol all along. And we are still
ther exacerbating the positive feedback loop drinking their Kool-Aid. •

48 Journal of Regulation & Risk North Asia


Book review

Red Capitalism: doubts about


China’s economic supremacy
Benjamin Shobert, Managing Director of
Teleos, casts a critical eye over Carl Walter’s
and Fraser Howie’s latest tome on China.

The collapse of Western financial mar- Howie believe that the lack of transparency
kets – a series of events the aftershocks in China’s banking system in particular
of which are still being felt almost three could pose a fundamental structural flaw to
years after the first tremors – provided the country’s short-term path forward.
yet another opportunity to reflect on the As understood by the authors, it is
differences and similarities between the important to illuminate the role of the
financial markets of Western developed State-owned banks in aggregating China’s
economies and China. And, as the dust national savings: Chinese citizens, as poor
settled, questions remained about these people world-round tend to do, are savers.
two very different models, perhaps none Motivated by a lack of the sort of social safety
more problematic than whether China’s nets which tend to exist in more developed
closed banking and political system countries, Chinese channel large portions of
might actually provide better stabilising their incomes into state-owned banks. As
mechanisms in the face of extreme finan- a result, these banks are awash with capital
cial turbulence than those in the West. that needs to be deployed.

In their new book, Red Capitalism: the Potential problem


Fragile Financial Foundation of China’s This phenomenon has been primar-
Extraordinary Rise, Carl Walter and Fraser ily understood as part of what needs to
Howie push back against the idea that change for China to become a nation of
China’s financial market is somehow supe- consumers and not simply savers, as is cur-
rior to its American and European coun- rently the case; however, Walter and Howie
terparts. In fact they suggest that much of see this concentration of savings as creat-
what has allowed China’s economy and ing a potential problem, one made worse
banking system to grow as it has is a mis- because of the singular role and politically
perception of the Beijing model’s inherent insulated place banks occupy inside China’s
superiority. Additionally, both Walter and banking system:

Journal of Regulation & Risk North Asia 49


“In China, the banks are the finan- financial services firms, but Red Capitalism
cial system; nearly all financial risk is con- manages largely to avoid this problem.
centrated on their balance sheets. China’s Where Walter and Howie’s analysis is likely
heroic savers underwrite this risk; they are to be most prescient is in its assertion that
the only significant source of capital ‘inside China’s closed system and lack of transpar-
the system’ of the Party-controlled domes- ency is fostering an environment of excess
tic economy. This is the weakest point in risk-taking, of poor economically rational-
China’s economic and political arrangement, ised decision-making, and detachment from
and the country’s leaders, in a general way, fundamental economic principles that tend
understand this. This is why over the past to guide debt markets and banking systems.
30 years of economic experimentation, they
have done everything possible to protect the Too large to hide
banks from serious competition and from The net of this all is likely to be – if it is not
even the whiff of failure.” (pp. 25) already the case – grotesque amounts of
There are several points worth making excess capacity across all manner of indus-
in response to the authors’ assertion here, tries and a real estate bubble of historic mag-
but one is perhaps most important to keep nitude. Consequently, the authors believe
in mind: the authors’ perspective is highly China’s banking system may be faced with
influenced by their respective capacities as a crisis of their own making which will be,
financial professionals. As such, they under- at least initially, largely invisible to outsid-
stand the opportunities denied the global ers until it becomes too large to cloak with
financial services’ industry as long as China China’s massive cash reserves.
continues to wall off its domestic bank- On this point, they write: “By the end of
ing sector from outside competition. What 2009, the banks had lent out over RMB9.56
access has been afforded outside financial trillion (US$1.4 trillion) and warning lights
services’firms has been paltry in comparison were flashing as capital-adequacy ratios
to the size of the potential Chinese market. approached minimum internationally man-
dated levels. In 2010, these banks are scram-
Vexing challenge bling to arrange huge new capital injections
China presents this industry with a genu- totaling over US$70 billion . . . Looking for-
inely vexing challenge: highly liquid poten- ward, the lending binge of 2009 threatens,
tial customers with very high savings rates and will most certainly generate problem
held captive to State-owned and controlled loans of sufficient scale to require yet a third
banks, all inaccessible to Western banks who recapitalisation in the next two to three years.
know they could offer more attractive and China’s major state banks . . . appear to be
innovative financial products if only they heading toward a situation not unlike that of
could get China to open its banking system. 1998. But their problems will, in fact be much
A lesser analysis would focus only on cri- worse than 1998 since the old problem loans
tiques of China’s financial system that pre- of the 1990s were only swept under the car-
vent the involvement of Western banks and pet . . . China’s banks look strong, but are

50 Journal of Regulation & Risk North Asia


fragile; in this, they are emblematic of the way to achieve their desired political out-
country itself. The Chinese are masters of the come, the practical result of which is to say to
surface and excel at burying the telling detail outsiders: “this far, but no further.” As such,
in the passage of time.” (pp. 26-27) China’s financial and political reforms seem
In the midst of a book that certainly has perfectly in sync with one another, yet oddly
its share of technical details on the structure out of sync with what Western developed
of China’s nascent debt and equity markets, economies thought to be another inevitable
Red Capitalism manages to make points victory for the free market.
that are accessible and impactful for both the
professional economist and the more casual Absolutist, realist camps
China observer. Among the most important Indirectly, Red Capitalism manages to draw
that either sort of reader will take away from out not just questions and concerns about
the book is the underlying tension that exists China’s economy and banking system, but
not only between capitalism and China’s also to ask important questions about how
mixed embrace of free market principles, but the West understands China’s ascendancy.
the longevity of the Party in its attempt to If viewed through this light, Red Capitalism
orchestrate such a tightrope. offers the perspective of what Dr. Scott
Walter and Howie speak very pointedly Kennedy, an expert on China’s financial sys-
on how China’s political class views capi- tem and WTO policy as well as the founder
talism: “An inherently conservative political of Indiana University’s Research Center
class, whose natural instinct is to control, on Chinese Politics and Business, calls the
will not easily invite those it cannot easily “absolutist and realist”camps.
control to participate actively in its domes- The absolutist camp, of which it would
tic debt markets. But, as appearances have appear Walter and Howie’s most recent
to be preserved, there will always be slight book could be sympathetic to, looks at the
movements toward market opening. But still-ongoing involvement of the Chinese
there will be no true opening.” (reviewer’s Communist Party within the banks and
emphasis, pp. 108). financial markets, and the disproportion-
ate influence they are capable of exerting on
Heavy-handed guidance both, and believes that by playing this role
This cuts deeply against conventional think- neither the banking system nor the financial
ing in centres of power outside China. markets are capable of meeting the needs
Specifically, Washington’s own political class nor the expectations of the open market.
has been deeply invested in the idea that Realists take a more pragmatic view,
ultimately the mandates of the free market one that in many ways assumes it is inevi-
would force China’s political class to liberal- table that a country such as China coming
ise. And, in their own way, Beijing seems to from a centrally planned and organised eco-
agree. Only, as seen by Walter and Howie, nomic system with explicit collectivist politi-
China’s still heavy-handed guidance of the cal objectives would modernise and even
country’s financial system appears to be a liberalise without some ongoing role of the

Journal of Regulation & Risk North Asia 51


Party. Realists believe that the role of a politi- off. With a non-convertible currency, mini-
cally motivated Party is diminishing within mal foreign participation and few overseas
China’s economy (not that it has gone away), assets beyond US Treasuries and com-
and that China will continue to rebalance its modity investments that will neither be
financial markets with an ongoing predispo- marked-to-market nor sold, why shouldn’t
sition towards more openness, admittedly the system survive a major international
not at the speed those within the absolutist crisis better than open economies? China’s
camp might wish. financial system is designed so that no one
And while Walter and Howie certainly is able to take a position opposite to that of
express criticisms about China’s political the government.” (pp. ix).
goals and the role these play in preventing
further openness in the country’s finan- Impressive results
cial markets, the authors seem able to also For most of the past two decades, China has
speak with an appreciation of why China reaped the rewards of opening its economy
has elected to manage itself in this way. to the outside world and, as the authors of
Specifically, China’s own risk tolerance is Red Capitalism are quick to acknowledge,
framed by an acknowledgement by those in the results have been impressive.
Beijing of“knowing what they don’t know.” But China’s economy is not free of risk,
As a result, China’s banking and regula- and the extent to which it actively seeks to
tory systems have been kept closed in what restrict not just access by outside financial
amounts to an acknowledgement that as a firms to operate within China, but rather
political class they remain uncertain about the lengths the country’s leadership goes to
free market ideology, their industries are still make opaque the levels of under and non-
learning how to rationalise credit, and their performing loans, suggests that just like any
financial system as a mechanism for distrib- other economy around the world and across
uting society’s shared wealth. time, China will ultimately feel the weight of
poor decisions and an economic and bank-
Lessons learnt ing crisis of its very own making.
Additionally, China’s leadership has looked As Walter and Howie write: “After all,
at problems from other high growth emerg- every country and all economic and political
ing economies and taken away lessons that systems experience booms and busts, scan-
are driving Beijing. Writing on this point, the dals and wild speculative sprees. The differ-
author’s state:“Having seriously studied the ence lies in how each country manages the
collapse of Mexico’s peso in 1994, the Asian aftermath.” China’s first impulse may be to
Financial Crisis of 1997 and those sover- suppress and hide such an implosion. But
eign-debt crises that have followed, China’s doing so would only serve to magnify the
political elite has no intention of exposing political fragility of China’s political class
itself to international capital markets. The which Red Capitalism suggests is truly at
domestic economy and markets are, and the base of China’s opaque banking and
will continue to be, most deliberately closed debt markets. •

52 Journal of Regulation & Risk North Asia


Book review

The Blank Swan:


The End of Probability
Satyajit Das calls Prof. Elie Ayache’s latest
best-selling publication ‘an extraordinary
act of courage and self belief’.

The mythical Tower of Babel was an the Author of Don Quixote, by Argentinian
enormous building designed to reach writer Jorge Luis Borges. The story takes the
heaven. The story’s theme is competition form of literary criticism about the fictitious
between the divine and human beings, Pierre Menard, a 20th century French writer.
the construction of the tower being a The story describes Menard’s translation of
hubristic act of defiance against God. In Don Quixote, which in reality is a line for line
recent history, humans have constructed recreation of the original. Ironic and humor-
many financial towers of Babel, seeking ous, the story raises profound questions
to defy risk and the uncertainties that about writing and interpretation.
underlie markets. Borges, writing as the reviewer, considers
Menard’s Don Quixote to be much richer in
Unlike physical sciences bounded by actual allusion than the original text, to which it is
phenomenon, social pseudo sciences, identical.This reflects the context of the world
including economics and finance, entail and the author, which shapes the work. In
a peculiar dialectic. Someone somewhere Pierre Menard, Borges has anticipated post-
writes a paper. Someone somewhere else, modern literary theory and philosophy.
either in the next room or half a world away,
writes a paper citing the original, either ‘Known unknown’
agreeing or disagreeing with its arguments. Nassim Nicholas Taleb’s Black Swan is under-
If enough participants engage in the debate, going a similar developmental arc. If the
then it becomes in varying stages a discus- Black Swan is Donald Rumsfeld’s Unknown
sion group, a minor cult, an offshoot of Unknown, then the White Swan, a term
an existing discipline or, in a few cases, an now frequently used for anticipated crises, is
entirely new discipline. the Known Unknown. There is also the Grey
This idea was the subject of a disarm- Swan, which presumably has elements of
ingly short (six pages), simple yet intellec- both. In The Blank Swan, Dr. Elie Ayache, a
tually puzzling short story, Pierre Menard, former derivatives trader and principal of a

Journal of Regulation & Risk North Asia 53


software firm, extends the idea, perhaps cre- then the price is a function of a unique con-
ating the new discipline of Cygnus Finance. text and assigned probabilities are only valid
Pierre Menard has its own history. In for that context.
Italo Calvino’s, If on a Winter’s Night a As economic, political and social vari-
Traveleri, a character, Silas Flannery, tries to ables change, new contexts are created. In
copy a famous novel, Crime and Punishment, the new context, the original probabilities
to assist his own writing. Gonzo journal- may become meaningless, requiring the cre-
ist Hunter S. Thompson reportedly re- ation of a new set of probabilities to model
typed The Great Gatsby when studying the new scenarios. In addition, the premise
at Columbia University. Intriguingly, Dr. of acting in the market to hedge options of
Ayache’s critical analysis of The Blank Swan itself changes the context, creating an inher-
was specifically structured around Borges’ ent circularity. The title, Blank Swan, reflects
Pierre Menard. the fact that as these contexts change unex-
pectedly and unpredictably, the original
Underlying philosophy probability and its very idea become increas-
Dr. Ayache’s central thesis is that the exist- ingly meaningless.
ing approach to derivative pricing and, ulti- Dr. Ayache’s solution is to bypass the
mately, probability at least as it applies to probability conundrum. He would prefer
financial instruments, is incomplete and to think of all options as a special case of a
inherently inadequate. He sees the excesses deeper generalised problem of contingent
of modern finance, such as CDOs and claims. Pricing then becomes a function
CDO2, as a manifestation of an underlying of what people today, value different pay-
philosophy grounded in probability. offs, using any tractable logical framework
Traditional financial theory assumes that available. At an extreme, this implies that
risk equates to standard deviation or vari- there is a market price for a contingent
ance of price changes in a Gaussian (stand- claim that exists independently of prob-
ard distribution) probability framework. ability or options.
Option prices “derive” from the underlying.
Options premiums are either an expression Jacobi’s advice
of expected volatility or the ability to dynam- This recognises a truth that anyone who
ically recreate the instrument through trad- trades option understands – option pric-
ing in the underlying asset. ing models don’t price options, instead
traders use models to recover the equiva-
Changing contexts lent volatility (the probability parameter)
Dr. Ayache argues that the price of stock or for a given option premium, frequently
an option cannot be based purely on prob- to derive the delta and other Greeks
abilities but must take into account the con- for hedging. The Blank Swan thesis is
text. So probabilities are meaningless since reminiscent of the advice of Jacobi, the
contexts keep changing. If a stock is priced Prussian mathematician, to always invert
at $10 based on all the available information, to solve the problem.

54 Journal of Regulation & Risk North Asia


The thesis is developed through dis- depends on the context of the work, while
cursive discussions of philosophy, lit- in The Library of Babel, meaning is a func-
erature, film and practical issues, arising tion of randomness, as the library contains
from a trip to a client in Sydney, Australia. all possible works. The Blank Swan can be
The book’s approach owes a considerable interpreted as Pierre Menard or The Library
debt to Roland Barthes’ textual analysis of Babel or both.
and the French Deconstructivist philoso- In post modern thought, there is anxi-
phers, like Derrida. ety about the nature of reality. As in all
modernism, the problem in finance is the
Relaxed reading? meta level. Modern meta finance creates
The writing style is dense, matching the instruments, like options, abstracted from
challenging content. Dr. Ayache told one real things, making traditional concepts of
interviewer that he tends “to write only the money otiose. In post modernity, the meta
things that will be as difficult to read as they level eventually dominates the primary level
were to write.” Paul Wilmott, the respected from which it emanates. Candy floss money
derivative researcher, advises on the cover of derivatives and securitisation dominates
that the book is not recommended beach ordinary money, creating circularity and
reading. He counsels reading its in front of a self-reference.
log fire with a large Scotch or several.
Economics developed out of politi- Fictitious earnings
cal thought and philosophy, eventually Value becomes driven by itself. New instru-
branching into macro- and microeconom- ments emerge, being traded in huge vol-
ics. Microeconomics spawned financial umes among institutions essentially trading
economics and quantitative finance. In with themselves. They undertake transac-
turn, there is now financial sociology and tions, price them and book fictitious earn-
financial philosophy. The Blank Swan, like ings, neglecting to establish whether any of
its namesake Black Swan, may be part of it is real or makes economic sense.The func-
that evolution. tion of money markets to raise and invest
money is undermined. The true function
Endless combinations of money as a mechanism for exchange,
Borges in another short story, The Library of a store of buying power, and a measure of
Babel, similar to his essay, The Total Library, value, is corrupted.
wrote about the impoverishment of text The significance of The Blank Swan is
through the means of its reproduction. All difficult to know, at least now. In another
texts are reproduced in a vast library only Borges short story ,Death and the Compass,
because complete randomness eventually detective Erik Lönnrot attempts to solve a
produces all possible combinations of letters. mysterious series of murders which seem
Like Pierre Menard, Borges’ The Library to follow a kabbalistic pattern. The detective
of Babel explores the complex nature of finds that his enemy, Scharlach, has set a
meaning. In Pierre Menard, meaning trap counting on Lönnrot’s overly developed

Journal of Regulation & Risk North Asia 55


intelligence to read into the events a pattern. history seems concrete and definitive when
The detective’s over-intellectualising leads to it is merely one of a number of possibilities.
his death.
Could it be that The Blank Swan over- Act of courage
intellectualises and creates its own labyrinth Has the world of economics and finance
from which it cannot escape? After all, finan- already taken a path in which probabil-
cial markets exist simply to facilitate invest- ity, ill considered and flawed as it may be,
ing and borrowing or make items tradeable shapes our framework of activities? Or is
to facilitate speculation. The rest, as they say, there still time in this journey to re-shape
is“noise”. our world in the way that The Blank
Another alternative is Borges’ story, The Swan argues?
Garden of the Forking Paths. Based on the Robert Frost describes this choice in
concept of parallel worlds, Borges outlines his poem, The Road Not Taken. Dr. Ayache
a series of infinite paths or sequences of has taken the path “less travelled by” and
events, in which every alternative can co- that is an extraordinary act of courage and
exist. As we can only take a singular path, our self belief. •

Journal of Regulation & Risk – North Asia

Call for papers


nce
Complia
liance
Legal & Comp

impacts
is subject to the l change
Who exactly financia iance and risk
t Practices Act? Global compl
Foreign Corrup managem
ent –
Yuet-Ming, DLA Risk man products ails a potent
In this paper, Tham
agement head of det
ines the EastNet’s David Dekker, rkets.
consultant, exam Of ‘Black e, ancial ma
Piper Hong Kong s of the FCPA in Asia. Swans’, str complianc al reaction in fin
pernicious effect optimise ess tests che mic
d risk ma & oth-
es amongst ices.
– many of which nagement compani
be one of to offer these serv t
ds of companies Sta signs
will just be able speak abou
es by hundre ies. The US legis- ndard & the first that will ld rather
Corrupt Practic Fortune 500 compan outlines the Poor’s we saw ld ers we shou moni-
The US Foreign beginnings in the were scandals by even- banks, or that
its responded to these positive ben David Samuels About
a year ago the financial wor s These days ns than , a name
Act (FCPA), has ate Special lature in 1977. efits of ban mation in the cred
it crisi
financial
institutio
ice providers
when the Waterg enacting the FCPA a transfor ths at serv
ate era, tually ns to the
testing on k stre of mon l wor ld cial re activities. ed
the bottom ss the last
Waterg disclo- main provisio finan
for voluntary There are two the and in financia is tored nt and futu mov
Prosecutor called had made provisions, and It is a big med the ge that rs their curre rapidly we have banks
nies that – the anti-bribery
the chal lenge for line . has tran sfor
. the chan cove
sures from compa utions to Richard FCPA Both the SEC and a robust banks to osive pace der in scop were
e than Look at
how n on the
nable contrib accoun ting provisions. have juris- of
approach
to man build dow an expl h broa ical interactio
of oper ation) to
questio of Justice (DOJ) wors g is muc that phys rs
ntial campaign. US Department
t-case aging the nturn capit
occurrin expected. banks fall from (location and hou Internet banking.
Nixon’s 1972 preside the SEC by definition stress scenarios that, risk unco al
ver risk conc adequacy programs to fail or
FCPA. Generally, ly terms ents then ge, but
diction over the provisions and unlikely , are trigg almost entrations
and risk depe to
original too big
ed to be beinOpinio nover by ronic paym still in char to a
disclosures revealed prosecutes the accounting or unpreced ered by apparentl encies, and;
applying consider g taken n- elect the banks were ing
However, these paymen ts ns as against issuers ente d events.
y to drive these improvem
nd-
faili ng or mor e fina
Again digm is shift
nable domestic anti-bribery provisio ings business
selection ents are either ons that
are
e para- d the para ons and
cor-
not just questio channelled the strative proceed However, through – for exam l instituti in a hug mentione sical pers s
that had been civil and admini fying the risk solving the problem
perfo
adjusted pricin rmance analysis financia by as re we (phy r without the bank
but illicit funds business. through tes companies and
ple, d, resulting regarded world whe as
s the DOJ prosecu
regulation
cially soun how banks are
ents to obtain concentra of identi- and risk- othe
to foreign governm wherea provisio ns cies tions g that takes ) pay each gies such
Deregulation, non-
ent investi- bery that and into accou stres t in tions tech nolo
led to subsequ als for the anti-bri give rise to dependen nt. s test resul digm shif r banks. pora
ent with
new
The information Exchange individu vital if the worst-cas - ts
lic and othe
ings.
’ involvem
and ‘desupervision
e outcomes
US Securities and criminal proceed indu
vidual bank stry is to thrive – is Top- the pub around payments
.
gations by the which revealed
that through s and level over ly revolves rs, los- mobile
Commission (SEC) funds” to on past two yearsare to turn the lesso if indi- Building sight
e bank ing large cust ome
kept “slush ibery provisi to competitiv ns of the a more robu Sinc ty to serv
ice iders nisations
many US issuers officials and politica
l The anti-br bery provision
makes it Banks that e advantag process for
uncoverin
st and comp
rehensive trust and
Black the abili
examines thethe impact Network prov banks and orgaother pay-
rmining
The FCPA’s anti-bri
Professor Williaingma customeepidem
tackle the e. r and dete the ongoing risk In the future the
pay bribes to foreign or anything be lauded g
by investors issue head-on will prise is clearly, in part, threats to the enter
and
or provide money of that NACHA
ge fraudld be partorgaicnisation, as wellnew such as SWIFT, become network provA to B
as iders
ry illegal to offer (“foreign”mean- coming years and regulator ance chall a corporate -
causes of the mortgaof it, shou
parties. up with a volunta to foreign officials of industry s in enge.The govern- . and
The SEC later came any cor- of value S”) with the intent to obtain
or most impo recuperatio the must have board of the States
theentUnited ment netw
orks money from traf-
me under which rtantly, will n and, the motivatio and top executives has swept managem ness of exist
ing
you to send the network
disclosure program payments ing
“non-U s to tained profi be able to g the riski g/buying
business, or for
directing busines deliver sus- scrutinise and call n and
omers usin changes that allowcharge you for lari-
self-reported illicit given retain that are well
tability gains a halt to appa the clout to monitorin the cust brings simi gy
poration which SEC was place
. Meanwh
ile,
able activ
ities rentl ucts and e are mor e and will rate. This ener
with the d to take banks term if these are y profit- prod ther criti- d that are you gene as telecom,
and co-operated likely any person. of value can include sponsor- consolida advantage not in the ucts. But threeing worl fic that
l assuran ce that it would Anythin g of a holi- can
tion proce
ss need of the the interests of the enter longer- and they these prod
implicitly demonst
in
rate bank
the e n it. indu stries such es. The financial
an informa result on, use understan intended prise or do a leading es know with pani
ment action. The for travel and educati d the risks to be sure they risk not fit author of this paper is cal failures and
challengn and
of regulatio
a wholesal
ing as we
have the ties cable com ortant
be safe from enforce more than USD$300 ship of future employ
ment, portfolios embedde But contrary profile of the organisat THE ing bank of fraud re, not be liers and ing an imp
home, promise
of potential d in the and former banking threaten market disciplinein the futu e our funds, supp is clearly undergo
was the disclosu
re that
(a mas- day meals. There is
no acquisitio ing corpo to popu academic, lawyer
ion.
‘white collar’ failure
of private will,The
banksrisk.
nable payments ts, drinks and
To improve
enterprise ns. rate governan lar opinion, improv- r specialising in formsThe of credit Financial
mov
which to ) folios; they worl
d
in questio discoun and stren risk tion ce is regulato of the and other cles by 135
million been made gthen inves man of putting not just a heroes defaultent vehiNetwork (FinCEN and port
the 1970s) had tor confidenc agement board the ‘right’ ques- As one of the unsung Enforcem balances
sive amount in bank
147 s can take the lead e, we members executives crime. of the 1980s, Crimes this our
week on Suspiciou
s
in three relate think appropria in place and and & Loans debacle released a study maintain
Asia
Better boar
d and senio d areas: te incentives giving themSavings Black nowadays spends much that federally & regu- North Asia
tion & Risk North sight and r executive For . Professor Activity Reports (SARs) ulationes) file
Risk
Journal of Regula control of over- sions the bank to mak ing why financial nal ofns
institutio Reg (sometim
agement;
re-invigor
enterprise when they e the right of his time research to become dys-
lated financialJour of Investigation
risk man deci- have a tendency Federal Bureau
ated stres - busin
s testing ess growth are difficult, e.g. markets on with the of mortgage
and or looks good when functional. Renowned for his theory when they find evidence
Journal of when risk in the uptu lectures at the (FBI)
Regulatio managem
ent looks rn, ‘control fraud’, Prof. Black fraud.
n & Risk
North Asia expensive i and Kansas City.
University of Missour Rob
‘The Best Way to
He is the author of e Epidemic warning
One: How Corporat of an “epidemic” of
a Bank is to Own The FBI began warning
163 and Politicia ns Looted the fraud in their congressional
testi-
Executiv es ta- mortgage years
prominent commen er 2004 – over five
S&L Industry.’ A mony in Septemb were
of the current financial ago. It also warned that if the epidemic

Contact
tor on the causes
is a vocal critic of
the cause a financial cri-
crisis, Prof. Black not dealt with it would to
ent has handled the adequate was done
way the US governm d institutions sis. Nothing remotely by regulator s, law
rewarde
banking crisis and respond to the epidemic dis-
failed in their fiduciary enforcement, or private sector “market
that have clearly and
. epidemic produced
duties to investors cipline.” Instead, the
in US housing prices

Christopher Rogers
hyper-inflated a bubble
ary does not nec- a crisis so severe that
it nearly
The following comment of that produced
view of the Journal of the global financial
essarily represent the caused the collapse
ented bailouts of
– North Asia.
Regulation and Risk system and led to unpreced
on criminal refer- largest banks.
“The new numbers many of the world’s
in the US are just in
rals for mortgage fraud

Editor-in-Chief
33
Asia
of Regulati on & Risk North
Journal

christopher.rogers@irrna.org

56 Journal of Regulation & Risk North Asia


Comment

Accounting shenanigans at
heart of the financial crisis
Qfinance journalist Ian Fraser dissects the
House of Lords inquiry into the role of au-
ditors in exacerbating the banking turmoil.

The many inquiries into the financial when in fact they were barely profitable or
crisis have turned over plenty of stones even loss-making – and all in ways that
but have failed to find any smoking auditors could invariably claim “complied
guns. However, the United Kingdom’s with the standards”.
House of Lords economic affairs com- In turn this enabled the banks to make
mittee inquiry, “Auditors: market concen- imprudent payouts to executives (in the
tration and their role” is making strides shape of bonuses) and to shareholders (in
in identifying and maybe rooting out the the shape of dividends) which in truth they
accounting shenanigans that lay at the could not afford to make.
heart of the crisis.
Recategorised assets
At a recent session of the House of Lords In an article published in May 2009, Brandon
inquiry, UK-based investors said that Davies, managing director of the Global
International Financial Reporting Standards Association of Risk Professionals Risk
(IFRS) had encouraged imprudent, reck- Academy said the switchover from the UK’s
less and even illegal behaviour by UK Generally Accepted Accounting Principles
and Irish banks, enabling them to deceive (GAAP) to IFRS in 2003-05 had prompted
investors, boost executive bonuses and ulti- banks to recategorise assets on their balance
mately destroy their institutions at taxpayers’ sheets in dangerous ways:
expense. (See text pages 72-73 of this report Under Basel II . . . a bank is incentivised
for a fuller explanation of the shortcomings in the growth phase either to acquire more
of IFRS) assets to increase income or to repay surplus
The investors told the Upper House – capital to its shareholders. In the contraction
which included former UK Chancellor of phase of the cycle, the systematic deterio-
the Exchequer, Lord Lawson – that IFRS had ration in credit quality requires an increase
enabled bank boards and auditors to pre- in capital resources to maintain the same
sent their institutions as massively profitable, total of balance sheet assets, or a significant

Journal of Regulation & Risk North Asia 57


reduction in the amount of assets supported lending, creating a Ponzi-like scenario in the
by a given amount of capital. frothiest market sectors. It also enabled bank
IFRS has produced a significant effect managements to make ludicrously low pro-
on capital ratios, because any fall in the price visions for bad debts.
of an asset in the accounting categories According to a transcript, Iain Richards,
‘available for sale’ and ‘held for trading pur- head of corporate governance at Aviva
poses’ produces a reduction in capital by the Investors, said:
amount of the fall in price, as will happen in “. . . you get – and I will characterise it
the contraction phase of the economic cycle, slightly – a finance director will approach
or an increase in capital as asset prices rise in the auditor and say: “What’s the range of
an expansionary phase of a cycle. fair values that would be acceptable under
the standards?” The auditor might answer:
Wider coverage “Well, it’s between 70 and 140 and we think
In practice, these two accounting categories the reasonable prudent number would
for assets cover a much greater proportion of be about 95”. The FD says: “Thanks, 140 is
the assets on banks’balance sheets than was just what I was looking for. Thank you very
the case for ‘mark to market’ assets under much,”and it’s compliant with the standards.
the old UK GAAP. This is because the new I’m exaggerating, but the auditor is then in
categories cover any assets where there is an invidious position of having very little
an intention to sell the assets. Such assets leverage, under the way that the standards
are often held for prudential regulatory pur- work, to push back on that.
poses in the banking book, which is actively
managed as with any investment portfolio. Home to roost
This has led to many relatively illiquid IFRS is pro-cyclical in that it allows mispriced
and long-term assets (such as loans to pri- credit to go unchecked. It enables banks to
vate equity, securitised assets such as mort- price risky loans as if they were safe loans.
gages and illiquid bonds) being covered by While the pro-cyclicality of IFRS has been
these categories. The effects on regulatory widely recognised, experts say the problem
capital are, moreover, exaggerated, as prices was exaggerated in the UK as a result of the
are also affected by an increase in liquidity in way it was implemented. Richards added:
the growth phase of a cycle, and by a decline “IFRS [as applied in the UK] is extremely
in market liquidity in the contraction phase. pro-cyclical. It facilitated and exacerbated the
credit bubble and then brought it home to
Illusion of strength roost in the crash and crisis. [In bank finan-
IFRS’s biggest flaw, however, is that it gave cial statements] there were valuations that
bank managements and their auditors too frankly [were not] rigorously carried out on
much latitude in the valuation of assets, some instruments where reliance on netting
which in the upcycle created an illusion of off against credit default swaps was fictional
capital strength and egged on managements given that the CDS market, which hit US$66
to indulge in more and more poor quality trillion at its peak, was 80 per cent naked

58 Journal of Regulation & Risk North Asia


and the counterparties could never meet been helpful . . . if whoever was auditing
their exposures. Reliance on an instrument HBOS had said: ‘Your loan book seems to
like that to support a toxic instrument that us to be rather different from the loan books
you are carrying on your balance sheet is that we’re finding in other banks’.”
imprudent — but it’s acceptable and allowed Under IFRS/mark-to-market account-
under the standards.” ing, HBOS auditors KPMG were not
required to differentiate between what
Excessive dividends appears to have been “phoney” lending by
In a letter to the Times dated July 27, 2010, the Edinburgh-based bank to a labyrinth of
a group of academics and accountancy already insolvent corporate borrowers and
experts said: “In its commencement phase, shady off-balance-sheet vehicles and kosher
the ‘fair weather’ model significantly over- corporates that were genuinely capable of
stated bank profits, resulting in excessive repaying their loans.
dividends. It also obscured true gearing Pitt-Watson said that “we as investors
and capital destructive business models. In and society”need to see the re-introduction
“storm”mode it accelerated and exaggerated of a principle-based accounting system that
losses, resulting in taxpayer-funded recapi- includes prudential and on-going assess-
talisations.” Aviva’s Richards added: ”The ments of risks.”
double-digit billions pumped into the banks
went to plug the gap created by both bonus Act contravention
distribution and dividend distributions that The fund managers’ concerns about IFRS
were made just preceding the crisis.” echoed those of Tim Bush, a former fund
His stark assessment was endorsed manager at Hermes and a member of the
by other fund managers in the House of UK“Urgent Issues Task Force”that is tasked
Lords session, including David Pitt-Watson with scrutinising the work of the Accounting
of Hermes; Guy Jubb of Standard Life Standards Board (ASB).
Investments; and Robert Talbut of Royal Last August, in a letter to the ASB, the
London Asset Management. Bank for International Settlements (BIS), and
other accounting regulators, Bush said the
‘Different’ loan books ASB’s failure to properly understand IFRS
And Pitt-Watson said: “If we had had more had caused it to implement the standards in
conservative accounting, then the profits a way that contravened the Companies Act.
and the equity of the banks would have Bush said the ASB had failed to get
been lower; the bonuses wouldn’t have its head around the law relating to credi-
been so big; they wouldn’t have loaned out tor protection, which is embedded in the
so much more money. I am intrigued that Companies Act (which applies to com-
when HBOS was taken over by Lloyds that, panies using IFRS and those using ‘UK
of their £432 billion loan book, Lloyds said GAAP’ ). As a result, said Bush, the ASB
£186 billion of that was not business that had approved standards that contravened
they would’ve wished to do. It would have the law in respect of creditor protection.

Journal of Regulation & Risk North Asia 59


Overall, Bush said the way in which IFRS paying dividends.They did not have the
had been implemented in the UK and capital that they presented, and they were
Ireland had “created ‘double dose’ to the not“going concerns”.
extent of being a deadly dose, by removing
what had underpinned banking solvency Phantom capital
for over 120 years,” leaving UK and Irish The true situation was that business models
banks dependent on a different (flawed) were loss-making and actually consuming
set of financial reporting standards to their capital. The accounts were unreliable for
counterparts elsewhere Europe. capitalism to function properly as they did
not show the capital.
Illegal payouts Bush said that IFRS, as applied in the
Bush also said the use of IFRS had prompted UK and Ireland, had created phantom bank
the boards of UK banks to make illegal pay- profits and phantom capital that had“misled
outs to executives and to shareholders: creditors, misled shareholders, the Bank of
“Overstating profits could lead to an England, FSA and others.” He claimed this
illegal distribution (which is a criminal had led to the “regulatory fiasco” that had
offence), as well as a breach of Section 386 caused the financial crisis and, owing to the
(also a criminal offence). Some aspects of authorities’ insistence on sticking with IFRS
IFRS do overstate profits and indeed sev- despite its flaws, continued to pose a severe
eral UK and Irish banks collapsed after risk to the financial system. •

Subscribe
Risk managem
ent

Of ‘Black
Swans’, stre
optimised ss tes
risk manag ts &
Com pliance ement
Legal & Standard &
outlines the Poor’s
positive ben David Samuels
efits of ban
to the k stress
subject testing on
actly is
the bottom line
Act?
Who ex
It is a big
Practices
chall .
a robust appro enge for banks to

today
Corrupt of worst-case ach to managing the
build down
Foreign
turn capita
DLA risk uncov l adequacy
t-Ming,
stress scena
by definition, rios er risk conce programs
Yue are triggered that, almost encie ntrations and to
s pap er, Tham t, examines the unlikely or
unpr by apparently s, and; apply
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risk depend-
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in Asia.
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pernic cies that give
concentrati
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identi- into
account.
g that takes
stress test result
which rise to worst den- s
many of
panies – legis-
vital if the
indus
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mes is Top-l
s of com es. The US vidual banks try is to thrive – and
by hundred compani even- are if indi- Buildi
evel overs
ight
Practices were Fortune 500 these scandals by past two years to turn the lessons ng
Corrupt d to to competitive of the proce a more robust and
Foreign gs in the responde FCPA in 1977. ss for uncov comprehen
The US its beginnin Special lature ting the ision s to the Banks that
tackle
advantage.
the issue head- prise ering threat sive
A), has Waterga
te tually enac main prov s, and the be lauded by
on will ance is clearly, in part, a corpo the enter-
s to
Act (FCP when the y disclo- e are two ision comin
investors and
challe rate
te era, ntar Ther ry prov the g years of indus regula tors nge. The board and gover
Waterga d for volu had made – the anti-
bribe SEC and in
try recuperatio the must have the
n-
Prosecut
or calle ies that ard FCPA s. Both the have juris- most impo
rtantly, will n motivation
top executives
compan s to Rich g provision J) be able to delive and, scrutinise and and the clout
sures from contribution accountin ent of Justice (DO y, the SEC tained profit
ability gains r sus- able call a halt to to
n. erall appar
question
able
idential
campaig US Departm the FCPA. Gen isions and
that are well
placed to take
. Meanwhile
, banks term
activities if
these are not ently profit-
Nixon’s
1972 pres
aled dicti
on over unting prov issuers
consolidatio
n process need
advantage
of the the
interests of
the enterprise
in the longe
r-
es reve es the acco isions as against can understand intended risk or do not fit
disclosur prosecut prov ngs to be
the risks embe sure they profile of the
, these payments the anti-bribery e proceedi But contrary organisatio
However domestic inistrativ and portfolios of dded in the

J
ble d and adm pani es poten tial acquisition to popu lar opinion, n.
questiona had been channelle . through civil prosecut
es com s To improve s.
ing corporate
governance improv-
not just provision
funds that in business reas the DOJ bribery and strengthen enterprise risk manageme tion of puttin is not just a
but illicit ents to obta nt investi- whe the anti- investor confid nt g the ‘right ques-
governm iduals for proceedings. banks can take ence, we think board members in ’ executives
to foreign to subseque Exchange indiv
mation led rities and ugh crim
inal
ournal of reg Better board
the lead in
three relate appropriate place and
giving them
and
The infor
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the US Secu h revealed
) whic
that thro
to ery prov
ision ulation & risk
makes it
sight and
contro
and senior d areas:
executive over-
incentives.
For the bank
to make the
ion (SEC h funds” anti-brib bribery provision agement; re-inv l of enterprise risk sions when
they are difficu right deci-
Commiss issuers kept “slus
many US gn officials
and political The
The FCPA
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north asia
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offer or prov ials (“foreign”mea or
anything
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looks good
lt, e.g. when
s to forei illegal to offic in when risk in the uptur
pay bribe a voluntary of value to forei
gn obta Journ al of Regu mana geme nt looks expen n,
intent to lation & Risk
parties. e up with with the ness to sive
later cam h any cor- ing “non-US”) for direc
ting busi North Asia
The SEC e under whic ents ness, or
e programm rted illicit paym n retain busi sor-
disclosur repo give include spon
which self- SEC was any pers
on.
value can , use of a holi- 163
poration with the ld likely thing of
co-o perated it wou Any educ ation ent, Volume I, Issue III,
and rance that result travel and loym
future emp e is no
Autumn Winter 2009-2010
an infor
mal assu action. The $300 ship forArticlesise&ofPaper
enforcement USD hom e, prom ls. s
Ther
be safe from osure that more
than - day and mea
discl ents (a mas e discounts Issues , drinks
in resolving systemica
was the ble paym
questiona been mad lly importan147 t financial institution
million in in the 1970s) had Resecuritisation
in banking: major
s Dr Eric S. Rosengren
unt challenges ahead
sive amo
North Asia
A framework for
funding liquidity Dr Fang Du
ion & Risk in times of financial
of Regulat Housing, monetary crisis
Journal and fiscal policies: from
bad to worst
Dr Ulrich Bindseil
Derivatives: from
disaster to re-regulat Stephan Schoess,
ion
Black swans, market Professor Lynn A. Stout
crises and risk: the
human perspectiv
Measuring & managing e
risk for innovativ Joseph Rizzi
e financial instrumen
Red star spangled ts

Contact
banner: root causes Dr Stuart M. Turnbull
of the financial crisis
The ‘family’ risk: Andreas Kern & Christian
a cause for concern Fahrholz
among Asian investors
Global financial
change impacts David Smith
compliance and
risk
The scramble is on
to tackle bribery David Dekker
and corruption
Who exactly is subject Penelope Tham & Gerald

Christopher Rogers
to the Foreign Corrupt Li
Practices Act?
Financial markets
remuneration reform: Tham Yuet-Ming
one step forward
Of ‘Black Swans’, Umesh Kumar & Kevin
stress tests & optimised Marr
risk management
Challenging the
value of enterprise David Samuels
risk management
Rocky road ahead Tim Pagett & Ranjit
for global accountan

Editor-in-Chief
Jaswal
cy convergence
The Asian regulator Dr Philip Goeth
y Rubik’s Cube
Alan Ewins and Angus
Ross

christopher.rogers@irrna.org

60 Journal of Regulation & Risk North Asia


Comment

Basel’s approach to banking


regulation is fatally flawed
Former regulator William Black criticises
the current inherently unsound regulatory
advice emanating from Switzerland.

Our current approach to banking regu- discipline poses an inherent dilemma for
lation exposes us to recurrent, intensify- banks. A bank run is a form of form of pri-
ing financial crises. The good news is vate market discipline.
that because we reached an all time low Banks have very short-term liabilities
in Basel II, Basel III almost has to be an and longer-term assets. This exposes them
improvement. The bad news is that Basel to interest rate risk and liquidity risk. A run is
III has not reexamined the fundamental the ultimate liquidity nightmare for a bank.
assumptions underlying the Basel pro- The conventional economic wisdom is that
cess. As a result, Basel III will be a vari- runs are not a desirable form of market dis-
ant on the common ineffective theme of cipline. Economists tend to use the word
banking regulation designed by econo- “panic”when they describe runs. Economists
mists and the industry. fear that depositors are likely to be financially
unsophisticated and to start runs on banks
The current Basel process is built upon three on the basis of false rumours that the banks
fatally flawed assumptions, these being in are unsound.

no particular order: Capital requirements are
the ideal form of banking regulation; Capital Trumping a run
requirements can be set without establishing Deposit insurance is designed to prevent
sound accounting; Accounting control fraud depositors from engaging in private mar-
is not a serious concern. ket discipline. The insurance limit is often
Capital requirements are the ideal form set at a sufficiently high amount that the
of banking regulation under conventional overwhelming bulk of depositors’ accounts
economic wisdom. The attraction of capital are fully insured – minimising private mar-
requirements to neoclassical economists is ket discipline.
elegance. Their theory is that while private Central banks often provide a “lender of
market discipline ensures that normal cor- last resort”facility to allow the central bank to
porations are inherently safe, private market trump any run. Many nations with advanced

Journal of Regulation & Risk North Asia 61


economies are so opposed to runs that they that capital regulation is the optimal form of
provide both deposit insurance and a lender bank regulation. The key is the alignment of
of last resort facility through the central shareholder’s interests with the public inter-
bank. The conventional economic wisdom est, but capital also provides a buffer against
is that deposit insurance renders private loss to the insurance fund and the taxpay-
market discipline ineffective because banks’ ers. When the incentives are right there is
principal creditors are fully insured deposi- little or no need for additional regulation.
tors. It is expensive for creditors to under- Any rules that constrained bank decision-
take the monitoring and analyses required making (when the incentives were correct)
to impose effective private market disci- would constitute the regulators substituting
pline, so fully insured depositors should not their business judgments for those of the
discipline banks. banks’ officers.
The conventional economic wisdom
Moral hazard asserts that private sector business judg-
The conventional economic wisdom has a ments are vastly superior to regulatory deci-
further prediction: the absence of private sion (Easterbrook & Fischel 1991). It follows
market discipline will increase the risk of that the conventional economic wisdom was
moral hazard. The conventional theory gets that the banking regulators that regulated
quite fuzzy at this point about how moral the least produced the best banking results.
hazard works, a point I return to below, but Increased regulation did not simply increase
it predicts that moral hazard can lead banks costs; it increased the risk of banking failures
to take excessive risks. The conventional and crises. Less banking regulation allowed
economic wisdom further predicts that financial intermediaries to be more efficient
imposing adequate capital requirements and increased economic growth.
will successfully constrain moral hazard.
As long as the shareholders’ have material Fundamental disconnect
capital at risk of loss should the bank fail The conventional economic wisdom also
they will not cause the bank to take exces- claimed that small levels of reported capi-
sive risks. The shareholders’ incentives will tal were sufficient to create the desired
be aligned with that of the public and the incentives among shareholders. In a bub-
banks’ creditors as long as the bank meets ble, bank loan losses are normally greatly
its capital requirement. reduced. Economists began to argue that
the lower the banks’ capital requirement
Recapitalise or close the greater the amount of productive loans
The conventional wisdom, therefore, that would be made and the faster the
requires that the regulators force the bank economy would grow. Basel II substantially
to be promptly recapitalised or closed if it reduced capital requirements.
fails to meets its minimum capital require- The fundamental disconnect with mak-
ment. The above analysis begins to explain ing capital requirements the pillar of banking
why the conventional economic wisdom is regulation is that “capital”,“net worth”, and

62 Journal of Regulation & Risk North Asia


“equity”are accounting concepts. They have $5 million. The bank will suffer a real loss of
no meaning outside of accounting. Worse, $5 million but will falsely report that its capi-
they are all residual accounting concepts. tal has increased by $10 million. Its capital
Accountants do not, and cannot, count a will be overstated by $15 million.
modern bank’s “capital.” They determine Banks also self-fund reported “income,”
assets and subtract liabilities to determine which can flow through to capital. I discuss
capital. The implication is that the accuracy this in more detail later, but the overall result
of reported“capital”depends on the accuracy that needs to be understood is that self-
of the valuation of every asset and liability. funding can be used to report guaranteed,
record income and capital.
Self-funded ‘capital’ All of this means that accurate account-
That means that capital is not only an ing is essential for banking regulation prem-
accounting concept, but the accounting con- ised on capital requirements to succeed. The
cept most subject to error. For a large bank, Basel process relies primarily on capital regu-
there are literally tens of thousands of ways lation, but ignores the accounting games that
to use accounting to distort reported capital allow banks to create their reported capital.
by enormous amounts. Beyond the obvious Bank examination and supervision, globally,
– understate liabilities and overstate asset puts only minimal emphasis on accounting
values – banks are the perfect vehicles to in the era leading up to the crisis.
self-fund“capital.”
Accountants do purport to count “capi- ‘Weapon of choice’
tal”when there is a purchase of newly issued The failure of Basel and the regulators to
stock or a capital contribution. Savings and make accurate bank accounting their cen-
loans and the Big Three Icelandic banks tral priority would be dangerous even if
self-funded the purchase of newly issued accounting control fraud did not exist. In the
stock by insiders, cronies and shills. Anglo- world of modern finance where accounting
Irish Bank self-funded the purchase of is the “weapon of choice” for control frauds,
shares from a distressed shareholder to the failure to take accounting seriously was
prevent the sale of a large block of shares in catastrophic.
the market. Banks can self-fund purported The four-part recipe that bank control
“capital contributions.” frauds use to produce guaranteed, record
fictional short-term income turns regula-
‘Improper’ valuation tory regimes based on capital regulation
The person controlling the bank, for exam- profoundly perverse, the recipe being: Grow
ple, can purport to contribute US$10 million extremely rapidly; by making loans to the
in capital to the bank by contributing real uncreditworthy at premium yields; while
estate (improperly) valued at $25 million to employing extreme leverage; while provid-
the bank and receiving $15 in cash from the ing only trivial loss reserves (ALLL)
bank. If the real estate actually has a market Akerlof & Romer (1993) emphasise that
value of $10 million he will make a profit of accounting fraud is a “sure thing.” If a bank

Journal of Regulation & Risk North Asia 63


can produce guaranteed, record income crises. One can understand the logic. Basel
then it can appear to be healthy. Regulators II reduced capital requirements and failed
are taught to worry about banks showing banks followed extreme leverage. Special
losses – not record gains. investment vehicles (SIVs) employed excep-
A bank reporting record income can tional leverage and many SIVs failed. The
pay its controlling officers huge compen- regulators are correct that leverage mat-
sation and still have plenty of fictional net ters – it is the third ingredient in the lenders’
income to flow through to fictional capital. accounting fraud recipe.
Regulators are taught to believe that firms What the regulators have not taken
reporting adequate capital have the correct into account is a series of means of gaming
incentives and have a buffer that will protect reported capital that render capital require-
the Federal Deposit Insurance Corporation ments malleable. Instead of correcting these
against losses. accounting abuses they have stood by, or in
the case of Ben Bernanke encouraged, the
Essential ingredient destruction of the remaining integrity of
The fictional increase in income and capi- accounting standards. Bernanke encouraged
tal makes it easy for the bank to meet the the Chamber of Commerce and the banking
first ingredient – extremely rapid growth. It lobbyists to use their political allies to extort
also makes the regulators feel comfortable the Financial Accounting Standards Board to
about the bank employing extreme leverage. junk the rules requiring banks to recognise
The fourth ingredient is an essential ingre- their losses.
dient of accounting control fraud. The first
three ingredients maximise real losses. The Circumventing the law
expected value to the bank, for example, of This massively overstates asset valua-
making liar’s loans is sharply negative. tions, which massively overstates reported
That means that the loss reserves (ALLL) capital – evading the requirements of
that the bank should establish under GAAP the Prompt Corrective Action law. It also
should exceed the net income from the loan overstates income, allowing bank offic-
(i.e., the loss reserves should be large enough ers to enrich themselves through bonuses
that the lender recognises a loss on the liar’s they had not earned.
loans when they are originated). That would Having just gimmicked the accounting
have meant ALLL provisions in the 20 per rules to achieve their goals of covering up
cent range for liar’s loans. Instead, ALLL fell the scale of the crisis (and claiming to have
each year in the peak of liar’s loan origina- “resolved”the crisis for a pittance), it is bizarre
tions to roughly one per cent. that the banking regulatory agencies treat
capital requirements as if they had meaning
Leverage matters independent of accounting. A sound system
Basel III is premised on the assump- of banking regulation cannot be based on
tion that raising capital requirements will capital regulation as it is conceived in the
greatly reduce the risk of future failures and Basel process. •

64 Journal of Regulation & Risk North Asia


Comment

Bridging the great divide


of counterparty risk
Xavier Bellouard, co-founder of Quartet FS,
says counterparty risk is crucial to banking
sector stability and its future success.

While the European stress testing exer- and unanimously agreed that risk managers
cise undertaken last summer may be a need to have better access to data, especially
fading memory, the tests further demon- related to credit risk, in order to gain a thor-
strated the fact that financial institutions ough view of counterparty risk exposure.
continue to grapple with risk manage- With board accountability a major con-
ment in the wake of the 2008 banking sideration in today’s market environment,
crisis. In particular, counterparty risk forward-thinking financial institutions are
exposure is still under the spotlight after casting the net farther and wider within their
coming to the fore during the demise counterparty risk calculations.
of Lehman Bros. While the majority of
European banks passed last year’s tests, Give them the tools . . .
few can rest on their laurels as regulators In order to leverage this broader insight, risk
and investors continue to push for trans- managers must not only overcome the chal-
parency and accountability. lenge of the data deluge, but also have the
appropriate tools in place to make scientific
The evolving regulatory landscape and data accessible to ‘non quant’ users. Only
increased need to monitor, measure and by undertaking this second stage will they
report, has advanced in such a way over the be able to analyse the data in real-time and
past three years that understanding and real- make informed recommendations against it
ising risk exposures in real-time has become to the board.
crucial to a financial institution’s stability and While an element of risk is to be expected
success. Amongst other things, the finan- with every trade, the financial crisis served to
cial crisis served to highlight the inadequacy highlight the need to be aware of the asso-
of the technology that was traditionally in ciated risk and be comfortable as a business
place to establish and manage counter- with it. However, pinpointing where risk lies
party risk in particular. A number of surveys is no mean feat, with even the largest of insti-
released during 2010 have reiterated this tutions not fully aware of their exposures.

Journal of Regulation & Risk North Asia 65


With this in mind, better understanding the ability to simulate the impact of various
and management of risk – especially coun- strategies for credit exposure, inclusive of any
terparty – is crucial to the ongoing finan- collateral held, in real-time.
cial recovery and to re-injecting confidence Ultimately, risk managers need to have
back into the interbank lending market. As the ability to communicate with manage-
a result, risk managers are now tasked with ment and collaborate on trading decisions
being able to provide aggregated figures in a credit-sensitive environment. The tradi-
quickly and accurately in order to truly estab- tionally siloed approach of banks has meant
lish the position the business finds itself in. that to date, this has been a pipedream
rather than a reality. However, aggregating
Collective impact high volumes of data from multiple streams
Due to its interconnected nature, counter- to produce both snapshots and the ability to
party risk analysis must not only take into drill down into the data in real-time is possi-
account various data, including VaR, P&L ble by combining Complex Event Processing
and sensitivities, but must also integrate a and Online Analytical Processing.
number of asset classes and draw together The combination of the two technologies
an understanding of the collective impact allows users to view their risk, and profit and
that they have. Once counterparty risk is loss data in the way they want, while enjoy-
accurately established, risk managers need ing real-time/push technology that provides
to gain better access to, and analysis of, this constant updates from market data as well
data so they can more effectively bridge the as new and amended trades. In addition
gap between‘quants’and decision-makers. to providing a real-time view of exposure,
For example, modern credit risk frame- made up by multiple data sources, firms
works imply stochastic evaluation of risk, can slice and dice information and analyse
based mainly on the traditional Monte Carlo as required, down to the smallest detail or
simulation. But, in order to truly manage risk, building up to provide a top-level overview.
this scientific data must be made available to
‘non quant’users so that they can act on it. Duplication of effort
As with all things risk related, technology If implemented and deployed appropri-
plays a significant part in not only collating ately, technology can avoid duplication of
information but in making it digestible to analysis and aid risk managers in making
‘non quant’users. Alongside intuitive naviga- well informed decisions quickly that sup-
tion to understand the raw data,‘non quant’ port the business. Whilst technology is by
risk managers want to be able to integrate no means the universal remedy to solving all
sophisticated calculations such as future the issues associated with counterparty risk,
exposure, as well as complex netting and the quicker a firm can realise its true coun-
collateral rules (including the inherit corre- terparty positions and potential exposures
lation of the collateral vs. the specific coun- in the context of the overall risk picture, the
terparties), go beyond single indicators that greater its overall market competitiveness
need to be put into perspective, and have and confidence will be. •

66 Journal of Regulation & Risk North Asia


Comment

Latest Basel accord increases


rather than decreases risk
Banking futurologist Dr. Brett King argues
Basel III will have the opposite effect to its
stated ambition of risk reduction.

The Basel III accord’s stated ambition player. The issue with this is, of course, that
as laid out in the Basel Committee of by creating a set of rules and by changing
Banking Supervisors consultative pro- the system, this very approach generates a
posals for strengthening the resilience reflexive feedback loop that increases com-
of the banking sector is as follows: “This plexity of the processes between customers
consultative document presents the Basel and the institution, and between the institu-
Committee’s proposals to strengthen tion and third parties. The more complexity
global capital and liquidity regulations that is built into the system, the greater the
with the goal of promoting a more resil- likelihood of abuse as complex systems are
ient banking sector. The objective of the harder to control or police than their more
Basel Committee’s reform package is to simplistic brethren.
improve the banking sector’s ability to
absorb shocks arising from financial and Inordinately complex
economic stress, whatever the source, While payments, interbank networks and
thus reducing the risk of spillover from such may appear inordinately complex,
the financial sector to the real economy.” there are those that maintain that such net-
works produce predictable or measurable
The intent of the Basel accord must be to behaviour in response to specific shocks or
afford consumers, shareholders, the cor- trends, but essentially this is through either
poration, and the ‘banking sector’ at large, the emergence of a dominant sentiment (i.e.
protection from shocks, abuse, corruption or the old“buy on rumour sell on facts”saying)
intended manipulation. In that respect, Basel or through exogenous events.
broadly takes a position of “trust no one,” While some claim that sentiment analy-
and builds into the system a comprehensive sis through tools like Twitter, might predict
framework of understanding, monitoring the way the network or market will move
and mitigating any risk of sufficient inten- in the short-term, the problem with Basel
sity that it could do harm to the sector or III is that its very complexity might possibly

Journal of Regulation & Risk North Asia 67


have a deleterious effect on the market as a risk. For example, Professor Hal Scott, in
whole, but most certainly on the effective- his paper “Competitive Complacency in the
ness of the institution. decline of US Public Equity Capital Markets”
(May 2007) challenges regulators and the
Short-term effects market in this way: “While America’s public
The primary concern for institutions will equity market place is still winning the war
be that Basel III might actually reduce as the world’s most dominant market place,
the ability of the organisation to respond it is losing many of the key battles to for-
to shocks in the system, because it might eign and private markets. America is losing
be outside of the approved risk manage- its place of primacy, power and influence
ment process. Essentially working exactly as the global leader in public equity capital
the opposite to its intended purpose. markets competitiveness.”
However, the implementation of Basel “Further, the evidence is equally compel-
III could actually have a more short-term ling that New York is losing its place as the
effect on institutional competitiveness. dominant center for global financial mar-
There are many illustrative lessons to kets. There is a tremendous price America’s
be gleaned from the regulation of markets; economy may pay for failing to compete suf-
one case in point is that of China’s larg- ficiently to stay ahead of its global rivals.”
est bank by capitalisation, the Industrial
and Commercial Bank of China – usually Dire forecast
referred to as ICBC. The semi-privatisation Hal Scott and George Dallas make another
of ICBC by the Chinese authorities remains dire forecast with respect the present US
the world’s largest initial public offering. regulatory environment, they claim: “What
At the time of its IPO in October 2006 we are witnessing is the latest chapter in the
there was much discussion over where the evolution of the euromarkets. In the past, US
bank’s shares were going to be placed, but banks moved to London to escape onerous
it was telling that ICBC chose, not NewYork banking regulation and the eurobond mar-
or London to launch their IPO, but Hong ket was created in part to avoid US taxes.
Kong. The long and the short of these dis- Now exchanges are moving abroad in part
cussions are essentially that the US market, to avoid the US capital market’s regulatory
in particular, is now too heavily regulated regime. Europe should not be threatened. It
to stay competitive on a global stage as a is the US that should be concerned. Once
capital market. a market moves abroad it is difficult to get
it back.”
Demise of US capital markets In a report commissioned by Mayor
The US continues to find some momentum Michael Bloomberg in 2007, supported by the
around its reputation as the biggest and strategy research firm McKinsey, Bloomberg
best market, but a number of proponents states the shifting competitive environment
of change in the US cite the medium-term in the following way: “Traditionally, London
demise of the US capital markets as a real was our chief competitor in the financial

68 Journal of Regulation & Risk North Asia


services industry. But as technology has vir- revenue and competitiveness is taking a hit.
tually eliminated barriers to the flow of capi- Is there a better way?
tal, it now freely flows to the most efficient
markets, in all corners of the globe. Today, in Prohibitive cost
addition to London, we’re increasingly com- So given the cost of implementation, the
peting with cities like Dubai, Hong Kong, loss of competitiveness, the fact that Basel
and Tokyo.”– Michael Bloomberg, Sustaining III adds inordinately to the complexity of the
New York’s and the US’ Global Financial institution from an organisational structure
Services Leadership, January 2007 and process perspective, why don’t we see
more of the world’s largest financial institu-
Regulatory dilemma tions complaining? Probably because purely
So as competition heats up, the heavy regu- the cost of implementing Basel III is prohibi-
latory environment of the US and UK mar- tive and it is likely to produce more consoli-
kets has not actually helped those markets dation of the sector as they snap up banks
to be more competitive; in fact, exactly the who can’t afford to comply. There has to be a
opposite. The downside of taking a heavier better way, though.
approach to risk mitigation and manage- Members of the Basel Committee of
ment is the reduction of competitiveness. Banking Supervisors, rather than encour-
In this respect, while dotting the i’s and aging further complexity, should instead
crossing the t’s, Basel III doesn’t contribute be focusing on the reduction of complex-
positively in any immediately recognisable ity in the system, which in itself creates
form to the competitiveness of an institution. risk. Rather than enforce new reporting or
In the long-term, we might argue that Basel analysis elements for existing processes,
III is ultimately about insurance, and reduc- what this author would much prefer to
ing future risk, which will make you more see is a real revolution in process redesign.
robust or less risky than your competitors Let’s look at ways of taking the complexity
who don’t adhere to the standards.The same out of the system, reducing risk by reduc-
argument is made for regulation in markets ing handling, process and silos – the Basel
like the US, but essentially the cost has to Committee of Banking Supervisors evi-
be weighed up because in the short-term dently just don’t get it! •

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Journal of Regulation & Risk North Asia 69


J ournal of Regulation & Risk
North Asia
Articles & Papers
After effects of 2008 financial crisis will last decades 73
Prof. Carmen M. Reinhart & Vincent R. Reinhart
Awkward things, even ugly facts can be useful 105
William R. White
Central bankers need to be more, not less, proactive 115
Adam S. Posen
Macroprudential policy perspectives: Emerging markets 141
Ramon Moreno
European crosshairs focus on short selling, OTC derivatives 159
Carlos Tavares
Economists’ hubris: The case of equity asset management 163
Shahin Shojai, George Feiger & Prof. Rajesh Kumar
Can the yuan ever become an international reserve currency? 177
John H. Makin
How Spain can avoid a repetition of the Irish error 185
Prof. Charles W. Calomiris & Desmond Lachman
The European Union debt crisis: Worrisome delusions 189
Prof. Charles Wyplosz
Fiscal policy in the US and European Union ‘misguided’ 193
Prof. Paul Krugman
Reliance on financial models risks repeat of 2008 fiasco 197
Dr. Jon Danielsson
The economic consequences of naked credit default swaps 201
Dr. Rajiv Sethi & Dr.Yeon-Koo Chi
Collateralised debt obligation detox for the European Union 207
Satyajit Das
Capital in large financial institutions can’t be measured 215
Steve Waldman
Lambs to the slaughter: Real causes of the financial crisis 221
Peter J. Wallison
Sarbanes Oxley regulation in current financial markets 233
Gavin Sudhakar
Integrating China’s economy into global capital markets 243
Terry Tse & Gene Guill
Historical analysis

After effects of 2008 financial


crisis will last decades
Prof. Carmen M. Reinhart’s and
Vincent R. Reinhart’s seminal paper ‘After
the Fall’ makes uncomfortable reading.

Three years have elapsed since the The events of the past three years are not
troubles in the United States subprime without precedent. However, those prec-
mortgage market erupted in the summer edents are spread across countries and over
of 2007. In the interim, a global panic time. Two features, in particular, appear to
developed and, just as normalcy began to have made the global economic contraction
return this year, concerns about a Greek more virulent. First, financial intermediation
default and widespread contagion in was dealt a body blow. Financial institutions
Europe shook the confidence of finan- slashed new lending, and some markets
cial markets anew. As the dust has once were seriously impaired for a time. Second,
again begun to settle, policymakers and the declines in output were synchronous
financial market participants have begun across many countries. Virtually every coun-
to ponder the economic effects of these try reporting export values posted significant
adverse shocks beyond their immediate drops in the fourth quarter of 2008, and fully
and evident costs. one-half of 182 countries recorded outright
declines in real GDP in 2009.1
Critical to those considerations are the inter-
mediate- and longer-term effects of severe Post-war crises
economic dislocations, which potentially To capture both aspects, we examine 15
matter for spending behaviour, aggregate severe post-World War II financial crises in
supply growth, asset pricing, fiscal budget advanced and emerging economies and
prospects, and inflation determination. To three synchronous global contractions, the
shed light on these matters, this paper exam- Great Contraction after the 1929 stock mar-
ines the behaviour of real GDP (both levels ket crash, the 1973 oil shock, and the 2007
and growth rates), unemployment, inflation, US subprime collapse.
bank credit, and real estate prices in a 21-year Our main results can be summarised
window surrounding various adverse global as follows:
and country-specific shocks. Real per capita GDP growth rates are

Journal of Regulation & Risk North Asia 73


significantly lower during the decade fol- higher. In 10 of the 15 post-crisis episodes,
lowing severe financial crises and the syn- unemployment has never fallen back to its
chronous world-wide shocks. The median pre-crisis level, not in the decade that fol-
post-financial crisis GDP growth decline in lowed nor through end-2009.
advanced economies is about 1 per cent. 2 Real housing prices for the full period is
available for 10 of the 15 financial crisis epi-
Massive output decline sodes. For this group, over an eleven-year
What singles out the Great Depression, period (encompassing the crisis year and
however, is not a sustained slowdown in the decade that followed), about 90 per cent
growth (which was smaller than that after of the observations show real house prices
the 1973 oil shock) as much as a massive below their level the year before the crisis.
initial output decline. In about half of the Median housing prices are 15 to 20 per
advanced economies in our sample, the level cent lower in this 11-year window, with
of real GDP remained below the 1929 pre- cumulative declines as large as 55 per cent.
crisis level from 1930 to 1939.3 The observations on unemployment and
During the first three years following house prices, of course, may be related, as
the 2007 US subprime crisis (2008-2010), a protracted slump in construction activ-
median real per capita GDP income levels ity that accompanies depressed housing
for all the advanced economies is about two prices may help to explain persistently
per cent lower than it was in 2007; this is higher unemployment.
comparable to the median output declines
in the first three years after the 15 severe post Private sector leverage
World War II financial crises. Another important driver of the cycle is the
However, 82 per cent of the observa- leverage of the private sector. In the decade
tions for per capita GDP during 2008 to 2010 prior to a crisis, domestic credit/GDP climbs
remain below or equal to the 2007 income about 38 per cent and external indebtedness
level. The comparable figure for the 15 crises soars.5 Credit/GDP declines by an amount
episodes is 60 per cent, indicating that dur- comparable to the surge (38 per cent) after
ing the current crisis episode recessions have the crisis.
been deeper, more persistent, and wide- However, deleveraging is often delayed
spread. 4 and is a lengthy process lasting about
seven years. The decade that preceded the
Jobless rates soar onset of the 2007 crisis fits the historic pat-
In the 10-year window following severe tern. If deleveraging of private debt follows
financial crises, unemployment rates are the tracks of previous crises as well, credit
significantly higher than in the decade that restraint will damp employment and growth
preceded the crisis. The rise in unemploy- for some time to come.
ment is most marked for the five advanced The paper proceeds as follows. Section I
economies, where the median unemploy- briefly describes our empirical strategy,
ment rate is about five percentage points although most of the methodological

74 Journal of Regulation & Risk North Asia


details are reserved for an appendix. significant differences in the decades pre-
Section II focuses on the performance of ceding and following crises that go beyond
income levels and growth in the decades the more immediate boom-bust pattern.
preceding and following 15 severe financial The cyclical behaviour of credit, external
crises in advanced and emerging economies; debt, and housing prices over 21-year win-
it also presents comparisons to the global dows supplements this analysis. Section IV
(or, more accurately, advanced economies) examines the prior episodes of severe and
crisis that began in 2007. The emphasis is synchronous economic contraction, the 1929
on testing the hypothesis that there are stock market crash and the 1973 oil shock.
Figure 1. Varieties of crises: World aggregate, 1900-June 2010
Figure 1. Varieties
A composite index of
of crises: World
banking, aggregate,
currency, 1900-June
sovereign default 2010
and, inflation crises, and
Astock
composite
market index
crashesof(weighted
banking,bycurrency, sovereign
their share default
of world and, inflation crises, and
income)
stock market crashes (weighted by their share of world income)
180

Great Depression
WWI-hyperinflation
160
WWII-more defaults

Global crisis
140
and crash

120

BCDI index +
100
stock market
Panic of 1907 crash
80
Oil shock-inflation

60

40
Banking, currency,
default,
20 and inflation crises
(BCDI index) Emerging market crises and
Nordic and Japanese banking crises
0
1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Notes: The banking, currency, default (domestic and external) and inflation composite (BCDI index) can take a
value between 0 and 5 (for any country in any given year) depending on the varieties of crises taking place on a
particular year. For instance, in 1998 the index took on a value of 5 for Russia, as there was a currency crash, a
banking and inflation crisis, and a sovereign default on both domestic and foreign debt obligations. This index is
then weighted by the country’s share in world income. This index is calculated annually for the 66 countries in the
sample for 1800-2010:6 (shown above for 1900-onwards). We have added, for the borderline banking cases
identified in Laeven and Valencia (2010) for the period 2007-2010. In addition, we use the Barro and Ursua (2009)
definition of a stock market crash for the 25 countries in their sample (a subset of the 66-country sample-except for
Switzerland) for the period 1864-2006; we update their crash definition through June 2010, to compile our BCDI+
index. For the United States, for example, the index posts a reading of 2 (banking crisis and stock market crash) in
2008; for Australia and Mexico it also posts a reading of 2 (currency and stock market crash).

Journal of Regulation & Risk North Asia 75


Section V examines the post-crisis inflation of 1907 to the debt and inflation crises asso-
performance, and some of the policy impli- ciated with World War II and its aftermath.6
cations of our findings are taken up in the The six decades immediately after the
brief concluding section. war were not tranquil as they included the
first oil shocks in the mid-1970s; the debt
I. Empirical strategy crises in emerging markets, notably Latin
The simplest way to set the stage for a dis- America, in the early 1980s; the severe bank-
cussion of economic crisis is to consider ing crises in the Nordic countries and Japan
the“World” aggregate crisis indices that in the early 1990s; and the Asian crisis of
were introduced in Reinhart and Rogoff 1997-1998. However, these episodes pale in
(2009). The updated indices are shown in comparison with their pre-war counterparts
Figure 1 for 1900-2010 (the entry for 2010 and with the “global” turmoil that begins
reflects data through end-June) and aggre- in 2007. Like its pre-war predecessors, the
gates the performance of 66 countries that recent episode is both severe in magnitude
account for about nine-tenths of world and global in scope, as reflected by the large
GDP. The indices are weighted by a coun- share of countries mired in crises. Stock mar-
try’s share in world GDP. ket crashes during 2008 to early 2009 have
While inflation and banking crises pre- been nearly universal.
date independence in many cases, a sover-
eign debt crisis (external or internal) is, by Dust begins to settle
definition, not possible for a colony. In addi- Banking crises have emerged as asset price
tion, numerous colonies did not always have bubbles erupted and high degrees of leverage
their own currencies. Thus, the country com- became exposed. Currency crashes against
ponents (without stock market crashes) are the US dollar during 2008 in advanced
compiled from the time of independence (if economies took on emerging market mag-
after 1800) onward; the index that includes nitudes and volatilities. However, turmoil in
equity market crashes is calculated based on Greece and other highly indebted European
data availability. The BCDI index stands for countries notwithstanding, it is evident from
banking (systemic episodes only), currency, the world tally in Figure 1 that the dust has
debt (domestic and external), and inflation begun to settle since the 2007-2008 eruption.
crisis index. When stock market crashes are Here, we quantify some of the longer-term
added to the BCDI composite, we refer to it characteristics of the post“fall”landscape.
as the BCDI +. Our analysis first focuses on 15 severe
and relatively well known financial crises
Panic, debt and inflation since World War II (Table 1). Five are consid-
A cursory inspection of Figure 1 reveals a ered to be the more severe and systemic in
very different pattern for the pre- and post- advanced economies while the remaining
WWII experience. Before World War II, crises 10 befell middle-income emerging mar-
episodes were frequent and severe, ranging ket economies. While Reinhart and Rogoff
from the banking crisis driven“global”panic (2009) study the immediate antecedents and

76 Journal of Regulation & Risk North Asia


Table 1. Episodes and Coverage
10-year window 10-year window after
Region or country Beginning of crisis
before (t-10 to t-1) (t-10 to 1-1)
Global episodes1
21 advanced economies and 1929 1919-1928 1930-1939
20 emerging markets
21 advanced economies and 1973 1963-1972 1974-1983
49 emerging markets
22 advanced economies and 2007 1997-2006 2008-20172
49 emerging markets
Country-specific severe financial crises
Advanced economies
Spain 1977 1967-1976 1978-1987
Norway 1987 1977-1986 1988-1997
Finland 1991 1981-1990 1992-2002
Sweden 1991 1981-1990 1992-2002
Japan 1992 1982-1991 1993-2003
Asian crisis
Indonesia 1997 1987-1996 1998-2007
Korea 1997 1987-1996 1998-2007
Malaysia 1997 1987-1996 1998-2007
Philippines 1997 1987-1996 1998-2007
Thailand 1997 1987-1996 1998-2007
Other emerging markets
Argentina 2001 1991-2000 2002-20123
Chile 1981 1971-1980 1982-1991
Colombia 1998 1988-1997 1999-2008
Mexico 1994 1984-1993 1995-2004
Turkey 2001 1991-2000 2002-20123

1 The analysis of the global episodes is based on individual country data, not on an aggregation into global or regional aggregates. Details
about the empirical approach are discussed in part 3 of this Section.
2 Data is through, 2008, 2009, or 2010, as noted in individual tables and charts, for the particular time series. For instance, the comparison
to post 2007 real per-capita GDP is through 2010 for all countries, as IMF forecasts for 2010 are used.
3 Data is through, 2008, 2009, or 2010, as noted in individual tables and charts, for the particular time series.

aftermath of these crises, our emphasis here associated with the onset of a considerable
extends the before-and-after window to amount of economic turmoil across a great
decades rather than years. many countries. Two of these events origi-
We also study three global episodes that nate in the United States, the stock market
are dated by defining events which were crash of 1929, which ushered in the great

Journal of Regulation & Risk North Asia 77


depression and the unravelling in the sub- index that sets the pre-crisis (t-1) year or the
prime mortgage market that began in 2007. crisis year (T) equal to 100.
The third global shock was the first oil price
hike of 1973 (which also coincides with the II. Post-WWII financial crises and 2007
break down of the Bretton Woods system To set the stage for the analysis, we first turn
of fixed exchange rates). Table 1 defines the to the individual country crisis episodes and
coverage of the 10-year windows around the more recent experience in advanced
these events. economies following what began with the
The statistical analysis, which is described subprime crisis in the US in the summer of
in more detail in the appendix, is based on 2007. Irrespective of bailout costs and swell-
nonparametric comparisons of the data that ing government deficits and debts, the most
are applied to the episodes listed in Table basic measure of the severity of a crisis is its
1. Simply put, we examine if key macro- impact on the standard of living. Since the
economic indicators seem to come from the standard of living is a multi-faceted concept,
same distribution before and after a dislo- we will start with examining the record of
cating event. The exact time periods of the per capita GDP in and following the crisis.7
before-and-after windows vary across our
exercises, but we usually try to employ the 1. GDP levels
longest possible spans of comparison. How bad was what just happened to the
The variables of interest to us are those of global economy? An intuitive metric is the
interest to policy makers and include the level level of real GDP in and immediately after
and growth or real GDP, the unemployment the crisis relative to the peak year. To that
rate, and inflation. Not all the manipulations end, we rebased real GDP in 22 advanced
of the data are used across-the-board for all economies in the three years from 2008 to
the time series. For instance, peak-to-trough 2010 to their levels in 2007. For comparabil-
comparisons are extremely helpful in under- ity, we took the forecast for the levels of real
standing pre-and post-crisis patterns in the GDP in 2010 from the latest World Economic
level of GDP, housing prices, credit/GDP, etc. Outlook of the IMFund (2010).
but less helpful for comparing growth and The frequency distributions of those 66
inflation. annual observations are plotted as the blue
line in Figure 2. As is evident from the figure
Country-specific rates (and the inset box providing summary statis-
All exercises aim to address the broad ques- tics), economic performance has been varied.
tion of whether the decade after the crisis Output has been as much as 13.5 per cent
systematically differs from the decade before below and 2.4 per cent above its 2007 value
it. In all instances, any cross-country or cross- in this country set over the past three years.
period analysis requires that the data is in The red line provides the same calculation
similar units and comparable. To this end, we for 15 severe financial crises, where the level
work with country-specific annual growth of GDP for each of the three years following
rates (per cent changes), ratios to GDP, or an the peak (years t, t+1, and t+2) is re-indexed

78 Journal of Regulation & Risk North Asia


Figure2.2.Levels
Figure LevelsofofReal
RealPer
PerCapita
CapitaGDP
GDPinin theFirst
the First Three
Three Years
Years of of Crises,
Crises, 15 Fifteen
Post-
Post-WWII
WWII Episodes
Episodes and
and the the Second
Second GreatGreat Contraction,
Contraction, 2007-2010
2007-2010
Probability density function
20
Advanced economies 15 crisis episodes
18 2007=100 t-1=100 Above
2008-2010 T to t+2
16
median 98.0 98.0

14 min 86.5 83.7


max 102.4 106.1
12 obs. 66.0 45.0

10 Per capita GDP


2007=100
8

6 Per capita GDP


t-1=100
4
Below
2

0
84 86 88 90 92 94 96 98 100 102 104 106 108
Real per capita GDP

Sources: World Economic Outlook, International Monetary Fund, Maddison (2010, webpage), Reinhart
and Rogoff (2009), and authors’ calculations
Notes: The fifteen crises episodes are those listed in Section II. Figures for real per capita GDP for 2010
are from the IMF’s April 2010 World Economic Outlook.

to the value at the peak. No doubt as IMF distribution). While 60 per cent of the obser-
forecasts for 2010 (as of April 2010) are vations for per capita GDP are below or equal
replaced by actual data and prior year are to 100 for the 15 crises episodes, the compa-
revised, this chart will change. But based on rable figure for 2008 to 2010 is 82 per cent.
what is available at the time of this writing,
output declines during the current crisis are Different approach
comparable to those observed during 15+ Using a very different approach from that
severe post-WWII financial crises. adopted here, Laeven and Valencia (2010)
The post crisis median is 98 (about two per reach the same conclusion about the sever-
cent lower) while upper and lower extremes ity of the output consequences of the recent
are not far apart. In effect, the post-2007 out- episodes versus earlier post World War II
put declines for the advanced economies are crises. These authors compute output losses
more comparable in orders of magnitude to as the cumulative difference between actual
those observed in emerging markets (which and trend real GDP, expressed as a percent-
account for the lower tail of the t+1 to t+3 age of trend real GDP for the period T, t+3.8.

Journal of Regulation & Risk North Asia 79


Figure 3. Real Per Capita GDP Growth in the Decade Before and the Decade After
Figure 3.
Severe Real Per Crises:
Financial Capita GDP Growth in
Post-WWII, the Decade
Advanced Before and the Decade After
Economies
Severe Financial Crises: Post-WWII, Advanced Economies

Probability density function

30 Big five: Spain, 1977; Norway, 1987;


Finland, 1991; Sweden, 1991, Japan 1992
t-10 to t-1 t+1 to t+10
25
median 3.1 2.1
min -0.7 -4.3
20 max 7.9 5.9
obs. 50.0 50.0

15
Post-crisis (t+1 to t+10)

10
Pre-crisis (t-10 to t-1)

0
-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
GDP growth, percent

Sources: Maddison (2010, webpage), Reinhart and Rogoff (2009), and authors’ calculations
Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 16.3 and 28.0, respectively.
If the K-S is greater than the critical value we reject the null hypothesis that the observations are drawn from
the same distribution.

Since, as noted earlier, the aim of the critically for economic welfare. A short but
paper it to better understand the pre-post sharp contraction can be made less conse-
crisis landscape over longer horizons, we quential by private behaviours, such as con-
confine our attention to the analysis of the sumption smoothing by households over
21-year window around the 15 financial crisis their lifetimes and production-smoothing
episodes of interest and confine most of our by firms, forbearance by regulators to allow
comparisons to the 1997-to-2006 experience, financial firms to rebuild capital, and gov-
with more limited reference (as data permit) ernment stabilisation policies. As the effect
to the world after 2007. lingers, it will look more a loss to permanent
income and wealth and those mechanisms
2. Growth and unemployment may turn out to be counterproductive.
Reinhart and Rogoff (2009) demonstrated We widen the window of the pre- and
that a severe financial crisis typically pro- post-crisis analysis to see how much appears
duced an acute disruption of economic temporary and how much is permanent.
activity. The duration of that fallout matters Figure 3 examines the marginal probability

80 Journal of Regulation & Risk North Asia


Figure 4. Unemployment Rate in the Decade Before and the Decade After Severe
Financial
Figure 4.Crises: Post-WWII,
Unemployment RateAdvanced and Asian
in the Decade Economies
Before and the Decade After Severe
Financial Crises: Post-WWII, Advanced and Asian Economies
Figure 4. Unemployment
Probability density function,Rate in the Decade
five advanced Before and the Decade After Severe
economies
Financial Crises: Post-WWII, Advanced and Asian Economies
Big five: Spain, 1977; Norway, 1987;
Probability
50 density function, five advanced economies Finland, 1991; Sweden, 1991, Japan 1992
45 Pre-crisis, (t-10 to t-1) t-10 to t-1 t+1 to t+10
Big five: Spain, 1977;
median 2.7 Norway, 7.9
1987;
50
40
Finland,
min 1991; Sweden,
1.1 1991, Japan
2.5 1992
45
35 Pre-crisis, (t-10 to t-1) t-10 to6.1
t-1 t+1 to 21.2
t+10
max
40
30 median
obs. 2.7
50.0 7.9
50.0
min 1.1 2.5
35
25 max 6.1 21.2
30
20 obs. 50.0 50.0
25
15 Post-crisis (t+1 to t+10)
20
10
15
5 Post-crisis (t+1 to t+10)
10
0
5 1 3 4 6 7 9 10 12 13 15 16 18 19 21 22

0 Unemployment rate, percent

Probability1 density
3 function,
4 6 five
7 Asian
9 economies
10 12 13 15 16 18 19 21 22
Unemployment rate, percent

Probability density function, five Asian economies Asian crisis, 1997: Indonesia, Korea,
40 Malaysia, Philippines, and Thailand
Pre-crisis, (t-10 to t-1)
35 t-10 to t-1 t+1 to t+10
Asian crisis, 1997: Indonesia, Korea,
40 median Philippines,
Malaysia, 2.9 and Thailand
3.7
30 Pre-crisis, (t-10 to t-1) min 1.1 1.4
35 t-10 to t-1 t+1 to t+10
max 9.8 11.8
25 median 2.9 3.7
obs. 47.0 50.0
30 min 1.1 1.4
20 max 9.8 11.8
25 obs.
Post-crisis 47.0
(t+1 to t+10) 50.0
15
20
10 Post-crisis (t+1 to t+10)
15
5
10
0
5 1 2 3 4 5 6 7 8 9 10 11 12
0 Unemployment rate, percent
1 2 3 4 5 6 7 8 9 10 11 12
Sources: International Financial Statistics, International Monetary Fund, various issues, Nicolau (2005),
Unemployment rate, percent
Rosende Ramirez (1990), Reinhart and Rogoff (2009), and authors’ calculations.
Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 16.3 and 68.0, respectively
Sources: International
for the advanced Financial
exercise Statistics,
(top panel) andInternational Monetary
16.3 and 35.1 for Asia Fund, various
comparison issues,panel).
(bottom Nicolau (2005),
Rosende Ramirez (1990), Reinhart and Rogoff (2009), and authors’ calculations.
Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 16.3 and 68.0, respectively
for the advanced exercise (top panel) and 16.3 and 35.1 for Asia comparison (bottom panel).

Journal of Regulation & Risk North Asia 81


Table 2. Unemployment Rates Before and Long-After Severe Financial Crises: 15
Post-WWII Episodes

Has it Lowest reached Difference


Level Maximum post
Country and fallen to since crisis of post-crisis
prior to crisis through 2009
Crisis year pre-crisis through 2009 minimum and
crisis, t-1
level year level? level year pre-crisis

Advanced economies
Spain, 1977 4.8 21.2 1986 no 8.3 2007 3.5
Norway, 1987 2.0 6.0 1993 no 2.5 2007 0.5
Finland, 1991 3.4 18.4 1994 no 6.4 2008 3.0
Sweden, 1991 1.7 9.4 1994 no 4.0 2001 2.3
Japan, 1992 2.1 5.4 2002 no 3.8 2007 1.7
Emerging economies: The Asian Crisis, 1997
Indonesia* 4.8 11.2 2005 no 6.1 1999 1.3
Korea** 2.0 6.8 1998 no 3.2 2008 1.2
Malaysia 2.5 3.5 1999 no 3.1 2000 0.6
Philippines 8.6 11.8 2004 yes 7.3 2007 -1.3
Thailand** 1.1 3.4 1998 no 1.4 2007 0.3
Emerging economies: Other episodes
Argentina, 2001* 14.7 18.3 2002 yes 7.9 2008 -6.8
Chile, 1981* 10.7 21.3 1982 yes 7.1 2007 -3.6
Colombia, 1998 12.1 20.5 2000 yes 11.2 2007 -0.9
Mexico, 1994** 2.4 4.7 1995 yes 1.6 1999 -0.8
Turkey, 2001** 6.6 10.5 2003 no 9.9 2006 3.3

Notes: An asterisk (*) indicates a sovereign default (or restructuring) took place during or shortly after that episode; a double asterisk (**)
are near-default episodes, as defined in Reinhart (2010), where a default was avoided with major international assistance.
Sources: International Financial Statistics, International Monetary Fund, various issues, Nicolau (2005), Rosende Ramirez (1990), Reinhart
and Rogoff (2009), and authors”’ calculations.

distributions of real per capita GDP growth two distributions. The note at the bottom of
for the decades bracketing severe financial the figure reports the Komolgorov-Smirnoff
crises for the most severe financial disrup- (K-S) critical value (at one per cent) for the
tions in advanced economies since WWII relevant number of observation and the K-S
prior to the most recent, also known as the statistic. Comparable tests were done for the
“Big Five”. The blue line gives the perfor- 10 emerging market crises combined as well
mance in the years before the crisis and the as separately for the subset of five Asian crises
red line gives that after the event. The inset episodes. To economise on space and avoid
provides basic descriptive statistics for the repetition, these figures are not reproduced

82 Journal of Regulation & Risk North Asia


here, but Appendix Table 1 presents the rel- answer to the question is no. In the“Big Five”
evant summary and test result statistics. economies, four-of-five Asian-crisis coun-
Long multi-country time series for tries, and in Turkey, unemployment remains
unemployment rates are not always read- perched at a level above the pre-crises values.
ily available. However, the coverage for In five cases (the Philippines and four Latin
the 21-year windows around the 15 crises American crises), lower unemployment
is nearly complete (but for three observa- rates do evenutally materialise after the cri-
tions) and the results are provided in Figure sis. In those five instances, however, the t-1
4. The upper panel provides the smoothed benchmark is high (from 6.6 to 14.7 per cent)
histograms of decade comparisons for the by historic norms of those countries.
“Big Five” countries and the bottom panel
presents similar treatment for the five Asian Imperfect measures
economies in the sample. The figures require It is important to highlight that this study
little explanation. Unemployment rates are relies of official estimates of unemployment,
significantly higher in the years of the decade which may underestimate under-employ-
that follow the crises than in the years of the ment that tends to rise in the years imme-
decade that preceded it. For the advanced diately after the crisis. But even the imperfect
economies, the pre- and post-crises medi- measures available show that unemploy-
ans are 2.7 versus 7.9 per cent, respectively. ment rates tend to be persistently high and
growth rates remain below their counter-
Jobless rate exceeds median parts in two-decade comparisons. Providing
Indeed, as the cumulative density func- a full and testable explanation as to why
tion highlights (bottom panel), nearly all crises leave such a long and pronounced trail
the observations for the post-crisis dec- is beyond the scope of this paper, particu-
ade show unemployment rates above the larly as we are silent on the macroeconomic
median unemployment rate for the t-10 to policy response to the crises. There are, how-
t-1 period. The Asian crisis comparison does ever, two important differences in the pre-
not represent as stark a contrast as that for and post-crisis landscape that merit further
advanced economies – a finding anticipated exploration. The first is the behaviour of real
for a shorter window in the trough-to-peak estate prices and, by extension, the implica-
analysis in Reinhart and Rogoff (2009). tions for construction activity. The second is
Unemployment rates are about one percent- the long cycles that characterise private debt
age point higher in the post-crisis decade. and bank credit, which are a central focus of
The stark difference between the pre- Reinhart and Rogoff (2010) and Schularick
and post-crisis experience raises the question and Taylor (2009).
as to whether the unemployment rate ever
returns to its pre-crisis level (t-1).Table 2 pro- 3. The housing market
vides an answer to this question but requires The top panel of Figure 5 plots the histo-
stretching the post-crisis period through the gram or frequency distribution for an index
end of 2009. For 10 of the 15 episodes, the that sets the level of real housing prices at

Journal of Regulation & Risk North Asia 83


Figure
Figure5.5. Real
RealHouse
HousePrices
PricesBefore
Beforeand
andTen
TenYears
YearsAfter
AfterSevere Financial
Severe Crises:
Financial Crises:
Ten Post-WWII Episodes
Ten Post-WWII Episodes
Probability density function: Advanced economies
Big five: Spain, 1977; Norway, 1987;
Finland, 1991; Sweden, 1991, Japan 1992
Index, t-1=100 t-1 to t+10
median 83.0
20 min (Finland, 1993) 58.9
House prices above pre-crisis level
18 max (Spain, 1987) 123.2
observations 60.0
16
14
12
10
8
6
4
House prices below pre-crisis level
2
0
55 60 65 70 75 80 85 90 95 100 105 110 115 120 125
Real house prices, t-1=100

Probability density function: Advanced and five emerging market economies


20 House prices above
All countries (10 with data) pre-crisis level
18 Index, t-1=100 t-1 to t+10
median 82.4
16 min (Philippines, 2004) 44.7
max (Spain, 1987) 123.2
14
observations 120.0
12

10

6 House prices below


pre-crisis level
4

0
40 45 50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125
Real house prices, t-1=100

Sources: Reinhart and Rogoff (2009) and numerous sources cited therein, and authors’ calculations.
Notes: The five emerging markets for which there is complete real house price data for the relevant
period are: Colombia, Indonesia, Korea, Malaysia, and the Philippines. As shown, there are only a
handful of observations fully (most notably for Spain) recovering to their pre-crisis level.

84 Journal of Regulation & Risk North Asia


Figure 6. Domestic Banking Credit/GDP Twenty-one Years Around Severe Financial
Crises: Amplitude of Boom-Bust Credit Cycles in fifteen Post WWII Episodes

Figure 6. Domestic Banking Credit/GDP Twenty-one Years Around Severe Financial


Crises: Amplitude of Boom-Bust Credit Cycles in 15 Post WWII Episodes
120

100 Chile
1981
Japan
1992 Korea
80 1997 Philippines
Median
Finland secular debt 1997
Argentina 15
60 Spain 1991 increase
2001 episodes
Change in domestic credit/GDP

1977
40
Mexico
1994
20 Credit booms

0
Deleveraging
-20 Colombia Turkey
Indonesia 1998 2001
Sweden 1997
-40
Norway 1991
1987 Malaysia
-60 1997
Thailand
-80 1997

-100

Sources: Table 3 and sources and authors’ calculations listed therein.


Notes: The magnitude of credit booms shown correspond to the difference between the maximum
domestic bank credit-GDP ratio around the crisis and the pre-crisis low for the ratio during the
10-year window preceding the crisis. Similarly the extent of deleveraging is calculated as the
minimum credit/GDP ratio reached during the 10-year window after the crisis and the maximum
ratio reached around the crisis. The specific dates and magnitudes for each episode are listed in
Table 3. For Korea, there is an uninterrupted secular rise in domestic bank credit-to-GDP during
1987-2007 (the 10-year window around the crisis). Post-crisis deleveraging appears to be confined to
external debts (see Reinhart, 2010).

t-1 equal to 100 for each of the 10 coun- below their t-1 level. As the chart reveals,
tries for which real estate market data are about 90 per cent of the observations over
available. The choice of t-1 (rather than T as an 11-year period show real house prices
was the case for real GDP) is that housing remaining below their level on the eve of
prices usually begin their descent prior to the crisis (t-1).
onset of the crisis and before the economic Median housing prices are 15 to 20 per
downturn, as documented in Reinhart and cent lower in the 10-year post-crisis win-
Rogoff. There are a total of 60 annual obser- dow, with cumulative declines as large as
vations for the advanced economies over 55 per cent. From 2006 to date, house prices
the 11-year period T to t+10.9 The area have declined, in varying degrees in most
under the curve to the left of the vertical advanced economies. This consistent feature
line at 100 gives the share of observations of the post-crisis environment is not unique
for which real housing prices remained to the more modern crises. While real estate

Journal of Regulation & Risk North Asia 85


Table 3. Domestic Bank Credit/GDP 10 Years Before and After Severe Financial
Crises: 15 Post WWII Episodes

Domestic credit surges Post-crisis deleveraging


Difference Lowest ratio
Minimum credit Maximum credit Difference
maximum reached in the 10
Country and ratio in 10 years ratio around the post-crisis
less years following the
crisis year prior to crisis crisis minimum less
pre- crisis crisis
maximum
level year level year minimum level year
Advanced economies
Spain, 1977 65.6 1967 102.5 1976 36.8 94.2 1980 -8.2
Norway, 1987 130.0 1980 162.4 1988 32.4 123.7 1994 -38.7
Finland, 1991 46.4 1981 92.9 1991 46.5 54.9 1997 -38.0
Sweden, 1991 56.1 1985 72.9 1989 16.8 45.0 1996 -27.9
Japan, 1992 193.8 1982 260.5 1996 66.7 221.9 1997 -38.6

Emerging economies: The Asian Crisis, 1997


Indonesia* 23.6 1987 62.1 1999 38.4 40.6 2007 -21.5
No post-crisis deleveraging
Korea** 50.5 1988 64.1 1997 13.6
through 2008
Malaysia 72.7 1990 163.4 1997 90.7 113.8 2007 -49.6
Philippines 19.5 1991 78.5 1997 59.0 40.9 2007 -37.7
Thailand** 84.1 1988 177.6 1997 93.5 104.2 2007 -73.4

Emerging economies: Other episodes


Argentina,
22.3 1992 61.9 2002 39.7 23.8 2008 -38.1
2001*
Chile, 1981* 31.1 1971 114.7 1985 83.5 60.5 1991 -53.9
Colombia, 1998 29.2 1992 42.5 1998 13.2 35.7 2008 -6.8
Mexico, 1994** 37.3 1990 53.0 1997 15.7 33.2 2005 -19.8
Turkey, 2001** 22.5 1991 52.7 2001 30.3 41.4 2004 -11.4
Memorandum item
Median for 15
38.4 -37.7
episodes

Notes: An asterisk (*) indicates a sovereign default (or restructuring) took place during or shortly after that episode; a double asterisk (**)
are near-default episodes, as defined in Reinhart (2010), where a default was avoided with major international assistance. Italics denote that
the deleveraging process is ongoing according to the latest available data.
Sources: International Financial Statistics, International Monetary Fund, various issues, Norges Bank
(website), Reinhart and Rogoff (2009), Reinhart (2010), and authors”’ calculations.

price data are not readily available, several in construction as key drivers of the abysmal
chapters in the Annual Reports of the League performance of output and employment.10
of Nations for the 1930s (the equivalent to As noted in Reinhart and Rogoff (2009),
the modern-day World Economic Outlook the housing cycle exhibits a longer duration
from the International Monetary fund (IMF) than the booms and busts in equity mar-
were devoted to documenting the collapses kets and is intimately connected with the

86 Journal of Regulation & Risk North Asia


Figure 7. Domestic Banking Credit/GDP Ten Years Before and Ten Years After Severe
Financial Crises: Duration of Boom-Bust Credit Cycles in fifteen Post WWII Episodes

Figure 7. Domestic Banking Credit/GDP Ten Years Before and Ten Years After Severe
Financial Crises: Duration of Boom-Bust Credit Cycles in 15 Post WWII Episodes
25
Korea
1997
secular debt
20 increase

Japan
1992
15
Spain
Finland
1977 Argentina
1991
2001
10 Philippines
1997 Colombia Turkey
1998 2001
Number of years

5 Credit booms

Deleveraging
-5
Norway
1987 Sweden Chile Median
1991 Indonesia 1981 Mexico
15 episodes
-10 1997 1994
Malaysia Thailand
1997 1997

-15

Sources: Table 3 and sources and authors’ calculations listed therein.


Notes: The duration of credit booms shown correspond to the difference (in years) between the maximum
domestic bank credit-GDP ratio around the crisis and the pre-crisis low for the ratio during the 10-year window
preceding the crisis. Similarly the duration of the deleveraging phase is calculated as the number of years
between the year minimum credit/GDP ratio reached during the 10-year window after the crisis and the year
maximum ratio reached around the crisis. The specific dates and magnitudes for each episode are listed in
Table x. Shown in italics are the episodes where leveraging (Korea) or deleveraging process is ongoing accord-
ing to the latest available data. For Korea, there is an uninterrupted secular rise in domestic bank credit-to-GDP
during 1987-2007 (the 10-year window around the crisis). Post-crisis deleveraging appears to be confined to
external debts (see Reinhart, 2010).

multi-year credit cycle, which we will turn source of financing for the corporate sector is
our attention to and examine next. the smallest in the United States. Across the
countries in the sample, banks play a much
4. Bank credit and external borrowing larger role for households. Given this vari-
Reliance on banks as the main source of ation, we complement the data with other
credit varies considerably across countries, sources of indebtedness or leverage, such as
as in many emerging markets domestic external debt or private sector indebtedness
capital markets are small and access to in capital markets.
credit by households is quite uneven. The Table 3 presents the usually long build-
importance of banks and bank-like institu- up of credit that characterises the decade
tions (included in the banking surveys) as a before the financial crisis and the subsequent

Journal of Regulation & Risk North Asia 87


unwinding of private debts in the decade in the ratio of credit to GDP. Typically, the
that follows. A depiction of these long cycles greater the unwillingness (or inability) to
on a country-by-country basis is presented write down non-performing debts, the
along the comparable data for public debt in longer the deleveraging process is delayed.14
Reinhart (2010). While our focus remains on This pattern is most evident in post-crisis
the 21-year window bracketing the financial Japan, where credit/GDP continues to climb
crisis, both the surge and retrenchment in until 1996, peaking at 260.5 per cent.
credit/GDP extends beyond the period of The median duration (in years) of these
analysis summarised here.11 credit booms, as shown in Figure 7, is about
Table 3 provides a measure of the ampli- 10 years. The unwinding or deleveraging fol-
tude of the credit cycle for each crisis episode lowing a crisis (shown in the lower bars) is of
as well as the duration (in years) of the surges comparable magnitude. Indeed, the median
and reductions in credit/GDP. decline in credit/GDP is also about 38 per
cent. This unwinding also stretches over
Japan holds ‘record’ many years – often a full decade (and even
Figure 6 focuses on the amplitude of the fluc- longer).
tuations. The top bar measures the increase We cannot discriminate from this analy-
in domestic credit/GDP from the minimum sis whether the retrenchment in credit arises
credit ratio in the 10-year window prior to primarily from financial institutions inabil-
the crisis (often the date for this minimum ity or unwillingness to lend after the crisis
turns out to be t-10) to the maximum value or from weak demand for loans associated
reached usually shortly before, during or with slower economic growth and greater
shortly after the financial crisis.12 (Column 5 resource slack. The surge in credit does
of Table 3 presents the relevant calculation.) appear to fuel growth in the pre-crisis dec-
As is evident, the increases in credit/GDP ade, while its contraction following the crisis
in the run-up to the crisis vary in size, with no doubt contributes to the subpar perfor-
surges in the 80-to-90 per cent range before mance in the macroeconomic aggregates
the crisis in Chile (1981) and Thailand (1997); and in real estate prices in the decade that
among the advanced economies, Japan follows.
(1992) holds the record, with an increase
of about 70 per cent.13 The median rise in 5. House prices, bank credit & external
domestic bank credit/GDP across these epi- borrowing cycles around the 2007 crisis
sodes is about 38 per cent. We now document the similarities in the
Quite often, this leverage ratio contin- decade prior to the 2007 crisis in most
ues to increase immediately after the crisis, advanced economies (and most markedly,
despite the fact that a credit crunch is under- in those countries that have experienced the
way. During this stage of the crisis, sharp most severe crises) to the boom in housing
declines in nominal GDP (not matched by prices, domestic bank credit and external
comparable write-downs in outstanding borrowing in the 15 systemic crises episodes
credits) importantly account for increases covered in this study. Furthermore, by the

88 Journal of Regulation & Risk North Asia


Table 4. Housing Prices, Credit, External Debt and Growth: Selected Advanced
Economies, 1997-2010
Change
Change in Change in
in gross Average Median per capita GDP
Banking crisis real house Domestic
external of growth
Country prices3 credit/GDP
debt/GDP columns
1997- 2007- 1997- 2007- 2003- 2007- 6 & 8 1950- 1997-
date magnitude Difference
2007 2010 2007 2010 2007 2010 1996 2010
Japan -30.1 -2.4 -8.9 17.5 8.4 -1.7 -0.3 4.7 1.6 -3.1
Germany 2008 systemic -11.1 -0.1 -12.4 6.0 17.8 -4.6 2.7 3.2 1.7 -1.5
Austria 2008 borderline 5.6 13.4 -4.9 11.1 54.0 -9.3 24.6 3.3 2.4 -1.0
Finland 51.1 2.3 30.3 13.2 17.8 31.3 24.1 2.7 3.6 1.0
Italy 35.3 0.6 39.6 12.3 24.1 -4.5 31.9 3.4 1.6 -1.8
Greece 2008 borderline 88.6 -9.3 31.5 4.4 41.4 25.1 36.5 3.3 4.0 0.6
Belgium 2008 systemic 101.2 2.3 -7.0 4.5 85.7 68.9 39.3 2.7 2.5 -0.2
France 2008 borderline 111.6 -11.6 21.0 6.1 58.9 5.6 40.0 3.0 1.8 -1.3
Switzerland 2008 borderline 9.9 1.4 7.8 5.9 86.1 -102 47.0 2.3 2.0 -0.3
Denmark 2008 systemic 79.7 -19.8 60.9 18.5 43.3 14.3 52.1 2.0 1.8 -0.2
Sweden 2008 borderline 114.9 2.8 84.8 9.1 39.4 43.7 62.1 2.4 3.0 0.6
Portugal 2008 borderline n.a. -5.5 81.4 33.5 44.0 -21.5 62.7 4.2 1.5 -2.6
Netherlands 2008 systemic 74.1 -6.6 54.1 46.4 74.8 29.5 64.4 2.3 2.9 0.6
US1 2007 systemic 86.5 -23.4 21.7 8.5 33.0 -1.3 27.4 2.5 2.1 -0.4
98.4 -48.0 65.7
Spain 2008 systemic 118.5 -16.6 95.4 31.3 48.9 14.4 72.2 3.1 3.5 0.4
UK 2007 systemic 150.1 -16.0 66.1 48.0 111.9 8.3 89.0 2.3 2.6 0.3
Ireland 2007 systemic 114.8 -23.1 107.5 31.1 407.2 169.8 257.3 2.8 5.0 2.1
Iceland2 2007 systemic 66.9 -32.1 234.2 -66.9 511.0 428.0 372.6 3.1 3.4 0.4
Memorandum items:
Median 79.7 -6.0 46.9 11.7 46.4 6.9 49.5 2.9 2.4 -0.5
Average 68.0 -8.0 54.4 10.2 94.9 30.0 74.7 3.0 2.6 -0.4
Sources: Flow of Funds, Board of Governors of the Federal Reserve, International Financial Statistics and World Economic Outlook, International
Monetary Fund, Laeven and Valencia (2010), Maddison (2004 and website), Reinhart and Rogoff (2009), Quarterly External Debt Statistics, World
Bank and Data Appendix for the multiple listings for real estate prices and authors’ calculations.
Notes: The data appendix provides a listing of the coverage of real estate prices and domestic credit. The external debt data is through 2010:Q1.
1 For the U.S., we report bank credit but the more relevant concept (as banks do not play nearly as big a role as in other advanced economies) is
private debt from the flow of funds. Beginning in 2010:Q1, almost all
Fannie Mae and Freddie Mac mortgage pools are consolidated in Fannie Mae’s and Freddie Mac’s balance sheets and, thus, are included in the
debt of government enterprises; this shows up a massive private
deleveraging (about 27 percent of GDP) in Q1. Absent this shift inliabilities, the deleveraging since 2007
is closer to 20 percent of GDP.
2 The credit boom ends in 2006, so the changes reported is 1997-2006 and 2006-2009, as no bank credit data for 2010 is available.
3 For most countries, real housing prices peak in 2007. For the US the peak is 2006, so the 1997-2006 change is 115.3 percent and the 2007-2010
decline is -33.3 percent.

standard of prior crises, the unwinding of domestic bank credit/GDP, gross external
housing prices and domestic and external debt/GDP, and real per-capita GDP growth.
debt is far from complete. The period is broken up into pre-crisis (1997
Table 4 provides evidence on selected to 2007) and post-crisis (2007 to 2010) sub-
advanced economies for 1997 to 2010. The samples. The table also provides information
data include real changes in housing prices, on the starting point of the banking crisis in

Journal of Regulation & Risk North Asia 89


Figure 8. Domestic Banking Credit/GDP and Financial Crises : Amplitude of the
Figure 8. Domestic Banking Credit/GDP and Financial Crises : Amplitude of the
BBoom
oom Phase
Phase of
of the Cycle,Advanced
the Cycle, AdvancedEconomies,
Economies,1997-2010
1997-2010
Change in Credit/GDP 1997 to 2007 Change in credit/GDP 2007 to2010
230

Systemic Borderline No
crisis crisis crisis
180
Ireland
Median
Change in Credit/GDP

Spain cumulative
130 increase
Netherlands 58.5
Sweden percent
Credit boom
80
Italy

Switzerland
30 Japan Austria
Belgium

Finland France Denmark Portugal UK


-20 Greece
Germany
Deleveraging
US
-70 Iceland

Sources: Table 4 and sources cited therein.


Notes: The median rise in credit GDP in fifteen post-war severe financial crisis is about 38 percent, well
below the 59 percent surge prior to the current crisis; with the exceptions of Iceland and the US, where
the crises unfolded earlier, there is little evidence of deleveraging.

each country, an assessment of its scale (in in leverage (whether domestic, external or
terms of whether it is considered systemic both) had larger increases in real housing
or borderline), and median per capita GDP prices and per capita GDP growth versus its
growth for 1950-1996 and its difference from long-run trend than those at the top. Without
the 1997-2007 median.15 exception, the countries in the bottom group
ended up with a full-fledged systemic bank-
Country rankings ing crisis. Iceland, Ireland, the Netherlands,
As a useful scheme for summarising the Spain and the UK all fit this description, but
upswing of the leverage cycle, we average the US does not quite meet the above-trend
the change in the ratios of domestic credit/ GDP growth criteria. Greece’s private debt
GDP and gross external debt/GDP (col- accumulation is not among the largest in the
umns six and eight) for the pre-crisis dec- set but, then again, its recent troubles had
ade (column 10) and rank the countries in more to do with high public debt.
ascending order by the magnitude of the The downturn in housing prices and
surge in leverage. banking solvency begins earlier (2007) in
On the whole, the countries at the bot- Iceland, Ireland, the UK and the US, but
tom of the table with the largest increases even in these cases there is either scant or

90 Journal of Regulation & Risk North Asia


Figure 9. Levels of Real Per Capita GDP in the Twenty Years around Global Shocks:
Figure 9. Levels of Real Per Capita GDP in the Twenty Years around Global Shocks:
The
The1929
1929 Crash
Crash and the1973
and the 1973Oil
OilShock
Shock

Probability density function, 1930-1939

14 21 "now-advanced" economies
1930-1939
median 98.1
12
min 65.4
max 139.0
10 obs. 210.0

6 About 50% of
observations lie
below 1929 level
4
Per capita GDP
above 1929 level

0
65 71 77 83 89 95 101 107 113 119 125 131 137
Real per capita GDP, 1929=100

Probability density function, 1974-1983

16 21 Advanced economies
1974-1983
14 median 109.5
min 92.3
max 138.1
12
obs. 210.0
About 10% of
10 obvervations
lie at or
8 below 1973
level

4
Per capita GDP
above 1973 level
2

0
92 96 100 104 108 112 116 120 124 128 132 136 140
Real per capita GDP
1973=100
.
Sources: Maddison (2004 and webpage), Reinhart and Rogoff (2009), and authors’ calculations

Journal of Regulation & Risk North Asia 91


Figure
Figure10.
10. Real
RealPer
PerCapita
CapitaGDP
GDPGrowth
Growth in the Decade
in the DecadeBefore andand
Before thethe
Decade After
Decade After the
the Onset of the Great Depression, 1929 and the First Oil Shock,
Onset of the Great Depression, 1929 and the First Oil Shock, 1973 1973
Probability density function, 1919-1939
21 "now-advanced" economies
1919-1928 1930-1939
20 median 3.0 1.8
min -17.5 -23.0
18
max 33.9 17.8
16 obs. 207.0 210.0

14

12

10

8
1930-1939
6

4
1919-1928
2

0
-23 -21 -19 -17 -15 -13 -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25
GDP growth, percent

Probability density function, 1963-1983


21 Advanced economies
1963-1972 1974-1983
median 4.0 1.8
30 min -6.0 -7.5
max 11.7 6.8
25 obs. 210.0 210.0

20 1963-1972
1974-1983
15

10

0
-8 -7 -5 -4 -2 -1 1 3 4 6 7 9 10 12 13 15
GDP Growth, percent

Sources: Maddison (2004 and webpage), Reinhart and Rogoff (2009), and authors’ calculations .
Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 7.98 and 15.5,
respectively for the 1929 exercise(top panel) and 7.95 and 37.6 for 1973 comparison (bottom
panel). If the K-S statistic is greater than the critical value we reject the null hypothesis that the
observations are drawn from the same distribution.
92 Journal of Regulation & Risk North Asia
no evidence of deleveraging through 2010. each country. There are a total of 210 annual
In effect, in most countries, credit/GDP and observations for 21 “now-advanced” econo-
external debt/GDP have continued to climb mies over the 10-year period 1930-1939.17
since 2007, as Figure 8 illustrates. Not unlike The area under the curve to the left of the
the crises episodes studied here, part of the vertical line at 100 gives the share of obser-
continued upward march in debt/GDP owes vations for which GDP remained below its
to marked declines in real and even nominal 1929 level. As the casual inspection of the
GDP during the height of the crisis and part chart reveals, about one half of the entries
of it to forbearance. show income levels that are below that of
Missing from Figure 8 is the bottom pan- 1929.
els of Figures 6 and 7, which document the
magnitude and duration of the deleveraging Less-than-spectacular ’70s
phase of the cycle which has, in nearly all The bottom panel displays the same concept
cases, followed the boom. for the post-1973 oil shock. Not surprisingly,
If the protracted unravelling of private the stark collapse in income levels of the
debt (coupled with a high public debt bur- Depression is nowhere close to being rep-
den) unfolds in the same pattern as previous licated in the less-than-spectacular 1970s.
crises, one can infer that this would exert a Less than six per cent of the observations
dampening influence on employment and during 1974-1983 lie below the 1973 output
growth, as in the decade following earlier level. The worst reading in post-1973 is 92.3
crises. (a cumulative decline of about eight per cent)
compared to 65.4 (a cumulative income col-
III. Global Episodes: 1929 and 1973 lapse of about 35 per cent). Median income
This section offers comparisons between levels were about 10 per cent higher during
the pre- and post-crisis landscape around the post-oil shock decade as compared to
the 1929 stock market crash at the onset of median income levels about two per cent
the Great Depression and the first oil shock lower during the 1930s.
of 1973, which about doubled oil prices and
coincided with stock market crashes in most 2. Growth
of the advanced economies and numerous A separate but related “cost of the crisis” is
emerging markets.16 Some of the results whether GDP growth following the crisis
confirm well-known stylised facts. Other is comparable in the decades prior and fol-
findings are more novel and have potential lowing the crisis. This question is particu-
implications for the coming decade. larly pertinent to ongoing concerns about
whether the post-subprime decade will be
1. Decline and recovery: Per capita GDP characterised by a “new-normal” associated
levels with lower potential output growth for the
The top panel of Figure 9 plots the frequency advanced economies.18
distribution for an index that sets the level of Figure 10 plots the marginal probability
real per capita GDP in 1929 equal to 100 for distributions (top panel) for the pre-crisis

Journal of Regulation & Risk North Asia 93


Figure
Figure11.
11.Inflation in the
Inflation Decade
in the Before
Decade andand
Before the the
Decade AfterAfter
Decade 1929 1929
the Onset of of the
the Onset
the Great Depression, 1929 and the First Oil Shock,
Great Depression, 1929 and the First Oil Shock, 1973 1973

Probability density functions, 1919-1939

40

35 21 "now-advanced" economies
1930-1939 1919-1928 1930-1939
30 median 1.3 0.4
min -23.2 -14.6
25 max hyperinflation 23.4
obs. 202.0 209.0
20

15

10

5 1919-1928

0
-25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95
plus
Inflation, percent

Probability density functions, 1963-1983

40

35
21 Advanced economies
30 1963-1972 1974-1983
median 4.4 10.3
25 min -2.1 0.7
1963-1972 max 34.9 25.3
obs. 210.0 210.0
20

15

10
1974-1983
5

0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Inflation, percent

Sources: World Economic Outlook, International Monetary Fund (various issues), Reinhart and Rogoff
(2009), and authors’ calculations

Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 8.05 and 18.06,
respectively for the 1929 exercise(top panel) and 7.95 and 61.9 for 1973 comparison (bottom panel).If
the K-S is greater than the critical value we reject the null hypothesis that the observations are drawn
from the same distribution.

94 Journal of Regulation & Risk North Asia


and the post-crisis decade. The inset pro- following the adverse shocks of 1929, 1973,
vides basic descriptive statistics for the two and 15 country-specific financial crises. The
distributions. The note at the bottom of the more immediate output costs (in terms
figure reports the Komolgorov-Smirnoff of declines in GDP levels during the first
one per cent critical value for the relevant three years of the crisis, t+1 to t+3) were by
number of observation and the K-S statistic. far greatest for the Depression of the 1930s,
Adding to the precipitous output declines at followed by the 2007 crisis, followed by the
the outset of the Great Depression, median 15 post-World War II crises. The smallest
growth rates for the entire decade of the declines were recorded in the wake of the
1930s for the advanced economies is 1.8 per 1973 oil shock. All these episodes, except the
cent versus three per cent for the 1920s. last one, involved a major domestic financial
crisis and a boom-bust real estate and credit
Shocked into lower growth cycle of varying degrees. 19
The gap in pre-and post-1929 growth rates Applying our methods to the inflation
is even greater for the 20 emerging econo- data does not yield uniform results across
mies for which we have output data, with a these experiences. Figure 11 presents the
median of 2.9 per cent versus 0.7 per cent in familiar histograms comparing the dec-
the 1930s (see Appendix Figure 1). ade prior to the crises to the one that fol-
The bottom panel of Figure 10 presents lowed. The inflation performance difference
the comparable exercise for the 1973 oil between post-1929 and post-1973 could not
shock. It is noteworthy that, despite the fact be more disparate. There are no surprises
that income levels were higher for 94 per here, as this inflation performance of these
cent of the observations and median income eras is well-known and documented.
levels were about 10 per cent higher, during
1974-1983 growth rates were significantly Oil prices surge
lower after the shock. Indeed, the slow- Median inflation falls to 0.4 per cent after
down in growth exceeds that of the Great 1929. Indeed, nearly one-half of the observa-
Depression. For the advanced economies, tions for the 21 advanced economies during
median growth rates during 1974-1983 were 1930-1939 record deflation.Turning to the oil
about the same as the 1930s but these came shock, median inflation during 1963-1972,
off a far more robust growth performance which was already high by historical stand-
(with a median of 4 per cent) in the decade ards, more than doubles to over 10 per cent
ending in 1972. There is a significant decline following the surge in oil prices. Deflation is
in the volatility of GDP growth for nearly all not even part of this picture.
advanced economies versus the pre WWII A less well-known stylised fact are the
sample. patterns documented in Figure 12, which
plot the frequency distributions for the
IV. Inflation pre- and post-crisis decades inflation for
Thus far, we have shown that real per capita the five advanced economy (top panel) and
GDP growth has been consistently lower five Asian (bottom panel) crises. While the

Journal of Regulation & Risk North Asia 95


Figure 12. Inflation in the Decade Before and the Decade After Severe Financial
Figure 12. Inflation in the Decade Before and the Decade After Severe Financial Crises:
Crises: Post WWII, Advanced and Asian Economies
Post WWII, Advanced and Asian Economies
Probability density function, five advanced economies

40 Big five: Spain, 1977; Norway, 1987;


Post-crisis (t+1 to t+10)
Finland, 1991; Sweden, 1991, Japan 1992
35 t-10 to t-1 t+1 to t+10
median 6.5 2.2
30
min 0.1 -0.9
max 18.0 18.6
25
obs. 50.0 50.0
20

15
Pre-crisis, (t-10 to t-1)
10

0
-1 1 2 4 5 7 8 10 11 13 14 16 17 19 20
Inflation rate, percent

Probability density function, five Asian economies

45 Post-crisis (t+1 to t+10)


Asian crisis, 1997: Indonesia, Korea,
40 Malaysia, Philippines, and Thailand

35 t-10 to t-1 t+1 to t+10


median 5.9 3.6
30 min 0.3 0.3
max 18.5 58.0
25
obs. 50.0 50.0
20

15

10 Pre-crisis, (t-10 to t-1)

0
1 4 6 9 11 14 16 19 21 24 26 29 31
Inflation rate, percent

Sources: World Economic Outlook, International Monetary Fund (various issues), Reinhart and Rogoff
(2009), and authors’ calculations
Notes: The Kolmogorov-Smirnoff 1 percent critical value and the K-S statistic are: 16.3 and 48.0,
respectively for the advanced exercise (top panel) and 16.3 and 28.0 for Asia comparison (bottom panel).

remaining five emerging market crises are considerable heterogeneity in monetary


not plotted here (descriptive statistics are and fiscal policies adopted in response to
provided in Appendix Table 1), this group the crisis the homogeneity of these results
also records a decline in inflation rates fol- across the five advanced economies, five
lowing the financial crises. In light of the the emerging Asian economies, and the

96 Journal of Regulation & Risk North Asia


chronic and high inflation group (four Latin attempt to restore employment to an unat-
American countries and Turkey) this result tainably high level. Many past policy mis-
is quite remarkable.20 This is all the more takes across the globe and over time can be
remarkable considering that the emerg- traced to not recognising in a timely basis
ing market countries all sustained massive that such changes have taken place.23
devaluations/depreciations in their curren-
cies at the height of the economic turmoil Collapse in intermediation
which extends into t+1. What we observe, of course, is an association.
The post-crisis disinflation of these epi- Growth falls and the unemployment rate
sodes does not match the extreme of the remains high after a severe economic dislo-
1930s deflation, but it is equally significant cation. That observation, itself, is not inform-
(from a statistical and quantitative stand- ative as to the balance between changes in
point).21 Thus, the exception on the inflation aggregate demand and aggregate supply.
performance is the oil shock case, which also The outcome could materialise as a con-
differs from the depression and the financial sequence of the failure of policy makers to
crisis episodes, in that there is no evidence of provide sufficient stimulus after a wrench-
a credit boom-deleveraging cycle during the ing event in an economy where rigidities
21-year window around 1973. 22 give ample scope to demand management.
An important role for credit in supporting
VI. Policy reflections spending might imply that an associated
Large destabilising events, such as those collapse in financial intermediation length-
analysed here, evidently produce changes ens and deepens the downturn (with the
in the performance of key macroeconomic unavailability of credit serving as the propa-
indicators over the longer term, well after gating mechanism discussed in Bernanke,
the upheaval of the crisis is over. There is lit- 1983).
tle good news to be found in the result that
income growth tends to slow and unem- Self-fulfilling prophecy
ployment remains elevated for a very long In such circumstances, slow growth might be
time after a severe shock. a self-fulfilling prophecy produced by timid
The human temptation to credit good authorities who neither supported spending
fortune to good character and bad results nor dealt with the capital-adequacy prob-
to bad luck further complicates matters. lems of key financial institutions.
A ubiquitous pattern in policy pitfalls has Economic contraction and slow recov-
been to assume negative shocks are tempo- ery might also feed back on the prospects
rary, when these were, in fact, subsequently for aggregate supply. A sustained stretch of
revealed to be permanent (or, at least, very below-trend investment and depreciation
persistent). of human capital prompted by elevated
Misperceptions can be costly when and lengthy spells of unemployment could
made by fiscal authorities who overestimate hit the level and growth rate of potential
revenue prospects and central bankers who output. The unemployment rate stays high

Journal of Regulation & Risk North Asia 97


because it has been high, exhibiting hyster- of forces. We have presented evidence here
esis as described by Blanchard and Summers that many of those patterns are reversed not
(1986). only in the immediate vicinity of the crisis,
The forcing mechanism for a reduction (as Reinhart and Rogoff, 2009 show), but
in aggregate supply might be policy itself. also over longer horizons that span several
In adverse economic circumstances, political years.24
leaders sometimes grasp for quick fixes that
impair, not improve, the situation. Included Inflation buffer benefits
in the list of unfortunate interventions are For whatever the initiating change, the real
restrictions on trade (both domestically interest rate consistent with full employment
and internationally), work rules and pay of resources presumably falls as a conse-
practices, and the flow of credit. The output quence of slower economic growth. The
effects of crises might be persistent because logic is that households need less induce-
we make them so, in the manner posited for ment to defer consumption when future
the Great Depression by Cole and Ohanian consumption prospects are bleaker.
(2002). In addition to the fall-out of a lower
real interest rate on asset prices, monetary
Outsized expectations policymakers need to reconsider the ben-
Or, changed prospects after a crisis might efits of an inflation buffer to protect from
reflect the correction of outsized expecta- the zero lower bound to nominal interest
tions that fed the prior boom. If, for instance, rates. If real GDP growth has permanently
investors grossly overestimated the possi- tilted down as a consequence of a severe
bilities for productivity improvement from economic dislocation, or at least has done so
a new technology, they might bid up asset in a time frame measured by decades, fiscal
prices, borrow against future anticipated authorities face lower prospects for revenue
income, and invest in myriad capital projects and higher pressure on outlays. Similarly, the
in an unsustainable manner. Chancellor apportioning of the current budget stance
(2000) casts many episodes of financial into its cyclical and structural components
euphoria and ensuing crash over the centu- will shift with changes in the level and rate of
ries in exactly this sequence, from the diving growth of potential output. •
bell, through the steam engine, to the radio,
and thereafter. References
Spending advances rapidly on hope, and, Barro, Robert J. and José Ursúa (2008). “Macroeconomic
on reality, contracts, and then recovers only Crises Since 1870,” NBER Working Paper 13940,April.
slowly. Recent discussions about the “new Bernanke, Ben S (1983). “Nonmonetary Effects of
normal” in reference to the post-crisis land- the Financial Crisis in the Propagation of the Great
scape leave the impression that the pre-crisis Depression,” The American Economic Review, Vol.. 73
environment was“normal.”In fact, there are (June), pp. 257-276.
reasons to believe that the pre- crisis decade Blanchard, Olivier J. and Lawrence H. Summers (1986).
set a high-water mark distorted by a variety “Hysteresis and the European

98 Journal of Regulation & Risk North Asia


Unemployment Problem,” NBER Macroeconomics Annual, Orphanides, Athanasios (2001).“Monetary Policy Rules
Vol. 1, pp. 15-78. Based on Real-Time Data,” The American Economic
Chancellor, Edward (2000). Devil Take the Hindmost: A Review,Vol. 91 (September), pp. 964-985.
History of Financial Speculation (New York: Plume) Reinhart, Carmen M. and Vincent R. Reinhart, (2008).
Claessens, Stijn, Giovanni Dell’Ariccia, Deniz Igan, and Luc “Capital Flow Bonanzas: An Encompassing View of the
Laeven, (2010), “Cross- Country Experiences and Policy Past and Present,” in Jeffrey Frankel and Francesco Giavazzi
Implications from the Global Financial Crisis,” Economic (eds.) NBER International Seminar in Macroeconomics
Policy,Vol. 62, pp. 267–93. 2008, (Chicago: Chicago University Press for NBER,
Cole, Harold L. and Lee E. Ohanian (2002). “The US and Reinhart, Carmen M., and Kenneth S. Rogoff (2009).
UK Great Depressions through the Lens of Neoclassical This Time is Different: Eight Centuries of Financial Folly,
Growth Theory,” The American Economic Review,Vol. 92 (Princeton: Princeton University Press).
(May), pp. 28-32. Reinhart, Carmen M. and Rogoff, Kenneth S. (2010).“From
El Erian, Mohammed (2008). When Markets Collide Financial Crash to Debt Crisis,” NBER Working Paper,
(New York: McGraw-Hill, Inc.). Gourinchas, Pierre-Olivier, forthcoming in American Economic Review.
Rodrigo Valdes, and Oscar Landerretche (2001).“Lending Romer, Christina,(1990).“The Great Crash and the Onset
Booms: Latin America and the World.” Economia, Spring, of the Depression,” The Quarterly Journal of Economics,
pp. 47-99. Vol. 105, No. 3 (August), 597-624.
International Monetary Fund (various issues) International Rosende Ramirez, Francisco, (1988). “Una Interpretación
Financial Statistics (Washington, DC: International del Desempleo en Chile,” Estudios Públicos, No. 32.
Monetary Fund). Schularick, Moritz, and Alan M. Taylor, (2010). “Credit
International Monetary Fund (various issues) World Booms Gone Bust: Monetary Policy, Leverage Cycles, and
Economic Outlook (Washington, DC: International Financial Crises, 1870-2008,”
Monetary Fund).
Laeven, Luc and Fabian Valencia (2010). “Resolution of Appendix: Data and Methodology
Banking Crises: The Good, the Bad, and the Ugly,” IMF Unless otherwise noted, the pre- and
Working Paper. post-crises decades (which form a 21-year
League of Nations. All issues, Statistical Yearbook: 1926– window centred on the crisis year) in our
1944 (Geneva: League of Nations, various years). analysis are those defined in Table 1. Any
League of Nations. All issues. World Economic Survey: departure from this coverage owes to lack of
1926–1944 (Geneva: League of Nations, various years). data and is noted accordingly.
Maddison,Angus (2004) Historical Statistics for the World
Economy: 1–2003 AD (Paris: OECD) http://www.ggdc.net/ Statistical analysis
maddison/ The first benchmark exercise is to pool the
Mendoza, Enrique G. and Marco E. Terrones (2008). data across countries into two groups, the
“An Anatomy of Credit Booms: Evidence from macro pre-crisis decade (t-10 to t-1) and the post
Aggregates and Micro Data, NBER Working Paper 14049, crisis period (t+1 to t+10). The probability
May. distributions (marginal and cumulative) are
Nicolau, Roser (2005). “Población, Salud, y Actvidad,” in tabulated, enabling simple comparisons for
Estadísticas históricas de España: Siglos XIX - XX. Bilbao: per capita GDP growth, unemployment and
Fundación BBVA. Second revised Edition. inflation through standard statistical tests,

Journal of Regulation & Risk North Asia 99


Appendix Table 1. Summary of Pre- and Post-Crisis Descriptive Statistics and
Kolmogorov-Smirnoff Test Results
Episode and sample Median Minimum Maximum K-S Statisitic 1% critical
values
Pre- and post- 1929 comparisons of real per capita GDP growth
21 “Now-advanced” Economies
1919-1928 3.0 -17.5 33.9
1930-1939 1.8 23.0 17.8 15.5 7.98
20 Emerging Economies
1919-1928 2.9 -15.2 27.7
1930-1939 0.7 -22.5 34.7 12.2 7.72
Pre- and post- 1973 oil shock comparisons of real per capita GDP growth
21 Advanced Economies
1963-1972 4.0 -6.0 11.7
1974-1983 1.8 -7.5 6.5 37.6 7.95
48 Emerging Economies
1963-1972 3.0 -18.0 27.0
1974-1983 2.2 -37.2 14.7 14.6 5.26
Pre-(t-10 to t-1) and post-(t+1 to t+10) severe post WWII financial crisis
Advanced economies, the Big Five
Comparisons of real per capita GDP growth
t-10 to t-1 3.1 -0.7 7.9
t+1 to t+10 2.1 -4.3 5.9 28.0 16.3
Comparisons of the unemployment rate
t-10 to t-1 2.7 1.1 6.1
t+1 to t+10 7.9 2.5 21.2 68.0 16.3
Five Asian crisis, 1997episodes
Comparisons of real per capita GDP growth
t-10 to t-1 6.6 -2.8 11.7
t+1 to t+10 3.8 -14.4 8.7 54.0 16.3
Comparisons of the unemployment rate
t-10 to t-1 2.9 1.1 9.8
t+1 to t+10 3.7 1.4 11.8 35.06 16.55
All countries
Comparisons of real per capita GDP growth
t-10 to t-1 3.8 -14.4 11.7
t+1 to t+10 3.2 -15.1 8.7 18.61 9.51
Comparisons of the unemployment rate
t-10 to t-1 3.7 1.1 18.7
t+1 to t+10 7.8 1.4 21.3

Sources: See Data Appendix for sources and the countries included in the 1929 and 1973 comparisons. The 15 post-WWII crisis episodes
are listed throughout the paper.

100 Journal of Regulation & Risk North Asia


such as the Kolmogorov-Smirnoff (K-S) States) synchronicity in cycles across sectors
for the pre-and post-crisis decades. The null and indicators is not the norm.
hypothesis of the K-S test is that the obser- This approach to the comparisons of the
vations for the two sub-periods are drawn pre and post-crisis landscape is not with-
from a common population. out limitations. A pure before- and after-
crisis comparison with a 10-year window
Informative calculations is bound to be clouded by other important
The second type of exercise, applied to the events that influence economic outcomes in
level of real per capita GDP and real housing such a long horizon before or after the crisis.
prices examines the marginal and cumula- At the individual country analysis compara-
tive probability distribution of these time ble issues arise.
series during (t+1 to t+10) relative to the
benchmark level at the time of (T) or just Economic tranquillity
prior (t-1) to the crisis. For the five advanced economy episodes
These calculations are informative on and the five Asian crisis episodes it is reason-
two grounds: first, it provides a glimpse able to state that the pre-crisis decade was
into the duration of the shock, if there is a one of relative “economic tranquillity” and
high share of observations below the initial even prosperity. For the four Latin American
level; second, it is also informative as to the and the Turkish crises listed in Table 1 a com-
magnitude of the initial decline or collapse parable statement cannot be made. Chile
in the series, as the 1929 and 1973 compari- was mired in economic and political turmoil
sons discussed in the following section make in the mid-1970s (the half point in the t-10
plain. to t-1 window), while Argentina, Mexico
and Turkey grappled with high (three-digit)
Peak-to-trough calculations inflation rates in the decade prior to the
Third, to examine the cycle in credit, respective crises studied here.
external debt, and real housing prices, we The 1919-1928 window prior to the 1928
calculate on a country-by-country and crash captures the immediate aftermath
(importantly) series-by-series basis the of war while the tail end of the 1930-1939
peak-to-trough calculations, as in Reinhart episode capture the preparation for the
and Rogoff (2009). The calculations facilitate next war.25 The post-1973 oil shock sample
an assessment the amplitude and duration includes another major subsequent shock.
of upswings and downturns in the cycle of Even a 21-year window may not fully
the indicator in question. cover the very long debt and credit cycles.26
The dating of these cycle turning points The build-up in debt in Japan (among oth-
also facilitates comparisons across markets ers) prior to the onset of the banking crisis in
and indicators, as even when we have a well- 1992 pre-dates the 10-year window begin-
grounded dating system for recessions and ning. The post-crisis deleveraging (domestic
recoveries (for example that of the National and external debts) in countries like Chile
Bureau of Economic Research for the United (1981) and Indonesia (1997) lasted past

Journal of Regulation & Risk North Asia 101


Appendix Table 2: Data Coverage
Real per capita
Real housing Domestic Credit Gross external debt
Country GDP through
prices End date End date Full period
2010. Start date
2007 crisis analysis, latest observation
Austria 2010:Q1 2010:M5 2003:Q4-2010:Q1 1918
Belgium 2009:Q4 2010:M5 2003:Q4-2010:Q1 1918
Denmark 2010:Q1 2009:M8 2003:Q1-2009:Q4 1918
Finland 2010:Q1 2010:M5 2002:Q1-2010:Q1 1918
France 2010:Q1 2010:M5 2002:Q4-2010:Q1 1918
Germany 2010:M6 2010:M5 2001:Q4-2010:Q1 1918
Greece 2010:Q1 2010:M5 2003:Q2-2010:Q1 1918
Iceland 2010:M6 2008:M8 1923-2010:Q1 1918
Ireland 2010:Q1 2010:M5 2002:Q4-2010:Q1 1921
Italy 2009:H1 2010:M5 2001:Q4-2010:Q1 1918
Japan 2010:M4 2009:M5 2003:Q1-2010:Q1 1918
Netherlands 2010:M6 2010:M5 2003:Q2-2010:Q1 1918
Norway 2010:M6 2008:M12 2003:Q4-2010:Q1 1918
Portugal 2010:Q1 2010:M5 2003:Q3-2010:Q1 1918
Spain 2010:M6 2010:M5 2002:Q4-2009:Q4 1918
Sweden 2010:Q1 2009:M8 2003:Q3-2010:Q1 1918
Switzerland 2010:Q1 2010:M4 1999:Q4-2010:Q1 1918
United Kingdom 2010:M6 2010:M5 2003:Q1-2010:Q1 1918
United States 2010:Q1 2009:Q4 2009:Q3-2010:Q1 1918
Net private debt 2010:Q1
15 severe financial crisis episodes availability before and after crisis dates
Argentina, 2001 1981-2007 1960-2008:12 1970-2010:Q1 1918
Chile, 1981 n.a. 1960-2009:6 1970-2010:Q1 1918
Colombia, 1998 1997:Q1-2008:Q4 1948-2009:8 1970-2010:Q1 1918
Finland, 1991 1970-2010:Q1 1948-2010:5 n.a. 1918
Indonesia, 1997 1994:Q1-2010:Q1 1969-2009:8 1970-2010:Q1 1918
Japan, 1992 1955:H1-2010:M5 1953-2009:M5 n.a. 1918
Korea, 1997 1986:M1-2010:M3 1951-2009:M9 1970-2010:Q1 1918
Malaysia, 1997 1988-2009:Q4 1959-2009:M4 1970-2010:Q1 1918
Mexico, 1994 n.a. 1948-2009:M8 1970-2010:Q1 1918
Norway, 1991 1970-2010:M6 1948-2008:M12 n.a. 1918
Philippines. 1997 1994:Q1-2010:Q1 1948-2008:M2 1970-2010:Q1 1918
Spain, 1977 1970-2010:M6 1952-2010:5 n.a. 1918
Sweden, 1991 1970-2010:Q1 1948-2009:M8 n.a. 1918
Thailand, 1997 1991:Q1-2010:Q1 1948-2009:M8 1970-2010:Q1 1950
Turkey, 2001 n.a. 1949-2009:7 1970-2010:Q1 1923

Notes: Inflation is available for all the countries listed above for the full sample covering the Great
Depression through 2010.

102 Journal of Regulation & Risk North Asia


the 10-year benchmarks of 1991 and 2007, Australia, Austria, Belgium, Canada, Denmark,
respectively.27 Finland, France, Germany, Greece, Ireland, Italy,
Some crises begin early in the calendar Japan, Netherlands, New Zealand, Norway,
year while others begin much later; in the Portugal, Spain, Sweden, Switzerland, United
later case, the year t+1 may also reason- Kingdom, and the United States. The 2007 analy-
ably classify as a crisis year. To deal with sis also includes Iceland.
these cases, perform sensitivity analysis 4 Using a very different approach from that adopted
that compares (t-10 to t-1) to (t+2 to t+11). here, Laeven and Valencia (2010) reach the same
Unless otherwise noted, these results are not conclusion about the severity of the output con-
appreciably different from the core exercise sequences of the recent episodes versus earlier
described above. post-World War II crises.
5 This boom in lending/borrowing is importantly
Data and country coverage fed by large capital inflows (i.e., borrowing
The primary time series we cover in our from the rest of the world) as documented in
analysis are per-capita GDP levels and rates Mendoza and Terrones (2008) and Reinhart and
of growth, unemployment rates, inflation, Reinhart (2008).
real housing prices, domestic bank credit/ 6 It is important to note that Austria, Germany,
GDP, external debt/GDP, and real housing Italy, and Japan remained in default in varying
prices. The coverage is not uniform across duration after the end of the war.
countries for all the episodes in question, so 7 Per capita GDP is measured in 1990 international
particulars are given for each exercise. Geary-Kamiris dollars.
The greatest amount of detail is pro- 8 Trend real GDP is computed by applying an
vided for the 15 individual crises episodes HP filter (λ=100) to the GDP series over
listed in Table 1 and for the 2007 crisis case. [T-20, T-1].
For the global episodes, the data covers 21 9 This is the “advanced economy” category rou-
or 22 advanced economies, listed already in tinely used by the IMF,World Bank, OECD, etc. It
the Introduction, and 20 emerging markets is questionable in numerous cases whether coun-
for the Great Depression episodes and 49 tries several countries in that list would have clas-
emerging markets. • sified as advanced in the pre-World War II era.
10 See the reports for the years, 1938-1940, in
Footnotes particular.
1 See the first table in Reinhart and Reinhart 11 Our data for domestic bank credit/GDP is
(2009) for a century-long perspective on exports confined to the post-WWII period, with the
around crises. series beginning usually in the late 1940s for the
2 The five advanced economy crises are: Spain advanced economies and somewhat later for the
(1977), Norway (1987), Finland (1991), Sweden emerging markets.
(1991), and Japan (1992). 12 Korea is an exception, in that the secular rise
3 See the discussion in chapter 14 of Reinhart and in domestic credit/GDP is largely uninter-
Rogoff (2009). The advanced economy group for rupted by the 1997-1998 crisis. This pattern
the 1929 and 1973 comparisons is comprised of is very different from the very clear pre-crisis

Journal of Regulation & Risk North Asia 103


boom and post-crisis bust in external debt/ 21 As shown in Figure 3 (inset), the median
GDP for Korea during the same period. inflation rate for 1919-1928 for 21 advanced
13 In effect, the rapid rise in leverage pre-dates our economies was 1.3 – placing it at the door-
10-year window, which begins in 1982 for Japan. step of deflation.
14 In Mexico, for example, poorly defined consumer 22 During 1963-1983 there is a secular rise in credit/
rights delayed the adjustment in the mortgage GDP of modest magnitude in most advanced
market following the 1994-1995 crisis. economies.These results are not reported here,
15 See Caprio and Klingbiel (2003), Reinhart and but are available from the authors.
Rogoff (2009) and Laeven and Valencia (2010) on 23 Orphanides (2001) provides an exposition
the systemic/borderline differentiation. of a classic policy misperception – the Federal
16 The 1929 dividing line as the onset of the Great Reserve’s failure to recognise the slowing of pro-
Depression for the US has been convincingly ductivity after the oil shock.
argued in Romer (1990); our data on equity 24 This also fits the pattern of adjustment after
markets and output in advanced and many an inflow of foreign capital, or what Reinhart
emerging markets offers, together with sparse and Reinhart (2008) refer to as a “capital flow
data on consumer durable spending from the bonanza.”
League of Nations (various issues), broad sup- 25 This is most evident in the GDP and particularly
port for this dating. unemployment data for Germany and Japan.
17 This is the “advanced economy” category rou- 26 See Reinhart and Rogoff (2010) , Reinhart (2010)
tinely used by the IMF,World Bank, OECD, etc. It and Schularick and Taylor (2009) for a documen-
is questionable in numerous cases whether coun- tation of these “long cycles.”
tries several countries in that list would have clas- 27 Table 3 provides sufficient information to pin-
sified as advanced in the pre-World War II era. point which cycles exceeded the time-frame
18 El Erian (2008). boundaries imposed in this study.
19 We do not have complete time series for the
depression episode to replicate our empirical Editor’s note
exercises on housing and unemployment, but The publisher and editor would like to thank
the League of Nations publications do provide the Federal Reserve Bank of Kansas City,
a rich volume of cross- country information, so Prof. Carmen Reinhart and Vincent Reinhart
as to fit together this panorama (see Reinhart for allowing the Journal to publish in its
and Rogoff, 2009, Chapter 16). On credit prior entirety one of the seminal papers delivered
to WWII also see Schularick and Taylor (2009). at the Kansas City Fed’s annual Economic
20 See Reinhart and Reinhart (2009) for an analy- Policy Symposium hosted at Jackson Hole in
sis of monetary and fiscal policy during the August 2010. Please note, copyright for this
Depression. The study highlights the heteroge- paper is held by the Federal Reserve Bank
neity of the policy response across countries. of Kansas City and that any reproduction
See also Claessens et. al. (2010) and Laeven and requests or attributations must be directed
Valencia (2010) for full description of the multi- to the relevant person at the Federal Reserve
faceted policy responses to financial crises from Bank of Kansas City and not the Journal of
the 1970s to the current episode. Regulation & Risk – North Asia.

104 Journal of Regulation & Risk North Asia


Critique: ‘After the Fall’

Awkward things, even ugly


facts can be useful
The OECD’s William R. White gives
a sympathetic critique of the Reinharts’
Jackson Hole presentation, ‘After the Fall’.

ThE paper by Prof. Carmen M. Reinhart financial institutions) effectively deny it on


and Vincent R. Reinhart is essentially the basis of a different assumption; namely,
about facts, assuming of course that his- that appropriate policy can always stop out
torical data is more or less factually cor- the downturn and return us to good eco-
rect. Someone once said that facts can nomic performance.
be awkward things, indeed even ugly Since this second assumption seems
things, but they can also be useful – and more plausible than the first, which seems
that applies whether you prefer the use particularly hard to sustain after almost
of inductive or deductive methods, or three years of global economic turmoil, I will
even some healthy mixture of both. return to an assessment of its plausibility in
a moment. If, when, and how policies might
Keynes famously addressed the awkward- improve our economic circumstances is cur-
ness of facts when he replied to a journal- rently a matter of crucial importance.
ist. “When the facts change, I change my
mind. What do you do sir?” Both Keynes History’s clear teaching
and Hayek began their analysis of the Another awkward fact revealed by historical
1930s with the observation of a simple studies is that many deep slumps have not
fact. Deep slumps are possible, and the been preceded by high inflation. There was
evidence presented in this paper further no significant inflation in the United States
confirms that fact. The awkward thing is in the 1920s, nor in Japan in the 1990s, nor in
that much of modern macro theory seems Southeast Asia on the eve of their crisis, nor
to deny this possibility. indeed prior to the current crisis.
New Keynesian and New Classical Price stability might then still be a neces-
models deny it by the assumption that the sary condition for macroeconomic stability,
economy quickly re-equilibrates in response though that too is questionable in growing
to shocks. In contrast, the models used economies, but history clearly teaches us
by central banks (and many international that it is not a sufficient condition. Monetary

Journal of Regulation & Risk North Asia 105


frameworks based on the objective of price hypothesis about what causes deep slumps.
stability must find some way to take this fact And I would note that they also have some
into account. trenchant observations about the dangers
inherent in inappropriate policy responses
Huge step forward as well.
The database of facts assembled for this Let me say a few words about each
paper, and the book published earlier by aspect of this paper. While I welcome its
Reinhart and Rogoff constitutes a huge step broad thrust, no one will be surprised if I do
forward in improving our understanding not agree with everything that the authors
of past events, however awkward the facts have to say.
that they reveal might be. For many years, First, a few words about the facts, includ-
a number of people asserted, on the basis ing the Reinhart’s empirical strategy. Second,
of more limited data and often mere anec- I will add a few words about theory. What
dote, that problems were building up under causes slumps, after financial crises, to be so
the surface of the “Great Moderation”. deep and sustained for such long periods?
Whether rightly or wrongly, these warnings Third, I will finish with some comments
were ignored as being based on assertion about possible policy responses. Again, this
only. But now the sheer volume of the evi- raises some awkward issues, since many
dence recently assembled carries a lot more recommended policies have positive effects
weight. There are simply too many facts to in the near term but negative effects over a
be ignored. longer time period. Decisions having inter-
temporal implications are never easy to
Churchillian conclusion make, particularly when the body politic
That brings me to the point that facts can be typically heavily discounts the future.
useful as well as awkward. Facts do not just
call into question old theories, but they also Optimism and otherwise
point the way to alternative theories and dif- The authors follow Reinhart and Rogoff
ferent ways of looking at things. As Winston (2009) in identifying big financial crises
Churchill said, while drawing a characteris- through the use of the BCDI and the BCDI+
tically firm conclusion in the British House (banking – systemic episodes only – cur-
of Commons,“One cannot argue with arith- rency, debt – domestic and external, and
metic. One cannot argue with the obvious inflation. When stock market crashes are
facts of the case”. added to the BCDI composite, it is referred
The Reinhart’s are perhaps overly mod- to as BCDI+). Three indices introduced in
est when they say that “providing a full and Chapter 16 of This Time is Different. I have
testable explanation as to why crises end in no major problem with this, but would like
such a long and pronounced tail is beyond to make two points. Unfortunately, one gives
the scope of this paper”. One does not grounds for optimism while the other points
have to read between the lines (or at least in the opposite direction.
not much) to see they do have an implicit On the one hand, the IMF has also

106 Journal of Regulation & Risk North Asia


undertaken research work designed to another source of uncertainty.The incidence
identify financial crises and the events sur- of sovereign defaults (D) has also been kept
rounding them. While using a quite differ- under control by IMF and European sup-
ent methodology from the Reinharts, the port packages. Nevertheless, worries about
Fund concludes that only half of the finan- the longer term prospects for sovereign
cial crises they identify develop into really debt continue to escalate, even for some
severe recessions. countries having their own currencies. This,
of course, raises again the threat of future
Problems understated? currency crises. As for inflation (I), it has
This provides some hope, despite the dam- not been a problem in recent years due to
age done in the post 2007 recession, that we globalisation.
may have seen the worst and that a sustain- However, there is now evidence of over-
able recovery might still be consistent with heating in a number of countries in Asia, and
historical experience. On the other hand, food and other commodity prices have been
there are also grounds for belief that the rising everywhere. Finally, stock prices (+)
indices used by the Reinharts might actu- rose sharply from March 2009. Indeed it was
ally understate the problems that we might a bigger rebound than anything seen dur-
face looking forward. Put otherwise, their ing the 1930s. However, many market com-
conclusion “that the dust has begun to set- mentators have also raised concerns that the
tle since the 2007-2008 eruption” might be underlying fundamentals are not supportive
somewhat premature. of a rebound of this magnitude.
To me, each component of these indi-
ces seems to have some element of down- Serious shortcoming
side risk. The incidence of banking crises (B) It should also be noted that these indi-
has thus far been lowered by government ces also have other shortcomings that
actions, yet the fragility of the banking sec- were explicitly identified in Chapter 16
tor in many countries continues to be a cause of Reinhart and Rogoff (2009). First, each
for concern. Consider remaining uncer- component of the index is either “on” or
tainties about the valuation of toxic assets “off” using their methodology. Thus, the
and doubts still being expressed about the severity of the crises identified in the sub-
adequacy of the recent stress tests of major components plays no role in the behaviour
European banks. of the index as a whole.
Given the unprecedented ‘imbalances’
Global trade imbalances that characterised the run-up to the 2007
The incidence of currency crises (C) could crisis, the peak of the indices might then be
also rise in the light of unresolved global somewhat misleading as a guide to the mag-
trade imbalances. Recent decisions by a nitude of the subsequent fallout. Second, the
large holders of dollar reserves to diver- debt default (D) component of the index
sify (albeit at the margin) into Japanese only includes sovereign defaults. Since the
and Korean government bonds highlights root of our current difficulties to date has

Journal of Regulation & Risk North Asia 107


been over-indebtedness in the private sector financial deleveraging (proxied by debt/
(especially households), this must be consid- GDP) is still going on 10 years after the cri-
ered a serious shortcoming. sis began. And to these observations we can
add some ancillary points from the work
Post-war financial crises of the IMF and the OECD. They note that
The single most important point revealed in household saving rates also rise very sharply
this paper is that the economic downturns, in recessions following financial crises, while
following the 15 post-war financial crises, private investment also falls dramatically.
identified by the authors, have been unusu- These last points raise the obvious
ally severe and protracted.These findings are, question of what else adjusts to satisfy the
moreover, corroborated by research work identity for saving and investment in the
done by both the IMF and the OECD. The National Income Accounts. The answer
former says: “Recessions following financial given by the IMF is that the identity is typi-
stress are more likely to be associated with cally closed by very significant increases
severe and protracted recession.” in government deficits as well as major
And the latter echoes the sentiment increases in exports. Of course the obvious
with “downturns following banking crises corollary to these latter two points is less
are found to be more protracted with larger comforting in current circumstances.
ultimate losses and disproportionate falls
in housing and business investment.” Such More serious consequences
common findings are as unusual in macroe- If government deficits are not allowed to rise,
conomics as they are striking. Evidently, they say because debt levels are already judged to
raise the question of whether policy might be dangerously high, and if exports cannot
have been conducted differently had this go up because the downturn is occurring
research work been done before the recent simultaneously across a number of coun-
crisis and not just afterwards. tries, then the resulting recession could be
significantly more serious than was typical
Increase in joblessness after past financial crises.
As to some of the more detailed results from Why is economic performance so poor in
the Reinharts’ paper, per capita growth rates the decades following severe financial crises?
are “significantly” lower in the decade after While the Reinhart’s are a little coy in
the crisis than the decade before. Moreover, drawing firm conclusions, I would agree
unemployment rises sharply, and generally with what I interpret to be the thrust of their
does not fall to pre-crisis levels even 10 years arguments and evidence. The root of the
afterwards. House prices also fall sharply (in severe problems following the average cri-
10 of the 15 Advanced Market Economies sis is to be found in what happened before
where data is available) and 90 per cent of the crisis. While this does not necessarily
all the observations for house prices in the rule out policy error after the crisis, this pos-
following 10 years remain below pre-crisis sibility seems for the Reinharts a matter of
levels. Finally, the Reinharts underline that secondary importance. To be more specific,

108 Journal of Regulation & Risk North Asia


the Reinharts document how an extended the boom phase of the credit cycle, but also
period of rapid credit growth drives the thereafter. In this regard, and it is a quibble,
boom in GDP and house prices. the Reinharts’ treatment of house prices as
almost an“independent”factor in the down-
Compelling evidence turn seems to me to be not quite right.
Moreover, they note, the greater is the credit Evidently, one could also delve more
leverage, the greater is the increase in these deeply into this process of deleveraging,
other data series. Finally, after the crisis, a and here I think my interpretation of events
decade-long process of credit deleverag- might differ a little from the Reinharts. Is
ing occurs, with the degree of deleveraging the problem of credit de leveraging and
being of “comparable magnitude” to what increased private sector saving due primar-
happened in the earlier period of rapid credit ily to a wounded financial system, and a
growth. Personally, I found this evidence decreased supply of loans, or is it primarily
compelling in its support of the general due to decreased demand for credit. This is a
hypothesis that problems which emerge crucially important issue for policy.
in the downturn primarily build up in the
expansionary phase of the credit cycle. As Highly relevant to Basel III
my former BIS colleague Claudio Borio has First, if the real problem is a decreased
said for some years, the exposures build up demand for loans, then restoring the finan-
in the booms and they materialise in the cial system to good health will not be suf-
busts. Interestingly, if belatedly, both the IMF ficient to get the economy expanding again.
and the OECD now seem to support this Second, it also implies that quickly tight-
hypothesis as well. ening regulation and capital requirements
will not hurt the economy as much as
Conventional wisdom might otherwise have been expected. This
All this said, the paper would still benefit is highly relevant today to the discussions
from giving a more explicit analysis of the (and lobbying) surrounding the introduc-
relationship between credit deleveraging tion of Basel III.
and the behaviour of other variables in the The paper gives the impression that the
downturn. The same is the case for the rela- Reinharts would give more emphasis to the
tionship between leverage in the upswing supply of loans. They say, for example, “if
and other variables in the downswing; is deleveraging of private debt follows the track
it possible that more credit in the upswing of previous crises as well, credit restraint
actually causes more disinflation (or even will damp employment and growth for
deflation) afterwards. some time to come”. Personally I am more
This would turn the conventional wis- inclined to believe it is the demand for credit
dom that “money drives inflation” com- that is more crucial. Those who have over
pletely on its head. What is important is borrowed, having looked into the abyss of
to make crystal clear that the financial and debt or even fallen into it, are going to repay
real sectors are intimately interrelated in debt regardless. This is a good part of the

Journal of Regulation & Risk North Asia 109


“headwinds”referred to by Alan Greenspan management. That is, slow growth might be
after the recession of 1990-91. This interpre- a self fulfilling prophecy produced by timid
tation is also consistent with Richard Koo’s authorities”.Yet, there is one crucial fact that
identification of “balance sheet” recessions emerges from the Reinhart’s work, and that
in both Japan in the 1990s and the United of others. It is that the deep slumps after
States in the 1930s. A hunkering down by financial crises all look very much the same.
debtors, rather than credit restrictions by Are we to believe that there was policy error
banks, also seems to me to be consistent in every case?
with some of the evidence in Reinhart and Consider too that the Reinharts classify
Rogoff (2009). our current crisis as being at least of equal
severity to the average of other post-war cri-
Demand side for credit, too ses. How could this happen, given the reality
They note that a more normal ordering of of unprecedented monetary and fiscal eas-
events was for the recession to begin first, ing in many countries which was based on
only followed by financial crises later, as the belief that past policy errors had to be
household and corporate bankruptcies avoided at all costs?
began to rise. Finally, as a Canadian, I was
also struck by the evidence in Reinhart and Dramatic reductions
Rogoff (2009) that Canada, Mexico and Finally, the IMF study referred to above
Indonesia suffered greatly during the Great (World Economic Outlook, 2009) docu-
Depression, even though their banking sys- ments that recessions preceded by financial
tems remained in quite robust health. At the credit crises were actually met with much
very least, we have to admit that the mar- sharper interest-rate cuts than in more nor-
ket for credit has a demand side, as well as mal cycles. Further, policy rates were reduced
a supply side. Similar to a conclusion that I even more dramatically in countries affected
drew in an earlier paper, that price stability by synchronised cycles.
is not “enough” to ensure good macroeco- To me, all this evidence indicates that
nomic performance, it may be that financial the essence of the problem has to do with
stability is not “enough”either. “imbalances” generated before the crisis,
even if policy error might in some cases also
Policymakers’ failure played a role. At the risk of revealing my
Still on the question of why these deep ignorance of the existing literature, we need,
slumps occur, the Reinhart’s do agree that not only to look closely at all these historical
policy error after the financial crisis might downturns following financial crises, but also
sometimes have had a role to play. They to document carefully the policy responses.
say, “That outcome (a deep slump) could On this basis, we could then assess how
materialise as a consequence of the failure much difference the policies followed really
of policymakers to provide sufficient stimu- made to final outcomes.
lus after a wrenching event in an economy All of these explanations for sharp down-
where rigidities give ample scope to demand turns after financial crises have focused on

110 Journal of Regulation & Risk North Asia


factors affecting aggregate demand, but we needed physical proximity. And, on an even
cannot forget that the economy also has a bigger scale, one has to ask what the effect
supply side. The OECD has been very active will be on frictional unemployment as global
using a production function approach to trade imbalances get resolved. There needs
investigate this issue. to be a significant move in the United States
out of the production of non-tradable and
Higher risk premiums into tradables, with the very opposite being
In an April presentation, they concluded: required in major countries with trade sur-
“While long-term growth rates may well pluses. This will not happen overnight, nor
have been unaffected by the crisis, potential without a significant increase in the NAIRU.
output is expected to have fallen by about And finally, to policy implications. The
three percentage points in the G20 countries Reinharts state clearly that they are wor-
for which OECD estimates are available.” ried that policymakers will treat contractic-
The forces they identify as being at work tory shocks as temporary, when they are in
include effects on the labour market (lower fact permanent. This mirrors concerns, often
participation rates and a rise in the non- expressed in upturns, that policymakers are
accelerated inflation rate of unemployment too inclined to treat shocks as permanent
(NAIRU) due to longer-term unemploy- when they are, in fact, temporary.
ment). In addition, accelerator effects and
higher risk premiums in financial markets Monetary policy implications
drive down the stock of capital. While the authors allude to over expansion-
Moreover, as if these factors influenc- ary macro policies, they do not in fact spell out
ing potential were not worrying enough, in any detail the mechanisms through which
two other considerations also warrant expansionary policies today might wind up
attention. The first comes from Reinhart having negative effects tomorrow. This is a
and Rogoff, both in their book and other pity, because a number of statements made
publications. High levels of sovereign debt by representatives of the current US admin-
do seem to stunt growth, while lower istration give the clear impression that they
levels of growth also raise debt levels – a reject the hypothesis that potential has been
potentially vicious circle. significantly affected by the crisis.
Building on some of the comments I
Sectorial demands have made above, let me now make some
While this topic of debt is now receiving a brief points about the implications of the
lot of attention, a second set of factors has Reinharts’ paper for monetary policy, fiscal
been less noticed. During booms, resources policy and supply side (or structural) policies.
get drawn excessively into certain sectors Turning to the implications for monetary
– banking, cars, construction, distribution – policy, a lower level of potential obviously
which must downsize subsequently.Workers means monetary policy must be more con-
must find jobs in different sectors, for which cerned about inflationary outcomes than
they might not have the required skills or the otherwise. This is not to say that there is

Journal of Regulation & Risk North Asia 111


not currently a large output gap, but that it Allowing faster credit and monetary
might be smaller than some people think. expansion to encourage inflation also
A second point, implied by the large num- encourages debt accumulation and other
ber of deep and lasting slumps identified by imbalances. In effect, this policy is internally
the Reinharts, is that monetary policy easing inconsistent in that it fosters the develop-
after severe financial crises might have less ment of the very problem (a deflationary
stimulative capacity than might normally be bust) that the inflation buffer is supposed
the case. Indeed, the “headwinds of debt,” to contain.
identified by Alan Greenspan in the early Turning to fiscal policy, the implications
1990s, have had 20 years to turn from head- are largely similar to those for monetary
winds to gales. policy. A lower level of potential implies
that a larger proportion of the current fiscal
No free lunch deficit is structural rather than cyclical. The
This should change the balance of argu- already formidable challenge of restoring fis-
ments concerning the net benefits of cal sustainability thus becomes even greater.
continuing monetary stimulus, since we Moreover, this fact also alters the trade-off of
ought properly to compare the dimin- risks between a too hasty “exit”, depressing
ished stimulative effects of easy monetary demand, and a too tardy one leading poten-
policy with its longer-run costs. These tially to an uncontrollable fiscal debt expan-
costs would include lower aggregate sav- sion. Restoring debt sustainability thus takes
ing rates, difficulties posed for insurance on even greater urgency.
companies and pension funds, misal-
located resources including “zombie” Special US responsibility
companies and banks, potential further These general policy implications apply to
bubbles and (as already noted) a possi- all countries, but it is also worth noting a
ble resurgence of inflation. In short, we couple of ways in which the United States
should not be thinking about expansion- is special. On the one hand, the probabil-
ary monetary policies as a free lunch. ity of a fiscal crisis in the United States is
much less than other countries with simi-
’Lean not clean’ lar levels of debt. The dollar is the reserve
Finally on monetary policy, I must take currency after all. On the other hand,
exception to one thought – albeit only a one- were there to be a flight from US sover-
liner from the Reinharts – that “monetary eign debt, the implications for the whole
policymakers need to consider the benefits global trading and financial system would
of an inflation buffer to protect from the zero be very substantial. Evidently, given these
lower bound of interest rates.” This policy externalities, the United States has a spe-
suggestion seems to me to be inconsistent cial responsibility to get its own house in
with the basic thrust of their paper which order. This is the flip side of the “extrava-
is that of avoiding credit excesses in the first gant privilege” referred to decades ago by
place; i.e.“lean not clean”. General De Gaulle.

112 Journal of Regulation & Risk North Asia


Finally, if it is the case that monetary and 3. Guichard S and Rusticelli R (2010) “Assessing the
fiscal policies have reached the limits of their Impact of the Financial Crisis on Structural Unem-
effectiveness, what else can policy do? I think ployment in the OECD countries” OECD Econom-
there are two things, but given time limita- ics Department Working Paper 767, Paris, May
tions I must be brief. 4. Haugh D, Ollivaud P and Turner D (2009) OECD
“The Macroeconomic Consequences of Banking
Half a loaf . . . Crises in OECD Countries” OECD Economics
First, we need to put more effort into debt Department Working Papers 683, Paris, March
restructuring, recognising that half a loaf is 5. Koo R C (2009) “The Holy Grail of Macroeconom-
always better than no loaf. This applies to ics” John Wiley and Sons (Asia) Pte. Ltd. Singapore
household debt, corporate debt and the debt 6. Mello de L and Padoan P C (2010) “Promoting
of financial institutions. Potential Growth: the Role of Structural Reform”
Second, we need to be thinking much Paper prepared for a Working group of the G20,
more about structural reforms to raise the Toronto, May
potential growth rates of our economies, 7. Peek J and Rosengren E S (2003) “Perverse Incen-
which is another way of making the burden tives and the Misallocation of Credit in Japan” NBER
of debt more bearable. Working Paper 9643, Cambridge ME,April
At the risk of my advice sounding like a 8. Reinhart C M and Rogoff K S (2009) “This time is
paid political announcement, the OECD has different” Princeton University Press, Princeton and
made numerous sensible proposals in this Oxford
regard over the course of many years. Their 9. Reinhart C M and Rogoff K S (2010) “Debt and
publication“Going for Growth”is a treasure Growth Revisited” Vox.EU August
chest of ideas. I do understand that structural 10. Selgin G (1997) “Less than Zero: The Case for
changes are always very difficult, but crises a Falling Price Level in a Growing Economy” IEA
present opportunities as well as challenges. Hobart Paper 132, London
As John Kenneth Galbraith once put it, 11.World Economic Outlook (2008) “From Reces-
“politics is not about the art of the possible. sion to Recovery” Chapter 3, International Mon-
It is about the choice between the disastrous etary Fund,Washington DC, Fall
and the unpalatable. ”We must learn to think 12. World Economic Outlook (2009) “Financial
about the political economy of structural Stress and Economic Downturns”Chapter 4, Inter-
reform in exactly this way. • national Monetary Fund,Washington DC , Spring
13.White W R (2006) “Is Price Stability Enough?” BIS
Bibliography Working Paper 205 Basel,April
1. Basel Committee on Banking Supervision (2010) 14.White W R (2008) “Globalisation and the Deter-
“Assessment of the Macroeconomic Impact of minants of Domestic Inflation”BIS Working Paper
Stronger Capital and Liquidity Requirements” Basel 250, Basel, March
,August 18 15. White W R (2009) “Should Monetary Policy
2. Furceri D and Maurougau A (2009) “The Effects Lean or Clean?” Federal Reserve Bank of Dallas,
of Financial crises on Potential Output” OECD Eco- Globalisation and Monetary Policy Institute Work-
nomics Department Working Paper 699, Paris, May ing paper 34, Dallas,August.

Journal of Regulation & Risk North Asia 113


Central banking

Central bankers need to be


more, not less, proactive
Adam S. Posen, independent member of the
Bank of England’s Monetary Policy Com-
mittee (MPC) calls for more fiscal easing.

In this policy brief I present my view on measures already taken and the assumption
the role of monetary policy in our recov- that there will be diminishing effectiveness
ery and whether the major central banks of further central bank actions. To still others,
in the United Kingdom and beyond this is a call for actions that would endanger
should be doing more in the coming price stability, central bank independence, or
months. Of course, every central bank’s fiscal discipline.
policy setting committee has to make its So this is an open debate, at least for
own assessment of the right policy meas- those with open minds. I believe that policy-
ures for its economy, based on its own makers face a clear and sustained uphill bat-
forecast and the mandate legally set for it. tle, in which monetary ease has an on-going
role to play, even if it may not deliver the
Thus, I am not presuming to offer a “one desired sustained recovery on its own.
size fits all” prescription for central bankers
beyond the UK. I would like, however, to Misplaced fear of inflation
try to give some general assessment of the In every major economy, actual output has
common challenges we face, and what I fallen so much versus where trend growth
believe to be the appropriate monetary pol- would have put us – and trend growth has
icy response, barring special circumstances. not been above potential for long enough
Not that there will be any doubt about it, as yet – that there remains a significant gap
but for the record, these are solely my own between what the economy could be pro-
personal views. ducing at full employment and what it cur-
The case I wish to make is that mone- rently produces. Thus, policymakers should
tary policy should continue to be aggressive not settle for weak growth out of misplaced
about promoting recovery, and I think fur- fear of inflation. If price stability is at risk over
ther easing should be undertaken. To some, the medium term, meaning over the two- to
that will sound obvious or even overdue. three-year time horizon for central banks’
To others, that will sound moot, given the decision-making, it is on the downside.

Journal of Regulation & Risk North Asia 115


There are, however, some very serious risks broadly consistent with these past pat-
if we make policy errors by tightening pre- terns as seen in Japan in the 1990s and in
maturely or even by loosening insufficiently. the US and Europe in the 1930s: Economic
recovery following a financial crisis is a
Political reaction threat long process dominated by the interaction
These risks are not primarily the potential of unemployed resources, dysfunctional
for a double-dip recession or even of tem- banking systems, and the degree of policy
porary measured deflation. While bad, these stimulus. We are a long way from home,
situations would still be within the range and a long way from overheating.
of short-term cyclical developments and The absence of any recent data inconsist-
could be weighed against simple inflation- ent with this pattern in the UK or elsewhere
ary pressures from monetary policy trying to in the West seems to me pretty conclusive. If
stimulate too much. The risks that I believe there was going to be a recovery that either
we face now are the far more serious ones of was inflationary through overheating or
sustained low growth turning into a self-ful- otherwise meaningfully different from that
filling prophecy and/or inducing a political established pattern, it should have been evi-
reaction that could undermine our long-run dent by now. Instead, we have seen global
stability and prosperity. interest rates on long government bonds,
Inaction by central banks could ratify determined by forward-looking markets, at
decisions both by businesses to lastingly historic lows.
shrink the economy’s productive capac-
ity and by investors to avoid risk and prefer Jobs, ouput gap threat
cash. These tendencies are already present, Absent evidence of a truly different recovery,
and insufficient monetary response is likely the analysis of mainstream macroeconomics
to worsen them. The combination of those should apply, as it did in Japan in the 1990s
risks with the potential attainable gains and in the US and Europe in the 1930s. That
motivate my call for additional monetary proven analysis tells us that, under the pre-
policy stimulus. sent circumstances, sustained high inflation
is not a threat, that persistent high unem-
Historical comparisons ployment and output gaps are the threat,
This view is based on my reading of histor- and we should take further monetary action
ical comparisons and cross-national evi- to sustain and promote recovery.
dence (including but extending far beyond As in the usual post-crisis difficult recov-
my own research). Such an assessment ery scenario, there will be a long period of
does not hinge on a specific interpretation ups and downs, also seen in Japan’s Great
of any particular recent data, let alone of Recession and during the Great Depression
new information suggesting an imminent – these short-term fluctuations are not what
double dip in the UK or elsewhere. My I think central banks should focus on. The
assessment instead rests upon the path case for doing more is about activism for sus-
of post-crisis developments having been taining a period of recovery from a low point,

116 Journal of Regulation & Risk North Asia


thereby preventing us from getting stuck in a real Great Depression in the US and Europe
long-term trap. The challenge for monetary will recognise the parallels. The Great
policy today is not about fine-tuning devel- Depression was not simply set in motion on
opments in prices and output. one day, even if there were dramatic trigger-
ing panics in 1929.Various asset price crashes
Why central banks should do more in the 1920s and 1930s, bank runs and finan-
When I parachuted into the debate over cial fragility, fitful recoveries, sequences of
Japan’s Great Recession some years ago policy mistakes regarding late exits from the
(Posen 1998), my working assumption was gold standard and budgetary austerity, and
that the problem was amenable to good ruinous global trade and exchange rate con-
old fashioned – some would say Keynesian flicts (thankfully absent in Japan in the 1990s
– macroeconomics. The field of policy-rel- and so far today) all cumulated into a pro-
evant macroeconomics had emerged out longed terrible period.
of the Great Depression, which bore some
profound similarities to the situation in Growth potential underestimated
Japan then. The Great Depression was not caused by a
This view has since been borne out by single shock or policy mistake, and it was not
subsequent research. The source of interest over quickly. Some extremely useful recent
was and is whether Japan’s situation could cross-national research has established that
happen to any economy, given the right set in broad terms the same pattern of persis-
of shocks and the wrong set of policy deci- tently slow and choppy recovery following
sions. I argued that it could, and now we are financial crises holds for a wide range of
all trying to avoid that outcome for our own economies in the post-war period as well.
economies. What drove many of the economic policy
mistakes in Japan, particularly on the mon-
Aborted nascent recoveries etary side, was repeated underestimation of
A key implication of this analysis is that Japan’s potential rate of economic growth.
there was no single decisive event that Similar mistakes played a contributing role
locked Japan into its fate. Neither the bub- in the harmful actions of the major central
ble bursting nor the mounting debt on banks in the 1930s (Ahamed 2009).
household or corporate balance sheets nor For monetary policymakers, the esti-
even the initial slow reactions of Japanese mate of the potential of the economy to
fiscal and monetary policy to the crisis made grow on average without inflation matters,
years of stagnation inevitable. The picture because when an economy’s growth rate
was instead of nascent recoveries being exceeds potential – aggregate demand is
aborted first by macroeconomic policy mis- too high – and the economy is already run-
takes, and then by the weight of financial ning close to capacity, inflation is the result,
problems accumulated over that slow and as seen in the 1970s. When a central bank
volatile growth path. underestimates how fast an economy can
People familiar with the history of the run without causing inflation, however,

Journal of Regulation & Risk North Asia 117


Figure 1 Simple measures of potential output: Japan
Figure 1. Simple measures of potential output: Japan
percent change oya
6
5-year moving average
10-year moving average
HP Filter 5

2
2000–2008Q2 average

1990s average
1
2000–2010Q2
average
0

–1
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Note: Hodrick Prescott (HP) Filter smoothing parameter =1600. 1990s average = 1.49 percent, 2000–2008Q2 average = 1.64 percent, 2000–2010Q2 average =
0.86 percent.
Sources: Thompson DataStream and Bank of England calculations.

Figure 2 Simple measures of potential output: United Kingdom


Figure 2. Simple measures of potential output: United Kingdom percent change oya

5-year moving average 5


10-year moving average
HP Filter
4
2000–2008Q2 average

2
1990s average
2000–2010Q2 average

–1
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Note: Hodrick Prescott (HP) Filter smoothing parameter =1600. 1990s average = 2.24 percent, 2000–2008Q2 average = 2.66 percent, 2000–2010Q2 average =
1.65 percent.
Sources: Thompson DataStream and Bank of England calculations.

118 Journal of Regulation & Risk North Asia


or how far away an economy is from full from the level of observed output, employ-
employment, it can cause slow growth and ment, and inflation, directives on what
even recession or deflation. There is no get- policy to pursue, let alone what outcome
ting away for central banks from having to to choose (the mistake of the early 1970s).
make this assessment of something directly After a financial crisis, with inflation low
unobservable, and there is no virtue to get- and deflation looming, it is even less direct.
ting it wrong in either direction. Kuttner and I (2004) document the unreli-
ability of output gap estimates, and thus of
Outright deflation ‘rare’ strict guidance from Taylor rules for mon-
This medium-term Phillips Curve relation- etary policy, in Japan in the 1990s due to the
ship between output and inflation is sup- low inflation environment.
ported by a robust set of results renewed in These should be taken as cautions
the empirical literature at intervals. Thus, it is against fine-tuning by monetary policy-
no surprise that in the aftermath of a finan- makers, however, and though important,
cial crisis, the general tendency is for sus- still support the big picture of basic mac-
tained downward pressure on inflation. roeconomics applying in the current situa-
Outright deflation emerges only rarely, tion: Times of low demand and idled factors
largely because of the resistance to nomi- of production lead to downward pressure
nal wage declines by both workers and on prices. This is how I would characterise
businesses (which means the unemploy- the reality that Krugman (2010b) channel-
ment rate is higher in times of low inflation ling Tolkien has called“One Model to Rule
or deflation than the usual Phillips Curve Them All.”
trade-off would imply). Krugman’s (1998)
justly famous liquidity trap model shows the Downward pressure kicks in
possibility of similar perverse effects in finan- None of these results support the idea that
cial markets when low or negative inflation on-going rises in inflation could emerge
expectations become entrenched, but the from such a situation as we now find our-
nominal interest rate cannot be cut below selves in. As I discuss below, the current
zero. overshooting of the UK’s inflation target is
not going to be sustained for long, largely
Real dislocations because this downward pressure is kicking
These perversities of low inflation or defla- in, and that outweighs the lingering impact
tionary environments exacerbate the real of forecast errors we at the Bank made previ-
economic harm of the situation – they do ously. How big a mistake could central banks
not counteract the downward pressure on make in underestimating potential growth?
prices simply because instead of immedi- Consider figures 1 and 2, which show
ately experiencing measured deflation the various computations of trend growth rates
economy sees real dislocations. Even in for Japan and the UK, respectively. In Japan,
normal times, central banks cannot simply official estimates of potential growth were
read off from a pre-crisis Phillips Curve, or as low as 0.5 per cent real year-over-year

Journal of Regulation & Risk North Asia 119


during the 1990s (Posen 1998, 2001), and stable low inflation outcomes enjoyed until
partly as a result, the Bank of Japan hesitated 2008. By including the awful experience of
to aggressively ease policy and then hesi- the crisis, we could drive down the average
tated to undertake unconventional stimulus. of real GDP growth rate since 2000 by a full
Yet Japanese output growth in the 1990s, percentage point a year, to 1.65 per cent.
excluding the end of the boom, averaged If one were to mistakenly do so, that
more than twice that rate a year, coincident would require one to take the growth rate of
with outright deflation. the past two years, from the 2008 Q3 to latest
available data, as representing a fundamental
Lost decade of growth shift in the UK’s potential, and/or to assume
When the Japanese economy recovered that the crisis somehow directly destroyed
from end of 2002 to mid-2008, it averaged a lot of UK productive capacity (instead of
more than two per cent real annual growth, leaving it idle and, over time, decaying). If
and prices took almost the entire period that were plausible, then one could become
of that recovery to begin to rise. Whatever concerned about recent good quarterly out-
damage to potential output was done by the comes causing inflation going forward.
crisis, and whatever lasting loss of productive
capacity Japan suffered, was not enough to ‘It’s the levels, stupid’
offset the downward pressures of under-uti- But there is no good reason to make that
lised resources. Clearly, the inflation threat of assumption; at least not to the degree that
overheating was much exaggerated and, as would lead one to believe we are already
a result, the Japanese people suffered a lost close to full capacity or growing well above
decade of employment and growth. sustainable trend. Mistaking the immediate
What about in the UK today? As impact of a financial crisis for a fundamental
shown in figure 2, the difference between decline is precisely the error that was made
UK gross domestic product (GDP) growth by monetary policymakers in Japan in the
rates during the boom of the 2000s and 1990s, and elsewhere in the 1930s, and could
on average in the more normal 1990s is be devastating here today.
meaningful but much smaller than was in This is my take from BoE Governor
Japan before and after the bubble, i.e. less Mervyn King’s famous comment that, after
than half a per cent annually. the crisis, “It’s the levels, stupid,” that count
primarily for the inflation forecast (BoE
Close to potential 2009). Recently, my MPC colleague Spencer
That relatively small difference suggests Dale (2010b) has re-emphasised that the
that the extent to which the UK was grow- fact that UK output is now 10 per cent lower
ing above potential, if any, prior to the crisis than it would otherwise have been, absent
was small, since a small improvement in the crisis, a number far in excess of even the
potential is more credible than a big jump. most pessimistic estimates of decline in UK
Saying that the UK was close to potential supply capacity. The crisis has had a nega-
in the 2000s is of course consistent with the tive impact on the supply side of the UK and

120 Journal of Regulation & Risk North Asia


other economies, and I do not dismiss it. increasing evidence of structural mismatches
In fact, I am on record forecasting that in the labour market and of a rise in the share
aggregate supply and trend productivity – of long-term unemployment (and leaving
that is, the determinants of potential output the labour force) among working age adults;
going forward over a central bank’s time in fact, the US seems to be on a path towards
horizon – will be noticeably damaged by channelling the EU unemployment experi-
the crisis, including in the US (Posen 2009b, ence of the 1980s.
2009c). There is no contradiction between And while many European economies,
recognising this reality and also making the most strikingly Germany but also includ-
assessment that the immediate fall in output ing the UK, have not seen such large rises
and employment after the 2008 panic was in unemployment in response to the initial
far larger than the contraction to date in pro- shock as in the US, these problems are still
ductive capacity. emerging (Guichard and Rusticelli 2010).
Of course, for Greece, Ireland, Spain and
Underemployed resources some others, risks of hysteresis reinforcing
That is the logical outcome because, as I already high long-term unemployment are
have put it in Posen (2010a) and elsewhere, out in full force. One should make the same
the workforces of the advanced economies kind of arguments regarding other factors of
did not wake up one morning and find that production than labour, meaning business
their left arms and their places of work both equipment and corporate finance.
had disappeared overnight. That leaves for
now large output gaps of underemployed Negative dynamic
resources pushing down on inflation. My MPC colleagues and I have spoken in
Yet, the longer that growth remains our last few Inflation Reports and meeting
below potential and that output gaps per- minutes about the macroeconomic impact
sist, the more lasting damage is done to our of temporary idling by businesses of, say, one
economic potential and to our citizens. That production line in a plant (or one line of ser-
is why I emphasised the word “immedi- vice in an consultancy) and of the associated
ate” when talking about the relatively larger skilled workers (e.g., BoE 2010, 26).
impact of the crisis on aggregate demand In a speech earlier this year, Deputy
than aggregate supply. Governor Paul Tucker (2010) summarised
this negative dynamic: “In the months after
Long-term jobless danger the Lehman crisis, the cutbacks in lending
The classic and all too relevant channel and in trade credit insurance were so severe
through which lasting damage to productive that some firms were probably unable to
capabilities occurs is the process whereby maintain production at previous levels.
people laid off from work during a recession Working capital is, after all, an intermedi-
have few options, those unemployed then ate input [to production]. Those constraints
become long-term unemployed and de facto have probably reduced over the months.
unemployable over time. In the US, there is But, given insipid and uncertain demand,

Journal of Regulation & Risk North Asia 121


not a few firms seem to have temporarily in employment and in productivity. Japan
suspended part of their capacity: whether showed clear signs over the course of its lost
by putting part of their workforce on short decade of diminishing corporate competi-
hours or closing down a production line. tion and innovation due to credit market
This makes it likely that supply conditions dysfunction. Economic researchers Aghion
are going to depend heavily on the path of et al (2009) and Ouyong (2010) establish
aggregate demand . . . [if ] demand proves across countries over time that R&D invest-
anaemic, then suspended capacity is more ment at the firm level suffers asymmetrically
likely to be permanently scrapped . . .” in recessions and periods of financial disrup-
tion – and lower investment in innovation
Permanent mothballing has a significant negative impact on long-
If sufficient demand comes back in time, it term growth.
is both feasible and profitable for compa- Of course, this adverse outcome for trend
nies to reactivate those machines and work- growth and productive capacity is only inevi-
ers; if not, it becomes inevitable for those table in the aggregate, because these effects
lines to be closed down and those work- are not the only processes at work follow-
ers to be let go. If the capacity and workers ing a financially induced recessionary shock.
are brought back on line in time, additional Some individual businesses do increase effi-
aggregate demand will not be as inflation- ciency during recessions by becoming leaner
ary as it normally would be, because capac- and meaner. Field (2006, 2009) establishes
ity will increase. Once the mothballing that the U.S. actually had significant produc-
becomes permanent, however, then infla- tivity growth during much of the 1930s.
tion responds more quickly to growth in
demand, given the lasting reduction in the Waiting for growth
economy’s productive capacity. As I argued in Posen (2001), Japan under-
This is more than a plausible theory or took meaningful structural reform of com-
collection of anecdotes about short-term munications, energy, financial, retail and,
feedback loops. Banking systems that are to a lesser degree, labour markets during
left undercapitalised or otherwise impaired its lost decade, which kept the potential
tend to roll over outstanding loans to larger growth rate there from falling on net as
borrowers and to under-supply credit to new well. But we must note that such reforms
firms and smaller enterprises during reces- increased the output gap until growth
sions. The banks’ idea is to avoid declaring kicked in, and still left unemployment high
large losses so present management can and inflation low or absent.
retain their jobs. In addition, as Eichengreen (2010) points
out for the United States in the 1930s, and
R&D, innovation factor as I would agree also holds regarding Japan
The upshot of persistent recession inter- in the 1990s, the productivity improvements
acting with such bank incentives to limit seen were the result of a multitude of policy
lending, however, is also to reduce growth decisions and business choices taking place

122 Journal of Regulation & Risk North Asia


against the weight of very evident negative our doing so now when the damage could
pressures of the sort I have discussed. The be great by so doing. When the overwhelm-
only inevitable aggregate supply effects of ing bulk of pressures in the economy are dis-
protracted recessions are the negative ones, inflationary, and when the levels of output
and more positive productivity develop- and employment are both clearly likely to
ments require sustained effort from busi- be below potential for an extended period, it
nesses and governments. is right for central bankers to take the addi-
tional negative effects of protracted recession
Central bankers’caution on trend productivity growth and on capac-
This is another reason why it is right to char- ity into account. That is a far cry from 1960s
acterise post-crisis periods as long struggles and 1970s monetary policy efforts to push
with on-going demands on macroeconomic the economy into growth without regard for
policy. Central bankers have been leery the limits on, and in fact the decline then in,
about drawing links between monetary potential growth.
stimulus and long-term supply for 30-plus To the degree that monetary policymak-
years. We fear repeating the mistakes of the ers have a choice about how we maintain
1970s, when central bankers overestimated price stability, we should always prefer get-
potential growth and overheated our econo- ting inflation back from below target by off-
mies, causing high inflation. setting insufficient demand rather than by
We internalised the insights of Nobel allowing aggregate supply to contract.
Laureates Milton Friedman and Edmund
Phelps on the independence of the natural Large-scale asset purchases
rate of unemployment from inflation expec- That takes care of why we should do more.
tations (i.e. the long-run Phillips Curve is Now I will turn to how we should do more.
vertical). We are wary of making politically As argued in Bean et al (2010) and Bernanke
dangerous or populist promises with regard (2010), uncomfortable though some might
to employment, since printing money can- be with utilising the unconventional mon-
not create jobs in normal circumstances, but etary policy measures undertaken over the
the demand for so doing is always there. As a past two years, there is no real impediment
result of these concerns, many central banks to undertaking more of them in the pre-
have adopted price stability-focused man- sent circumstance. Bernanke (2000, 2010),
dates as a bulwark against making policies Kuttner (2009), and Nishimura (2009) dis-
on the basis of such a link between short- cuss from a practitioners’perspective some of
term monetary stimulus and sustainable the various policy options currently available
growth. to central banks.
Speaking for myself, I believe that if we
Disinflationary pressures were to loosen monetary policy further, it
I believe, however, that central bankers’ fears must primarily take the form of large-scale
on this score can be taken to intellectually asset purchases (LSAPs, to use the acronym
unjustified extremes, and there is a risk of du jour). Changing interest rates on banks’

Journal of Regulation & Risk North Asia 123


reserves and making pre-commitments to earlier this decade and does not seem to be
keep instrument rates low might help at the at work in the UK or US at present – that
margin but would not have a large-scale is, one cannot simply map from so many
impact. These alternative measures also billion in government bonds bought to
seem to me to have some direct disadvan- so many percent higher inflation or lower
tages for the financial system that have to unemployment. Gagnon et al (2010) and
be taken into account in a way that does Joyce et al (2010) present rigorous event
not apply to LSAPs. Charging interest on study estimates of the effect of asset pur-
reserves is no substitute for directly fixing the chases (and announcements thereof) on
banking system as a means to increase lend- some overnight interest rate spreads of con-
ing and, counter-productively, could result in cern in the US and UK, respectively.
higher interest rates to borrowers. The message seems to be that cen-
tral banks were right to react quickly with
Prices, output, employment LSAPs when the zero-lower bound on
Pre-commitments to keep interest rates interest rates was reached – but it matters
low for a very long time could either lead how much was done, with what impact in
to a self-fulfilling prophecy where inves- practice, not just that we did react. The size
tors expect weak returns and stay in cash of central bank balance sheets versus past
(Bullard 2010, Cowen 2010) or could con- practice is no predictor of present perfor-
strain reacting to future events as needed. mance of QE. At least it is additional reas-
Targeting the 10-year government bond surance that the probability of our inducing
rate seems to me to violate both Goodhart’s sustained or large, let alone accelerating,
Law (that observed statistical regularities, inflation overshoots through additional
here between long-bond rates and real LSAPs can be safely ignored for now.
activity, break down when policymakers try
to exploit them) and what we know about Backwards logic
financial innovation (lenders will simply We will know we will have done enough
stop keying their contracts to a given tar- with QE or other monetary stimulus only
geted interest rate, to the extent that they when we have clear indications that our
can). The magnitude and timing of the policies are moving the desired variables –
impact of additional market interest rates, output, employment,
LSAPs on the macroeconomic outcomes and inflation expectations – sufficiently and
we care about – prices, output, employment in the right directions on a sustained basis. I
– remains somewhat uncertain. think that it is not enough for a central bank
to say: “Look, we expanded our balance
Mechanistic monetarism sheet more than any time in history” or “we
As I argued in Posen (2009a), while quan- did things we never did before” and argue
titative easing (QE) is clearly having some that “therefore we must have done a lot, if
benefit in the UK and elsewhere, mecha- not too much”.
nistic monetarism did not apply in Japan In my opinion, that is backwards logic.

124 Journal of Regulation & Risk North Asia


It would be like saying that “the fire must switch came in 2004 when it became appar-
be out because we’ve already pumped ent that the Bank of Japan was trying real
more water than for any previous fire we’ve LSAPs, and reflation was not arriving as eas-
fought”or“we must have gotten to our des- ily as others and I had presumed it would.
tination because I’ve been driving for hours Subsequent research suggests that part
and we’ve already used a full tank of gas.” of the problem was that the Bank of Japan
waited too long to begin LSAPs, so that defla-
Abnormal situation tionary expectations were already entrenched.
This is a worse fire than any of us have ever The BoE and other central banks took a les-
seen in our lifetimes, and we are farther from son from that, citing the example to motivate
home than we have ever been, and so we their rapid reactions in 2008-09.19 Another
cannot judge our progress by how much source of the difficulty the Bank of Japan had
effort or resources we have already put in. with getting maximum effect on prices from
We can only gauge the success of our efforts its QE programme was that the Bank actu-
by our results, and until we achieve those ally bought short maturity bonds, which are
results, there is no danger from our heavy close substitutes for cash and thus would be
use of the available instruments. expected to have only a limited effect on port-
This is not a normal situation with folio behaviour (McCauley and Ueda 2009).
finely balanced risks on both sides or with
monetary policy able to finely calibrate to Manageable risks
an outcome. The persistence of deflation That fact raises a legitimate issue whether
in Japan, despite the Bank of Japan’s own the only assets to be purchased by central
LSAPs of Japanese government bonds banks should be (medium- to long maturity)
from 2003-06, remains a cautionary tale. government bonds, or whether other private
While Krugman (2010a) can legitimately assets (such as corporate bonds, commercial
hoist some of us current central bankers paper, or high quality mortgages) might be
on our own rhetorical petard for inaction, purchased in quantity by central banks as
when we were the very people who loudly well. My feeling has always been that while
upbraided the Bank of Japan for its own purchasing private assets has some risks,
inaction prior to 2003, Japanese commen- notably in terms of public holdings over-
tators can turn that right around. hanging market prices, and of difficulty in
exiting the position in a given asset market
Rhetorical switch when monetary contraction becomes desir-
A Japanese economist friend teased me able, these risks are manageable or at least
recently that once I got inside a central bank, much smaller than the macroeconomic risks
I then realised how difficult it was to get of inaction.
the desired effects from QE, so I had toned In fact, my instinct, and I believe that I
down my rhetoric. I have indeed been less am not alone in this view, is that purchasing
loudly critical of the Bank of Japan’s now private assets should have a larger macroeco-
past actions, but, as I told him, my rhetorical nomic impact than purchasing government

Journal of Regulation & Risk North Asia 125


Figure 3 Investment grade corporate bond spreads
Figure 3. Investment grade corporate bond spreads
basis points
800

Sterling 700

600
Dollar

500

400

300

Euro
200

100

0
y

ay

ay

ay

ay

r
be

be

be

be
ar

ar

ar

ar
M

M
nu

nu

nu

nu
em

em

em

em
Ja

Ja

Ja

Ja
pt

pt

pt

pt
Se

Se

Se

Se
2007 2008 2009 2010
Sources: BofA Merrill Lynch Global Research; Bloomberg; and Bank of England calculations.

bonds, ceteris paribus, because then one is 2010) estimate that the immediate impact
going after risk spreads, as well as liquid- on interest rate spreads of LSAPs are com-
ity issues or term-premia, and potentially parable whether done with public or private
unblocking a distressed market (Nishimura asset purchases. Moreover, the feasibility
2009, Posen 2009a). Further, to the degree of the private assets purchase approach
one believes in the “preferred habitat” view depends upon the availability of different
as a source of QE’s effectiveness, purchasing types of assets and relative depth of mar-
assets that are less perfectly substitutable for kets in a given economy, as I discussed in
cash than government bonds would seem Posen (2009a). In the UK, perhaps sur-
to be the way to go to maximise bang for the prisingly, we have very limited depth and
buck (especially in a liquidity trap). breadth in our markets for corporate bonds
and mortgage-backed securities, and large-
Asset availability scale purchases by the central bank would
Reassuringly, however, the best empirical essentially overtake the whole market.
studies to date of the impact of QE in the
UK (Joyce et al 2010) and of the impact of No acute distress
“credit easing” in the US (Gagnon et al A central bank should not want to have a

126 Journal of Regulation & Risk North Asia


Figure 4 Sterling exchange rate index movements
Figure 4. Sterling exchange rate index movements
index, 01/01/2007=100
Maximum=102.4 QE start=75.2
110

QE end=77.2

Minimum=70.4 100

90

80

70

60
2007 2008 2009 2010

QE = quantitative easing
Source: Bank of England.

monopsony position as a sole buyer of all of or were financial fragility to become acute
an asset class or to make choices about spe- again, I would still want preparation ahead
cific private-sector assets’ relative worth, if it of a “plan B” of large-scale non-Gilt asset
can possibly avoid doing so. So I am com- purchases, in close co-ordination with HM
fortable with the idea that in the UK, if not Treasury. I mean that call for co-ordination
elsewhere, additional monetary stimulus at quite seriously, though it is my place only to
this point should begin in the form of addi- suggest such efforts.
tional QE as the BoE pursued by purchas-
ing Gilts in 2009-10. While we do still have Bank-supported measures
financial dysfunction of the sort discussed The selection of private assets to purchase is
above, we do not have acute asset market rightly done in consultation with, if not by,
distress at present in the UK as we did when elected fiscal authorities, and many forms
QE began (see figure 3, which shows how of direct credit-market intervention would
the spread on even highly rated corporate better take the form of fiscal measures sup-
bonds spiked during the acute crisis, and is ported by the Bank’s actions and imple-
down now though still elevated). mentation. That is no impediment to such
Thus, the potential relative advantage of actions, just a recognition of how in our
credit-market interventions over bond inter- democratic system with an independent
ventions is further narrowed. In case such central bank they should be managed and
QE were to prove insufficiently effective accountability defined.

Journal of Regulation & Risk North Asia 127


I would note that I am not counting on or Doing the right thing
even suggesting that a major channel of QE’s My bottom line is that we have to try fur-
transmission to the UK economy would be ther QE and if necessary other LSAPs now
through the exchange rate. Occasionally one whatever the required scale to have the
hears that LSAPs by central banks is a form needed effect. Fear of looking ineffective
of competitive depreciation of exchange should not be a deterrent to doing the right
rates, and even that the MPC wanted to thing. When facing a worsening situation,
drive Sterling down. If QE were such a ploy, I you work with the tools you have, whether
would oppose doing it – and in fact, nothing you’re a central bank in the aftermath of a
could be further from the truth. financial crisis, or someone stranded on the
road with a car problem when night is fall-
Sterling’s decline arrrested ing. And you try to get help. It is possible
Consider the graph of the Bank’s sterling that further QE will be insufficient on its
effective exchange rate over time presented own to create a sustained recovery because
in figure 4. In March 2009, the BoE began of widespread risk aversion and liquidity
QE, with the index at 75.2. Approximately preference killing investment demand (as
six weeks before QE was announced, the in Krugman 1998).
pound had stopped falling (the index hit If that situation becomes evident, then
a local low of 70.4 in January 2009 from a that is the time for further fiscal stimu-
relative high of 102.4 at the start of January lus, and monetary policy can support such
2007). While this may be mere coincidence, measures. Obviously, the room for fiscal
the claim that the Bank (or MPC) intended stimulus is subject to limitations from the
to depreciate competitively is demonstrably conditions of debt sustainability and market
false. After QE began, the pound moved credibility that any given government faces.
sideways until the euro crisis, and overall is I will not presume to make an assessment
flat between the announcement of our Asset of those conditions for any specific country,
Purchase Programme and the suspension of including the UK.
asset purchases in February of this year (77.2
versus 75.2 on the announcement dates). Low bond rates factor
In Japan’s QE period as well, the yen I will just note that, as a general proposi-
appreciated very strongly, even in the face tion, if QE is less than effective due to per-
of direct currency market intervention to sistent excessive liquidity preference and
sell dollars by the Japanese government on deflationary expectations, economic theory
a huge scale in 2003 and early 2004. It is my says that money-financed fiscal stimulus
belief that from both a UK and a global per- is the right response. The indicator of such
spective, we would be better off if more cen- a situation would be persistently low and
tral banks engaged in LSAPs simultaneously declining government bond interest rates.
(among those for whom stimulus is appro- In practice, it was when fiscal and monetary
priate at present) rather than were the BoE stimulus worked together in conjunction
to do it alone. with a banking clean-up that Japan did

128 Journal of Regulation & Risk North Asia


Figure 5. Spread over bank rate of indicative median interest rates on new SMEa
Figure 5 Spread over bank rate of indicative median interest rates on new SME variable-rate facilities
variable-rate facilities
percent
4.0

3.5

3.0

2.5

2.0

1.5

1.0

Smaller SMEs b

0.5
Medium SMEsc
All SMEs
0
November 2008 May 2009 November 2009 May 2010

SME = small and medium-sized enterprise


a. Median by value if new SME facilities priced at margins over base rates, by four major lenders. Data cover lending in both sterling and foreign currency,
expressed in sterling terms.
b. SMEs with annual bank account debit turnover under £1million.
c. SMEs with annual bank account debit turnover £1 million to £25 million.
Sources: BBA; BIS; Bank of England, Trends in Lending: August 2010; and Bank of England calculations.

grow in the 2000s and emerged from its Financial intermediaries


Great Recession. The intent and the hope for QE as practiced
Let us hope we do not face that dire by the BoE has been that it allowed us to
situation of mounting risk aversion, and I do go around the broken banking system, and
not think it very likely if we undertake more clearly that has to have happened to some
stimulus now, but let us not blind ourselves degree (Dale 2010a, Miles 2010). Yet, our
to the possibility of the situation arising current crisis and its impact bear out the
either. The more likely reason that further importance of financial intermediaries, and
QE might be insufficient to bring about what happens when they are impaired, just
sustained recovery on its own is because of as was the case during the Great Depression
continuing problems in the financial system. in the US.
Simply put, banks given additional liquidity While some lending, like mortgages,
may not lend, as we are currently seeing in can be directly influenced by easing
the UK (Note, this problem and the previous liquidity and interest rate conditions
one of excessive liquidity preference are not through QE, other lending, such as that
mutually exclusive and might in fact tend to on collateral to small business, cannot
occur together.). be so easily replaced. Figure 5 shows

Journal of Regulation & Risk North Asia 129


Figure 6 Lending to small and medium-sized enterprises (SMEs)a
Figure 6. Lending to small and medium-sized enterprises (SMEs)
percent change
20
Small businessesc
All SMEsb

15

10

–5
March 2008 July 2008 November 2008 March 2009 July 2009 November 2009 March 2010

a. Non seasonally adjusted


b. Lending by four major UK lenders to enterprises with annual bank account debit turnover less than £25 million. Data cover lending in both sterling and foreign
currency, expressed in sterling terms.
c. Lending by seven major UK lenders to commercial businesses with an annual bank account debit turnover of up to £1 million.
Sources: BBA; BIS; Bank of England, Trends in Lending: August 2010.

the continuing high interest rate spread view of recovery from the Great Depression
charged on loans to small and medium when intermediation was disrupted.
enterprises (SMEs) in the UK (in con- That failure of the credit system to
trast to the high-grade bond rate coming support recovery is one of several rea-
down in figure 3). sons that others and I continue to call for
further financial reform in the UK and
Long hard slog elsewhere, even though the situation has
Figure 6 shows the declining rate of lend- been stabilised. (See also King 2009 and
ing to small businesses – obviously, some Turner 2010, among others.) The help
of which is due to lower demand given needed for QE to fully succeed and the
prospects, and to higher lending standards UK to recover is to finish recapitalisation
(which is welcome), but not all of it. As I and restructuring of the country’s fragile
worried in Posen (2009a), the issue is not so lending institutions.
much the degree of credit crunch in the cri-
sis’immediate aftermath, as the likely failure Call for more QE
of lenders to support recovery, particularly Make no mistake, having some day-
in the SME sector of the economy. That to-day financial stability as a result of
point is consistent with the long hard slog unprecedented government guarantees

130 Journal of Regulation & Risk North Asia


Figure 7. Frequency distribution of CPI inflation based on market interest rate
a
expectations and £200 billion asset purchases in the August 2010 Inflation Reporta
probability, percent
100
2012Q3
2013Q3

80

60

40

20

0
<1.5 1.5–2.0 2.0–2.5 >2.5

CPI = consumer price index

the future.
Note: Values in each bucket (<1.5 percent, 1.5–2 percent, 2.0–2.5 percent, >2.5 percent) are as follows:
2012 Q3 bars: 47 percent, 13 percent, 11 percent, 29 percent.
2013 Q3 bars: 40 percent, 13 percent, 12 percent, 35 percent.
Source: Bank of England.

and liquidity provision is not the same as years. As I said earlier, my case for doing
having a fully functioning banking system more is not due to some new information
– and the proof of the functionality is in a about the UK forecast, and certainly not due
system’s lending behaviour, not in passing to any data previously unavailable to the
stress tests on either side of the Atlantic. public. Thus, I am not advocating more stim-
But so long as there is some transmission ulus because I am concerned about a double
from our QE efforts to the real economy dip at present.
as well as to prices, we have to try to make
use of it, even in the absence of a fully One state or the other
functioning banking system. In fact, such The main reasons that I had not argued
problems may make our trying further strongly for further ease before now par-
LSAPs all the more important. allel the two topics that I touched upon
I will conclude with why I believe that previously. First, I put on hold my strong
we should do more quantitative easing now presumption that we would not be hav-
in the UK. This is particularly important to ing a “normal” recovery in the aftermath of
address, given that inflation in the UK has a financial crisis in case the data came in
been above target for most of the past four showing that view to be obviously wrong.

Journal of Regulation & Risk North Asia 131


Figure 8 UK and Japanese recoveries in context: Real GDP
Figure 8. UK and Japanese recoveries in context: Real GDP
index t0=100
120

115

110

105

100

Japan (Q3 1993) 95


United Kingdom (Q3 1991)
United Kingdom (Q3 2009)
90
–12 –8 –4 0 4 8 12 16 20 24

quarters from trough in real GDP

Source: OECD and Bank of England calculations.

I believed that the UK economy was going of growth, while welcome, should not
to be in one state of the world or the other. be enough to persuade us that the UK is
I draw attention to figure 7, which can be indeed out of danger of a period of per-
interpreted as consistent with this two- sistent slow growth and soon sub-target
states view: In it, the MPC was indicating inflation.
that our collective view was that we believed Figure 8 plots the path of real GDP
there was a greater than 70 per cent chance levels for three relevant recoveries from a
that inflation would be either well above or recessionary trough in GDP. The line that
well below our target both two and three ends abruptly is obviously the course of
years out and a greater than 50 per cent our present difficulties; the lighter line
chance that it would be below target. shows the course of recovery of UK out-
put from its last recession in September
Sub-target inflation 1991; and the darker line shows the
As I said in Posen (2010b), though I was course of recovery of Japan’s real out-
sceptical about so doing, there was a plau- put from its post-crisis initial trough in
sible case to be made in spring 2010 that September 1993.
global growth and prior stimulus could Some observers would draw attention
combine to give us a recovery in the UK to the fact that our recovery is consist-
better than I expected. I would note, ently as fast, or faster than that in the UK
however, that a couple of good quarters in 1991, at least for the three quarters to

132 Journal of Regulation & Risk North Asia


Figure 9 UK and Japanese recoveries in context: Broad money
Figure 9. UK and Japanese recoveries in context: Broad money
index t0=100
130

120

110

100

90
Japan (Q3 1993)
United Kingdom (Q3 1991)
United Kingdom (Q3 2009)
80
–8 –4 0 4 8 12 16

quarters from trough in real GDP

Note: Japanese M2 +CDs, UK 1991 = M4, UK 2009 = M4 ex. Intermediate “Other Financial Corporations” (OFCs).
Sources: Bank of Japan and Bank of England calculations.

date. I would suggest it is a little early to the non-financial crisis recovery of the
declare victory on that basis, given that our UK in 1991 shows much stronger credit
current recovery is just in pace with the expansion.
Japanese recovery – and we all know how The point is that, in my opinion, recent
that turned out over the subsequent years. data on growth offers insufficient evidence
alone to distinguish which situation the UK
On track with Japan is now in, and the credit comparison with
The current UK recovery also has in com- past recoveries is if anything worrisome.
mon with Japan in 1993 the emergence To have a convincing indication of the UK
from a financial crisis, something not true being in the good situation, I would have
in the UK in 1991, and also has the steep- had to see more than household short-
est pre-trough decline level of output of the term inflation expectations creeping up as
three recessions shown here, so the most a result of past shocks, which is all they did,
ground to make up. One can perform a while other forward-looking UK inflation
similar exercise looking at the development indicators remained quiescent, as they have.
of broad money (that is credit) in these I would have had to see inflation and infla-
three recoveries (see figure 9), and the cur- tion expectations rise in a way inconsistent
rent recovery in the UK is almost precisely with the broad output gap framework that
tracing the track of Japan post-1993, while underlay my priors.

Journal of Regulation & Risk North Asia 133


Sterling’s decline, VAT cited According to the Office of Budget
That has not happened. As I discussed in Responsibility, a roughly equal number of
Posen (2010b), the response of actual con- jobs are forecast to be lost over the next four
sumer price index (CPI) inflation over the years in the private sector companies that
past couple of years may represent a small serve the public sector as in the public sec-
upward creep in backward-looking inflation tor directly. It seems impossible to have an
expectations by households, but the actual inflationary wage spiral under such circum-
target misses were largely due to sterling’s stances. Sterling’s exchange rate has been
depreciation in 2007Q4-2009Q1 and value- basically stable for the past 18 months, so no
added tax (VAT) increases. further inflation should come from that cor-
I agree with the MPC’s August forecast ner over the forecast horizon.
that, over time, excess capacity will bear
down on inflation in the UK, even though Credit growth stalls
our cumulative past target overshoots have The financial market measures of UK infla-
probably delayed that process. In a recent tion expectations, which the Bank moni-
more statistical analysis, Fathom (2010) tors, like five-year-five-year forwards on UK
comes to a similar conclusion. government bonds and the price of inflation
indexed Gilts, are consistent with a declin-
‘Positive’ forecast errors ing inflation forecast more than a year out.
They note that UK inflation forecast errors Many of our major trading partners, from
of late have been positive and tended to Ireland to the US, are showing declines in,
reinforce each other and include non- and further downside risks to, their growth
import products, all consistent with some (although Germany is an exception to date).
general drift, but that the upward drift is Credit is not growing, especially not to small
quite small and the trend for inflation – after and medium business.
next year’s VAT rise is taken into account – And behind all of this, there is the down-
is still forecast to be downward, albeit not ward pressure from our low level of gross
as soon as one might have thought in the domestic product (GDP) and of growth
absence of our past overshooting of target. versus where we were before the crisis hit
Ultimately, though, the MPC has to look the UK or would be now, had we grown at
forward, and except for the coming VAT trend rates since then. None of this presents
increase, all determinants of inflation sug- an inflation threat. Thus, the MPC defi-
gest that declines in UK inflation will occur nitely should not respond to a one-time VAT
over the next two to three years to well below increase by tightening policy, however much
target. Private sector wage settlements are it shows up in the CPI contemporaneously.
running at two per cent or less (excluding
bankers’ bonuses), which should be well ‘Core’ inflation
below productivity growth. The entire pub- As my co-authors and I stated about inflation
lic sector workforce will be affected by wage target design in Bernanke et al (1999, 27) a
freezes (as contracts come up) or job cuts. decade ago:“[The target] index should exclude

134 Journal of Regulation & Risk North Asia


price changes in narrowly defined sectors and simultaneous globally – an export growth
one-time price jumps that are unlikely to affect constraining external environment that
trend or ‘core’ inflation – for example, a rise in Japan did not face. My expectation about
the value-added tax or in a sales tax. the effectiveness of UK and global policy
“The index chosen should exclude measures were that they were a good effort
at least the first-round effects of such but would prove insufficient and had to be
changes.” Imagine if the coalition govern- sustained. As with the overall outlook, I was
ment had proposed a revenue equivalent open to data disproving those assumptions.
rise in payroll tax instead of a VAT increase.
In terms of short-term macroeconomic Just one vote
impact, the two measures are roughly the That has not happened, either, so far as I can
same in hitting citizens’ purchasing power tell. I have tried to convey my reasons for
and being collected continuously, but one believing that in general terms it is right for
shows up by design as an increase in the central banks to undertake more monetary
CPI and the other does not. stimulus in the coming months, and why
The MPC would be wrong to tighten in we should do so through LSAPs, even if we
response to such a tax increase, just because cannot promise that such measures on their
of a difference in labelling. The second thing own guarantee sustainable recovery.
that I was waiting for before calling for Of course, I cannot presume to speak
more stimulus was that I also wanted to see to the forecast, mandates, and other cir-
whether I had significantly underestimated cumstances of any specific central bank but
the simulative impact of prior QE and other my own, and my role at the BoE is that of
measures undertaken to date by the UK and being just one vote on the Monetary Policy
global policymakers in response to the crisis. Committee. For the UK at least, I believe
On one hand, as my research on Japan that the case is clear and consistent with the
indicates, early response by countercyclical MPC meeting our inflation target in future.
macroeconomic policy should make a posi- In fact, absent further monetary stimulus, I
tive difference, and the fact that it was glob- would expect UK inflation to fall well short
ally co-ordinated should have reinforced that of the target in 2012 and 2013, perhaps re-
effect. On the other hand, as my research on inforcing a persistently low-growth outcome
Japan also indicates, the actual size of the fis- as in Japan in the 1990s. Leaving our specific
cal measures implemented and the actual mandated target aside, some critics deem
transmission of the monetary ease under- today’s macroeconomic efforts to stimulate
taken are what count, not just the direction. the economy selfish, impatient, or short-
It is not a valid argument to say that sighted, despite the severe recession.
central banks have done much more than
they have ever done before, and therefore Loose credit ‘party’
it must be enough. And the admirable co- They tell us that we have had a party on
ordinated global policy response was also loose credit for the past few years (or longer),
necessary because the shock was essentially and we should cut back now so as not to

Journal of Regulation & Risk North Asia 135


leave future generations with our debts or and credit growth, in contrast to the usual
inflation. While this view has some merits pattern of post-financial crisis stagnation, it
in certain policy discussions, it misses two would have been evident by now. Absent that
important points with regard to this discus- kind of surprise, the analysis of mainstream
sion about monetary policy today. macroeconomics should apply, as it did in
First, the damage to our economy, our Japan in the 1990s and in the US and Europe
companies, and our workforce can be made in the 1930s, and a whole host of other cases.
permanent through inaction by policymak-
ers – this is not just about getting through a Elusive target
bad patch, being impatient about a return Historical experience tells us that inflation is
to growth and employment. The policy not a threat. If anything, it should be unsur-
challenge is about getting out of a self- prising that it has already taken more mon-
perpetuating negative outcome that would etary stimulus for longer than we expected
erode many of our children’s future as well. to try to get inflation safely onto a consistent
Second, and related, periods of persistently near-target path, and we are not there yet.
sub-potential growth and underemployed Instead, comparable experience tells us
resources erode political moderation and the that persistent high unemployment and out-
liberal governments we also must pass on to put gaps are the major threat to both price
future generations (Posen 2005). stability and to our long-term potential, that
Let us not forget that it was sustained persistently slow growth erodes aggregate
high unemployment and austerity, the supply and future growth, that a globally
sense that governments were unresponsive synchronised downturn for 50 per cent of
to average people’s dire economic condi- the world economy is going to be worse than
tions that led to the rise of extremist intol- one that hits only one country or region, and
erant parties in pre-war Europe. As we have that a great deal of unconventional mone-
seen sparks of late, thankfully limited, it can tary stimulus will be needed to have a major
also lead to less liberal economic relations impact when the financial system remains
between nations, or even trade wars. This is dysfunctional and risk aversion is very high.
a question of doing what is necessary to pre- That is the case for doing more now. •
serve the system we have, not to fine-tune
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Barclays Capital 14th Annual Global Inflation-Linked Tucker, P. 2010. Inflation, Growth and Stabil-
Conference, New York, June 14. Available at www. ity: Balancing the Bank of England’s Economic
bankofengland.co.uk. Priorities. Speech to the Institute of Economic
Posen,A., and N.Veron. 2009.A Solution for Europe’s Affairs 7th Annual Conference: The State of
Banking Problem. Policy Briefs in International Eco- the Economy, London, February 23. Available at
nomics 09-13 (June).Available at www.piie.com. www.bankofengland.co.uk.
Reinhart, C., and V. Reinhart. 2010. After the Fall. In Turner, A. 2010.The Future of Finance. Speech at the
Macroeconomic Challenges:The Decade Ahead, Fed- London School of Economics conference on the
eral Reserve Bank of Kansas City. Available at www. Future of Finance, July 24.Available at www.fsa.gov.uk.
kansascityfed.org. Ujikane, K. 2010.“Bank of Japan Board Member Miyao
Shimizu, Y. 2000. Convoy Regulation, Bank Manage- Sees Growing Risk of Prolonged U.S. Slump.” Bloomb-
ment, and the Financial Crisis in Japan. In Japan’s Finan- erg, September 22.Available at www.bloomberg.com.
cial Crisis and Its Parallels to US Experience, ed. R. Veron, N. 2010. “Detailed Disclosure Is the Key to
Mikitani and A. Posen.Washington: Institute for Inter- Stress-Test Success.” Eurointelligence, July 15.Available
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Shiratsuka, S. 2009. Size and Composition of the Cen- Wall Street Journal. 2010.“Opinion:What Should the
tral Bank Balance Sheet: Revisiting Japan’s Experience Federal Reserve Do Next?” September 9.
of the Quantitative Easing Policy. Bank of Japan IMES
Discussion Paper 2009-E-25.Tokyo: Bank of Japan. Editor’s note
Smets, F. 2010. Comments on Modelling Inflation After The publisher and editors of the Journal
the Crisis. In Macroeconomic Challenges:The Decade wish to thank Adam Posen and the Peterson
Ahead, Federal Reserve Bank of Kansas City.Available Institute for International Economics for
at www.kansascityfed.org. allowing us to reproduce an abridged ver-
Stiglitz, J. 2010. “Time to Build a Better Stimulus.” sion of this paper. Copyright for this article
Politico, September 15.Available at www.politico.com. remains the sole preserve of Mr Posen.

140 Journal of Regulation & Risk North Asia


Macroprudential policy

Macroprudential policy
perspectives: Emerging markets
Ramon Moreno of the BIS enquires, from a
macroprudential angle, about policy tools
utilised during the 2008 financial crisis.

The landscape for financial stability in would be amplified by booms in the prices
emerging market economies (EMEs) has of leveraged assets. Risks could materialise in
changed considerably since the first half the event of sudden capital inflow reversals.
of 2009. From having to deal with severe An important question is what tools are
financial stress and the impact of a steep available to manage the two effects cited
decline in global demand, EMEs now earlier. Raising interest rates is the stand-
seem to be confronting issues similar to ard response to deal with an increase in
those they faced before the bankruptcy aggregate demand, but it could attract more
of Lehman Brothers in September 2008. capital inflows and lead to appreciation pres-
sures, so it poses a dilemma. Furthermore,
Capital flows into EMEs are back, and given whether interest rate policy is an appropriate
current account surpluses and (in some instrument to deal with the financial stability
cases) efforts to manage exchange rates, for- implications of bank credit growth and asset
eign reserves are rising. This could have two prices is still the subject of debate.
effects, (i) an increase in aggregate demand
with a concomitant risk of inflation; (ii) an Different tools
increase in bank credit growth and asset Partly in response to these considerations,
prices, increasing financial fragility. EMEs have in the past used a number of
Rapid credit growth can mean deteriora- tools to supplement interest rate policy.
tion in credit quality over time, disguised by There seems to be a consensus that policy
rapid economic growth that may prove tran- instruments used with a view to preserv-
sitory. Credit growth could also be associated ing the stability of the financial system as a
with growing risks of spillovers or contagion, whole – beyond those needed to assure the
either due to common exposure to risky sec- stability of individual institutions – may be
tors (e.g. property markets) or networks link- considered “macroprudential”. Beyond that,
ing financial institutions (e.g. the interbank however, views on the appropriate defini-
market and payments system). The risks tion of macroprudential instruments differ.

Journal of Regulation & Risk North Asia 141


One view is that the definition should be during downturns); the interaction between
relatively narrow. In many cases, authorities macroeconomic conditions and the financial
have used “micro prudential” instruments system; and finally, the possibility of damp-
(e.g. in capital or loan-loss provisioning ening procyclicality in the financial system.
requirements, or loan-to-value ceilings) or The form of intervention broadly
monetary instruments (e.g. reserve require- falls under the following four groups. (i)
ments) in ways that seek to limit the build- Measures to control capital inflows; (ii)
up of systemic risk and preserve financial Foreign exchange market intervention and
stability over the business cycle (rather than foreign reserve accumulation; (iii) Measures
focusing on risks to individual banks). These to strengthen bank balance sheets and capi-
policy measures can thus be seen as reflect- tal; (iv) Measures to maintain the quality of
ing a“macroprudential”view. credit or to influence credit growth or allo-
cation. Each may have a bearing on finan-
Macroprudential instruments cial stability and thus have macroprudential
Experience has shown that three types of dimensions but may also reflect other goals
macroeconomic and financial risks are par- (e.g. stabilising the exchange rate or control-
ticularly relevant for small open emerging ling inflation). Each of these are detailed in
market economies. First, risks of spillovers the following paragraphs:
and contagion from international markets
(capital inflow reversals, interruptions in for- Measures to control capital inflows: Many
eign currency liquidity, and financial effects central banks value a regime of floating
of rising fiscal burdens). Second, domestic exchange rates because it reminds financial
credit and market risks from rapid credit markets of foreign exchange risk – and so
growth and booms in asset prices. Third, creates the right incentives for risk manage-
risks of domestic contagion/spillovers arising ment. Hence such a regime is seen as having
from common exposures (e.g. possible fire macroprudential benefits. But even under
sale externalities) and network links (see fol- floating, central banks intervene in foreign
lowing discussion on signals to respond to). exchange markets to dampen exchange rate
Policymakers in EMEs have sought to volatility, or to accumulate foreign reserves.
limit these risks during the extended period This is also apparent in rapid accumulation
of expansion in the 2000s by using what are of foreign reserves in this decade.
traditionally seen as “monetary” or “micro
prudential” tools but that are now applied Booms and busts
with a “macroprudential’ perspective. The Foreign reserve accumulation poses trade-
consensus on what this means is still evolv- offs. On the one hand, foreign reserves can
ing but there appears to be a focus on the be seen as a kind of macroprudential tool
following: Financial stability or containing that increases resilience during episodes of
systemic risks, rather than risks to individual financial stress. On the other hand, very large
financial institutions (i.e. to improve finan- and persistent inflows and related increases
cial system resilience in the face of shocks or in central bank foreign assets almost always

142 Journal of Regulation & Risk North Asia


expand the balance sheet of the banking than for a loan denominated in local cur-
system. This can support booms in credit rency; higher capital or loan loss provision-
and asset prices that could then be followed ing for foreign currency lending exceeding
by collapses. certain thresholds to domestic residents
such as households; prohibiting foreign cur-
Reserve adequacy rency borrowing by those borrowers with
Assessing this trade-off depends in part no foreign currency earnings or assets (e.g.
on whether foreign reserve holdings are in Argentina lending in foreign currency
thought to be adequate. A complication is to borrowers outside the export sector is
that in recent years there has been re-exam- restricted).
ination of criteria for reserve adequacy. The
costs of foreign reserve holdings, and the Rules for liquidity risks: Foreign currency
feasibility of alternatives: (e.g. central bank liquidity requirements are sometimes
swaps or the IMF FCL) are also relevant imposed, with higher liquid asset require-
considerations. ments on shorter-term liabilities. Estimates
of foreign currency liquidity (both at indi-
Foreign exchange market intervention vidual bank and aggregate levels) can be
and foreign reserve accumulation: Steps supplemented by stress tests on the impact
taken have included: (a) limits to net open of currency fluctuations. Some countries
positions of financial institutions; (b) more have used differential reserve requirements
stringent requirements on foreign currency to encourage local currency intermediation.
lending; (c) rules for liquidity risks; (d) rules
re currency and maturity mismatches; (e) Rules re currency and maturity mismatches:
capital requirements; (f) loan-loss provision- Goldstein and Turner (2004) argued that
ing requirements. regulators, in addition to overseeing mis-
matches in individual institutions, must
Limits to net open positions of financial monitor aggregate mismatches in the bank-
institutions: These are often defined as a ing system as a whole. There are two reasons
ratio to capital, supplemented by allowance for this. One is that those responsible for the
for forward transactions, at a point in time. detailed supervision of individual institu-
However, a key limitation is that borrowers tions need guidance as to what is important
may still be exposed; an example is borrow- in quantitative terms.
ing by households in foreign currency (euros
and Swiss francs) in central and eastern Maturity mismatches
Europe. Another is that individual institutions acting
in isolation may overestimate their ability
More stringent requirements on foreign cur- to hedge foreign exchange or interest rate
rency lending: This includes requiring higher risk over a short period of time during a cri-
creditworthiness from a customer who sis. As for maturity mismatches, banks are
applied for a foreign currency housing loan often required to construct explicit“maturity

Journal of Regulation & Risk North Asia 143


ladders,” so that they can calculate excesses of capital than the 8 per cent minimum tra-
or deficits (liquidity gaps) at selected matu- ditionally set under Basel I (e.g. 11 per cent in
rity dates – next day, next week, next month, Brazil and 9.5 per cent in South Africa), and
next year. These estimates could be subject actual capital ratios are often well above reg-
to stress tests. Aggregating the liquidity gap ulatory minima; e.g. until 2007 the ratio for
analysis of individual banks to construct Saudi banks averaged around 20 per cent; it
maturity ladders for the whole economy can was still over 16 per cent in 2009. High capi-
be very useful. tal ratios appear to reflect the recognition
that EMEs need to deal with volatile eco-
Liquidity shortfalls nomic and financial conditions. In line with
This could help to analyse liquidity risk in this, and as discussed below, there has been
the banking system as a whole, giving early much emphasis on improved quantity and
warning of liquidity shortfalls at particular quality of capital and capital conservation in
maturities for the entire banking system – relation to Basel III.
this is the macroprudential dimension. But Second, recent experience has high-
the extent to which this has been done has lighted the need to also take into account
apparently been limited. fire sale and network externalities when
Some authorities (e.g. the Saudi Arabian estimating capital adequacy. Gauthier, Lehar
Monetary Agency) have also required: (i) and Souissi (2010) find that systemic capital
bank self assessments of liquidity risk under allocations that reflect such externalities can
Pillar 2 of Basel II; (ii) the maintenance of differ by as much as 50 per cent from 2008
high overall liquidity ratios; and (iii) limits Q2 capital levels.
on loan-to-deposit ratios. Liquidity risks
also arise from fire sale externalities or net- Loan-loss provisioning requirements: Loan-
work externalities, which could be addressed loss provisions have in the past often been
with higher liquidity or capital adequacy set too low to cover loan losses, particularly
requirements. prior to crises, with significant macropru-
dential implications. However, provisioning
Capital requirements: Traditionally, capital and loan loss reserves have increased con-
has been seen as a way to deal with unex- siderably since the 1990s.
pected losses, and the amount needed was
estimated focusing on individual bank prob- Capital adequacy
lems. More recently, there has been more The median ratio of provisions to non-per-
emphasis on the need for capital buffers to forming loans (NPLs) in a set of EMEs was
take into account of systemic or macroeco- 120 per cent in 2007, before the crisis sig-
nomic risks. Two points may be highlighted: nificantly affected EMEs. This compares to
First, EMEs have a great deal of experi- 66 per cent at the beginning of the decade
ence with macroeconomic and financial and 146 per cent for the US. Issues of cycli-
sector volatility. This may explain why many cality of loan-loss provisioning are discussed
EME authorities require much higher levels in the next section. One factor has been

144 Journal of Regulation & Risk North Asia


convergence with international norms (e.g. by China, Korea and Thailand in the 2000s
improved loan grading and provisioning and and by Malaysia in the 1990s.
convergence towards international account-
ing standards such as IAS39). Another is Direct measures to limit credit: Since the
discretionary increases that bring provision- mid-1980s, most direct controls on bank
ing closer to expected loss. For example, in lending have been dismantled because they
Asia provisioning increased starting around undermined the efficiency of financial inter-
the middle of the 2000s, during the period of mediation. Nevertheless, several countries
credit growth. have used credit ceilings more recently (e.g.
Indonesia), and China has used window
Procyclicality and contagion risks guidance (involving consultations between
An important question is how various the authorities and the banks) to curtail
requirements to strengthen bank balance lending. Korea maintains a so-called aggre-
sheets (e.g. capital adequacy ratios, loan gate credit ceiling (set by the Monetary Policy
loss provisioning requirements, or maturity Committee) targeting credit to small and
mismatches) need to be adjusted to take medium enterprises. This ceiling was low-
into account of macroprudential concerns, ered from KRW9.6 trillion until end 2006 to
specifically procyclicality and contagion or KRW6.5 trillion by July 2007 and was then
network risks. raised in response to the crisis to KRW10
trillion.
Measures to maintain the quality of credit
or to influence credit growth or allocation: Reserve requirements: Although there are
Loan-to-value (LTV) ceilings on mortgage well-known drawbacks, reserve require-
loans have been used in a number of EMEs ments are less costly to authorities and are
to limit credit risks, including in China, Hong less distortional than controls on bank lend-
Kong SAR, Korea, Malaysia, Singapore, ing. Furthermore, reserve requirements can
Thailand and Turkey. Furthermore, LTV ceil- be increased when capital inflows and large
ings have in some cases been imposed or foreign reserve accumulation lead to a strong
lowered during periods of booming property rise in the liquid assets of the banking sys-
markets, thus tending to dampen the procy- tem. For example, in China, reserve require-
clicality of LTV ratios. ments were raised by 10 percentage points
For example, starting in October 2009 the to a peak of 17.5 per cent between July 2006
Hong Kong Monetary Authority (HKMA) and June 2008.
reduced the ceiling on the LTV ratio for
high-value properties twice, from 70 per India reserves move
cent to 50 per cent, in the context of sharp They were subsequently lowered starting
increases in property prices. Debt-to-income in October 2008 to 15 per cent but were
or debt service-to-income rules, that would later raised once more. In India, starting in
tend to ensure credit flows to those with a December 2006, reserve requirements rose
greater ability to repay, have also been used four percentage points, to a peak of nine per

Journal of Regulation & Risk North Asia 145


cent in October 2008. They then fell to five important non-bank financial institutions.
per cent but were raised in February 2010 In Brazil, reserve requirements have been
to six per cent. A similar pattern of rising or eased in such a way as to target priority
falling reserve requirements counter to the sectors. Lower reserve requirements fol-
credit cycle was also observed in this decade lowing the Lehman bankruptcy released
in Brazil and Saudi Arabia. an estimated R$116 billion (about US$69.8
billion today), or four per cent of GDP
Taxes on lending: At least one country (2009 prices). An innovation was the use of
(Turkey) has resorted to (indirect) taxes on rebates in reserve requirements to encour-
lending, specifically on consumer loans age purchases of bank assets and of foreign
(and also short-term commercial loans currency (as a way of offsetting the con-
from abroad). This tax, known as the tractionary impact on liquidity of US dollar
Resource Utilization Support Fund (RUSF) sales by the central bank).
has been used countercyclically and is set
by taking into account the level of capital Deductions allowed
inflows and credit conditions in the mar- Specifically, deductions of reserve require-
ket. For example, in order to reduce credit ments on deposits from leasing compa-
growth in Turkey the RUSF rate on con- nies and on time deposits were allowed
sumer loans granted by banks and financial if these were used to buy assets from
institutions was increased to 15 per cent other banks subject to certain restrictions,
from 10 per cent on 15 August 2004. It was or to buy US dollars. An interesting fea-
lowered back to 10 per cent on 16 March, ture of the use of reserve requirements to
2009, in order to boost consumption. Other encourage asset purchases is that they are
taxes related to financial services may also an alternative to having the central bank
be used in a similar way. expand its own balance sheet to under-
take asset purchases.
Targeting certain sectors: Authorities in some
jurisdictions have increased loan loss pro- Measures to control capital inflows:
visioning requirements (and in at least one Sudden changes in capital inflows have
case risk weights for computing capital ade- been a major contributor to financial insta-
quacy) to target certain sectors in a number bility in the EMEs over several decades.
of EMEs. For example, selective adjustments Detailed country experiences are discussed
of risks weights for housing loans, consumer in BIS (2008). Capital controls have therefore
credit and commercial real estate were been justified (rightly or wrongly) on finan-
implemented in 2005 in India. cial stability grounds.
While foreign currency borrowing has
Lower reserve requirements generally been liberalised, a number of
Furthermore, risk weights and loan loss EMEs still impose restrictions. For exam-
provisioning requirements were raised in ple, in the 2000s, Argentina has maintained
2007 on banks’ exposure to systemically a number of controls on foreign currency

146 Journal of Regulation & Risk North Asia


borrowing, including minimum holding A macroprudential view introduces an
periods and unremunerated reserve require- additional dimension to the discussion of
ments. Similar measures have been imple- economic stabilisation policies by focusing
mented in Colombia and had been used not only on inflation, but also considering
in the past in Chile. India traditionally has the possible effects of capital inflows on
maintained restrictions that seek to encour- credit, asset prices, risk-taking behaviour and
age FDI and limit external borrowing, partic- ultimately financial stability.
ularly short-term. More recently, in order to
curb portfolio inflows, the Brazilian govern- Supplementary instruments
ment reintroduced a financial transactions These effects tend to be related to business
tax on foreign capital investment, to apply and financial cycles, so many issues that
to local bonds and equities (but not on for- arise in discussions of monetary policy also
eign direct investment), setting it at two per are relevant for the use of supplementary
cent. However, some central banks see dis- instruments. It may be noted further that
advantages in capital controls (e.g. economic supplementary instruments sometimes
distortions, reductions in availability of directly influence the quantity of financing
financing, and higher costs of international as well as its cost, which may imply that
trade) or do not consider them feasible (e.g. they may be less “market-friendly” as well
in the EU). as more effective than interest rate policy.
As is well known, capital controls The issues we will consider here are:0 (1)
involve significant trade-offs. On the one What signals to respond to; (2) timing of
hand, they can help contain financial stabil- prudential measures and cyclicality; (3)
ity risks (e.g. exchange rate volatility, capital effectiveness and calibration.
inflows and credit booms, risks of capital
inflow reversals); on the other hand they What signals to respond to? Experience with
can cause distortions and impair financial crises has led to a number of indicators or
development. In particular, less onerous (or analysis that can guide policy responses by
more market friendly) measures are more shedding light on resilience, imbalances and
likely to be circumvented. systemic risks:
Indicators of the financial system’s resil-
Instructive learning curve ience: Starting this decade, a set of Financial
Relevant questions include (i) whether capi- Soundness Indicators (including capital ade-
tal controls are in fact macroprudential tools quacy ratios, loan-loss provisions, and bank
or motivated by other considerations; (ii) profits) covering a large number of countries
what factors determine whether countries is now regularly reported, although these
apply controls or not. Policymakers in EMEs indicators tend to be backward looking.
appear to disagree on the relative merits of Indicators of macroeconomic or financial
capital controls and these views appear to imbalances that could lead to crises. – The
vary over time; understanding the reasons predictive ability of some of these indica-
can be instructive. tors has been tested in empirical models

Journal of Regulation & Risk North Asia 147


of early warning systems of crises. In some central bank of Mexico using macro stress-
cases, authorities have developed monitor- testing suggests that the impact can be large
ing systems to assess the possible build-up even if these events are rare. The capacity to
of imbalances in the short-run. For example, assess this kind of impact has recently been
some authorities have systems to moni- enhanced by advances in incorporating a
tor capital movements, or monitor statistics banking sector in general equilibrium mod-
that highlight specific areas of banking sys- els, such as in work at the Bank of Canada.
tem exposure to currency and maturity
mismatches as well as repayment capacity. Common exposures: This could lead to a
Along these lines, one Asian EME has made simultaneous weakening of the financial
efforts to establish a balance of payments system that could increase vulnerability to
risk warning system, to assess the trend and the failure of one bank. It could also imply
the risks of cross-border capital movements fire sale externalities, because efforts by a
and develop contingency plans to deal with bank to meet its obligations could prompt
possible extreme circumstances. it to sell assets at fire sale prices, prompting
(under mark-to-market accounting) sharp
Monitoring mechanisms reductions in the value of other financial
The authorities (foreign exchange, tax and institutions holding similar assets. Network
customs, and public securities authorities) externalities, arising because a bank is
have also developed a co-ordinated “abnor- exposed (e.g. in the interbank market) to a
mal capital flows” monitoring mechanism. counterparty which might be unable to pay
In some cases, tracking mechanisms are its liabilities.
quite elaborate; for example in one Latin Some of this work reveals new areas of
American country, foreign exchange trans- vulnerability that were less obvious before
actions involving the banking sector are reg- the recent global financial crisis. For exam-
istered electronically, and FDI and portfolio ple, a recent study by the Bank of Mexico
transactions are captured in real time. suggests that under some stress scenarios,
the failure of a small bank as a result of mar-
Indicators of systemic risks: Recent ket risk could trigger widespread disruption
research at central banks has clarified cer- in the financial system. This implies that
tain types of risks to the financial system it is not enough to worry about “too big to
that traditionally are not the focus of micro fail”institutions; smaller institutions that are
prudential regulation. In time this could highly networked could pose risks too.
facilitate interpretation and systematic
monitoring of common exposures and net- 50pc differential
work links that could have systemic impli- In line with this, in work by economists at the
cations. Key topics include: Bank of Canada, Gauthier et al (2010) find
The impact of (extreme) macroeconomic that systemic capital allocations that reflect
shocks on the financial sector; Some recent fire sale and network externalities can dif-
work by the central bank of Brazil and the fer by as much as 50 per cent from 2008 Q2

148 Journal of Regulation & Risk North Asia


capital levels and are not related in a simple up in statistics. To illustrate, during the recent
way to bank size or individual bank default crisis corporations suffered large losses from
probability. While there has been some pro- derivatives exposures in foreign exchange
gress, the performance of empirical models markets in Mexico, Brazil and Korea.
of imbalances or early warning systems is EME central banks at BIS meetings have
mixed and there are a number of difficulties indicated that they relied on “market intelli-
of interpretation of data. gence”to help interpret available data. Which
For example, it is hard to tell when pre- data collection needs to be better focused
cisely deviations from the trend of credit or reduced remains an important question.
raise major vulnerability concerns given Whether certain types of regulation to limit
that rapid credit growth is desirable in financial innovations (e.g. limits to deriva-
fast-changing economies with large profit tives transactions such as those imposed on
opportunities and as part of financial deep- Colombia) are needed due to difficulties in
ening (e.g. Latin America). To clarify these assessing risks associated with such innova-
issues requires more systematic research tion is also a relevant question.
and a better understanding of the nature of
systemic risks and how these are related to Timing of prudential measures and
macro­economic outcomes. procyclicality: Much of the discussion
regarding the timing of macroprudential
Default data lack measures pertains to how these measures
Interpreting data and assessing risks in EMEs should be applied over the cycle. This is
also poses challenges. For example, there are partly because regulatory provisions (e.g.
still difficulties in assessing credit risk in indi- capital requirements, loan-loss provi-
vidual financial institutions, notably from sions and LTV ratios) are often procyclical.
fast-growing sectors, such as consumer and For example, loan-loss provisions tend to
mortgage lending, due to incomplete default decline as measured NPL ratios tend to fall
history data. Furthermore, systemic risks are during periods of expansion.
not fully understood. Information on inter-
bank exposures may also be limited or not Supplementary tools
easily analysed. The market itself is procyclical as risk spreads
Deregulation and deepening of financial tend to narrow during the expansion-
markets further accentuate these challenges. ary phase of the business cycle – and then
In this setting, detailed data on capital flows widen, sometimes abruptly, in downturns.
or the operation of the financial system can In this setting, from a risk-management per-
become harder to interpret or may still be spective, supplementary tools ideally would
insufficient to pinpoint risks. One reason be imposed early and in a manner that
is that changing risk exposures associated takes into account risks should economic
with financial innovations (e.g. through use conditions deteriorate (i.e. they should “see
of derivatives) or the use of over-the coun- through the cycle”).
ter transactions may not immediately show Some argue that measures should be

Journal of Regulation & Risk North Asia 149


applied countercyclically, i.e. tightening dur- benign periods probability of default esti-
ing periods of expansion and easing during mates used in the internal-ratings based
periods of contraction. approach might understate actual default
probabilities.
Recent thinking Forward-looking provisioning: The Basel
Illustrating the recent thinking of regu- Committee is supporting a move towards
lators on this issue, and in response to the an expected loss approach in accounting
crisis, the Basel Committee on Banking standards. This is in line with risk manage-
Supervision is taking a number of steps ment considerations that suggest that loan-
(in the context of Basel III) to mitigate pro- loss provisions should be forward-looking,
cyclicality. These include: (i) assessing and i.e. take into account expected credit losses
dampening the cyclicality of minimum over the medium term. In contrast, account-
capital requirements; (ii) encouraging for- ing standards (notably IAS 39) traditionally
ward-looking provisioning; (iii) adopting a require banks to provision based on specific
regulatory framework for capital conserva- “incurred loss”not expected loss.
tion and countercyclical buffers; (iv) intro-
ducing a minimum leverage ratio. Countercyclical movement
While the adoption of international account-
Dampening cyclicality of minimum capi- ing standards contributes to financial sta-
tal requirements: Apart from steps taken to bility by limiting the scope for arbitrary
deal with procyclicality taken previously in earnings manipulation, in a number of cases
the context of Basel II (e.g. the requirement it has implied lower loan-loss provisioning
to use long-term data horizons to estimate than many supervisors would have consid-
probabilities of default, or the use of so-called ered prudent during the expansion phase of
downturn loss-given-default estimates), the the cycle.
Basel Committee has been monitoring the In practice the ratio of loan loss provi-
impact of the Basel II framework on mem- sions to NPLs appears to have moved coun-
ber countries over the cycle and will initiate tercyclically in some EMEs (e.g. in Latin
steps to counter procyclicality if it is found to America, Russia and Korea), rising during
be excessive. the period of expansion in the 2000s, and
falling as the full impact of the financial crisis
Supervisory review hit EMEs following the Lehman bankruptcy.
The Committee also adopted a require-
ment that banks calculate a stressed Capital conservation and buffers: Basel III
value-at-risk, which will help reduce the promotes the conservation of capital and the
procyclicality of the minimum capital build up of buffers that can be drawn down
requirements for market risk. (countercyclically) during periods of finan-
Other measures have also been exam- cial stress. One element of this framework
ined, including the use of supervisory review involves a capital conservation buffer that
(Pillar 2) to take into account that during will require banks to hold an additional 2.5

150 Journal of Regulation & Risk North Asia


percentage points of common equity Tier 1 plus off-balance sheet exposures) of three
capital above the regulatory minimum capi- per cent has been introduced. A supervi-
tal requirements. Because it can be drawn as sory monitoring process has already begun
banks experience losses (unlike the mini- focusing on the development of templates to
mum requirement), it reduces pressure to track in a consistent manner the underlying
cut credit during downturns. components of the ratio and results.
However, restrictions on distributions
(e.g. dividends, share buybacks and discre- Supplementary measures
tionary bonuses) will be imposed on a bank At the micro level, the leverage ratio can
when its capital level falls within a published help counter possible deficiencies in risk
range in order to conserve capital. An addi- measurement and weighting (the crisis-
tional element of the framework involves a revealed that even highly-rated assets could
countercyclical buffer that would extend the experience large losses). At the macro level,
conservation buffer by up to an additional the leverage ratio can help dampen procycli-
2.5 percentage points. cality by avoiding a sharp build up of lever-
During periods of expansion, and in age in the system that is suddenly reversed,
response to certain reference indicators (e.g. and by reducing the scope for circumventing
unusually rapid growth in the ratio of credit risk-based requirements.
to GDP), an increase in this buffer would be Apart from the steps taken by the Basel
encouraged through the same restrictions Committee, procyclicality can be further
on distribution that apply to the conserva- countered by supplementary macropruden-
tion buffer. The buffer can then be released tial measures, particularly when capital has
by authorities in response to incipient finan- been at its maximum for an extended period
cial strains (e.g. aggregate losses or tighter and there are signs of continued booms in
credit terms). credit and asset prices. Indeed, some author-
ities have implemented macroprudential
No rigid formula measures in a way that counters the cycle.
Drawdowns of this countercyclical buffer One example is the countercyclical use of
will not be subject to any restrictions on reserve requirements described previously.
distribution, in order to encourage banks to
use it when needed. There is also more dis- Social goals
cretion in the use of this tool: the buildup of Another example is lowering loan-to-value
this buffer is based on judgment rather than ratios during periods of increases in credit
a rigid formula, and the decision to release or property prices, as was done by the Hong
the buffer would only involve meeting some Kong Monetary Authority in October 2009.
general guidelines. A lower LTV ratio reduces procyclicality.
Apart from this, regulation could attempt to
Minimum leverage ratio: A minimum tier make collateral valuations less sensitive to
1 leverage ratio (the ratio of Tier 1 capital asset prices.
to the bank’s total non-weighted assets One difficulty is that if restrictions are

Journal of Regulation & Risk North Asia 151


eased during downturns, it may be difficult longer-term trends. Financial innovation
to reimpose them during periods of recov- and the rise of new industries makes this
ery. Resistance to tightening credit stand- particularly difficult.
ards may be reinforced if such credit is seen Second, who should judge the cycle
as achieving social goals (e.g. providing low (e.g. public versus private sector)? The cycle
income housing). is unobservable, and current methods for
estimating it are associated with a great deal
Exposing risks of uncertainty. It could be argued that diver-
Applying measures countercyclically thus sity of opinion is more likely to be stabilis-
requires a clear and convincing exposition ing than uniformity, and that there is some
of the risks to financial stability. It is also presumption against having a single official
necessary to clarify that social goals are best body judge the cycle.
achieved through explicit subsidies and
ensuring that any risks to the financial sys- Independent experts
tem are avoided or contained. One solution is for authorities to rely on a
Relying on rules, rather than discretion, group of independent experts, an approach
could also facilitate the use of countercycli- that has been used in Chile (to define trend
cal prudential measures. As is well known, GDP and long run copper prices) in imple-
there are strong arguments for a rules-based menting its fiscal rule. Third, timeliness of
framework (e.g. an inflation or monetary tar- actions. Implementation lags could mean
get) to guide decisions about monetary pol- that measures taken could have procyclical
icy, because of inherent inflation bias. Further rather than countercyclical effects. Fourth,
analysis is needed to determine how far the whether prudential ratios should be fixed or
implementation of supplementary (macro- move with the cycle.
prudential) tools should be rules-based.
Fixed ratio
Cyclical stability An intermediate solution is to define quite
A number of other issues pertaining to the wide“corridors of stability”for the target (e.g.
use of prudential measures countercyclically GDP) to be stabilised. When the target is
may be highlighted: within that corridor, the ratio would remain
First, the weight to be given to stabilising fixed. Only when the target goes outside
the economic cycle (e.g. GDP) as opposed that corridor would a cyclical change in the
to some form of financial cycle (e.g. bank ratio be considered. Judgement could still
credit, asset prices, borrowing conditions in be required to set aside a rule or to calibrate
capital markets, and so on.) One question, policy action.
in this context, is whether it is possible to
extract in a timely manner the financial cycle Effectiveness and calibration: The appro-
(i.e. “excesses” of credit growth, “overshoot- priate calibration of measures would in part
ing” of asset prices, “overabundant” liquid- depend on their effectiveness. But, with
ity, etc) from normal cyclical variation and the possible exception of capital controls,

152 Journal of Regulation & Risk North Asia


where some of the evidence is unfavour- domestic deposits) and adjust rates or cover-
able, little is known about the effects of age if this appears to be necessary.
the various supplementary instruments in In some cases, however, the settings for
practice. what are increasingly recognised as possi-
ble macroprudential tools are still based on
Resistance to shocks microprudential norms. It will be difficult to
In contrast to the analysis of monetary policy change this until theoretical and empirical
transmission, there is no well-developed research clarifies how these settings should
theoretical framework or robust empiri- be adjusted to take into account macropru-
cal results to guide calibration exercises. dential risks. Some steps in this direction
Supplementary tools are generally seen have been taken in research at central banks
as enhancing banking sector resilience to (e.g. Meh and Moran (2010), Torres (2010),
shocks, but their perceived effectiveness in Gauthier et al (2010)) and also at the BIS
curbing credit growth appears to vary. For (Montoro and Tovar (2010)).
example lower LTV ratios in Hong Kong
Special Administrative Region (SAR) in 1991 Long-term benefits
and 1997 did not prevent a bubble. However, Two recent studies shed some light on the
they did limit bank losses and helped avoid implications of more stringent capital ade-
bank failures during the 1997-98 crash in quacy and liquidity requirements for eco-
property markets. nomic activity in the aftermath of the recent
Similar conclusions appear to have been financial crisis.
reached regarding the effects of dynamic In the medium term, a Basel Committee
provisioning in Spain. In line with this, study (BCBS (2010a)) finds that there are
credit did not appear to slow significantly clear long-term net economic benefits from
prior to the Lehman bankruptcy in some increasing the minimum capital and liquid-
of the larger EMEs, even if several of them ity requirements from their current levels,
have used supplementary tools such as as the benefits from reduced probability of
higher reserve requirements. CGFS (2010) financial crisis and the output losses associ-
discusses the effectiveness of some specific ated with such crises substantially exceed the
instruments in this area. potential output costs.
Regarding the short-run effects, the
Pragmatic behaviour Macroeconomic Assessment Group (MAG,
Partly reflecting uncertainties about the 2010) evaluation of the macroeconomic
effects of supplementary or macropruden- transition costs to stronger capital and
tial instruments, the authorities appear to liquidity standards concludes that the tran-
behave pragmatically when applying such sition is likely to have a modest impact on
tools. In particular, they appear to assess aggregate output.
the effectiveness of measures adopted (e.g.
unremunerated reserve requirements on Supplementary or macroprudential
capital inflows, or reserve requirements on tools and interest rate policy: The use

Journal of Regulation & Risk North Asia 153


of macroprudential instruments raises macroeconomic and financial stability con-
the question of how these instruments siderations coincide, and the relative effec-
might be related to interest rate policy. tiveness of these instruments.
Both interest rates and macroprudential
instruments are ways to influence (ease or Policy dilemmas
tighten) financial conditions. For example, an important question is how
to deal with possible policy dilemmas, e.g.
Effect on policy rate when inflation of goods and services prices
Macroprudential instruments do this by is low and both credit growth and asset
influencing the incentives and robustness price increases are rapid. One possibility is
of the financial sector and directly affect that interest rate policy could be assigned to
the monetary policy transmission mecha- deal with inflation, while macroprudential
nism. Such instruments can strengthen or policies (e.g. capital adequacy ratios, reserve
weaken how the policy rate is ultimately requirements) are assigned to deal with
reflected in the availability and cost of financial stability risks.
financing faced by borrowers (private and Under this interpretation interest rates
public). From this point of view, they can be might be left unchanged because infla-
seen as complements. tion is not rising, while reserve require-
ments could be raised to dampen rapid
Mutual reinforcement credit growth and asset price increases.
For example, in the face of rising inflation One possible advantage is that raising
pressures, rapid credit growth and higher reserve requirements might not attract
asset prices, policymakers would want to capital inflows in the same way raising
tighten monetary policy and use supple- policy rates might. However, whether
mentary tools countercyclically. In this case, this “policy assignment” is in fact optimal
both policy interest rates and macropru- requires further analysis.
dential instruments reinforce each other to
tighten financial conditions. Direct rate setting
However, as both ultimately affect In some situations, such as under a fixed
the availability and cost of financing, they exchange regime, policymakers will have
can also be viewed as substitutes. In par- no interest rate tool and would have to rely
ticular, it can be shown that interest rates exclusively on supplementary tools. The
and macroprudential tools may both be development or condition of the financial
adjusted to deal with the same macroeco- system may also have a bearing on the types
nomic or financial shock – for instance, the of instruments used.
authorities can raise interest rates or capital For example, in some cases where
requirements. domestic interbank markets are less devel-
How much interest rates and macro- oped the authorities may find it more effec-
prudential instruments will be used will tive to set bank lending rates (e.g. as in
depend in part on the extent to which China) directly rather than rely exclusively

154 Journal of Regulation & Risk North Asia


on open market operations to set interbank tember. Available at http://www.bis.org/publ/plcy08.
rates. htm.
Bank for International Settlements (BIS, 2008): Finan-
Medium term concerns: Over the medium cial globalisation and emerging market capital flows,
term, the use of supplementary and macro- BIS Papers No. 44. December. Available at http://
prudential tools raises issues of financial www.bis.org/publ/bppdf/bispap44.htm.
development and efficiency. On the one Bank for International Settlements (BIS, 2010), The
hand, many supplementary tools discussed International Banking Crisis and Domestic Financial
here have been abandoned in advanced Intermediation in Emerging Economies, BIS Papers
economies because of the heavy costs 54. See: http://www.bis.org/publ/bppdf/bispap54.htm.
imposed on the financial system and distor- Basel Committee on Banking Supervision (BCBS,
tions in resource allocation. 2010a): “Calibrating re.g.ulatory minimum capi-
tal requirements and capital buffers: a top-down
Recent experience approach,” October. Available at http://www.bis.org/
On the other hand, recent experience publ/bcbs180.htm
showed clearly that market discipline is not Basel Committee on Banking Supervision (BCBS,
enough to guarantee financial stability. The 2010b):“Basel III:A global regulatory framework for
crisis has prompted a reassessment of how more resilient banks and banking systems,” Decem-
these two competing considerations should ber. See: http://www.bis.org/publ/bcbs189.htm
be balanced. Basel Committee on Banking Supervision (BCBS,
Another concern is that the focus on 2010c): “Results of the comprehensive quantitative
supplementary tools, including capital con- impact study,” December. Available at http://www.
trols, could draw attention away from the bis.org/publ/bcbs186.htm
need for sound macroeconomic policies. Borio, C and M Drehmann (2009): “Assessing the
A number of central banks take the view risk of banking crises – revisited”, BIS Quarterly
that there is no substitute for conservative Review, March. Available at http://www.bis.org/publ/
fiscal, monetary and regulatory policies in qtrpdf/r_qt0903e.pdf.
order to prevent fluctuations in global capi- Borio C and I Shim (2007): “What can (macro)
tal flows from causing severe disruptions in prudential policy do to support monetary policy?”,
emerging market economies. • BIS Working Paper No. 242, December. Available at
http://www.bis.org/publ/work242.htm.
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Angklomkliew, S, J George and F Packer (2009): new early warning system of financial crises,” Jour-
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December. Available at http://www.bis.org/publ/ Caruana, J (2010a):“Basel III: towards a safer financial
qtrpdf/r_qt0912h.pdf system”. Speech at the 3rd Santander International
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have been different this time?” Speech at the People’s regulation over the business cycle,” hosted by Cen-
Bank of China seminar on macroprudential policy, in tral Bank of Argentina, Buenos Aires, March 18-19,
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Shanghai, October 18, 2010.Available at http://www. brobc100318/agenda/galeso_paper.pdf
bis.org/speeches/sp101019.htm. Gertler, M and N Kiyotaki (2010):“Financial Interme-
Cecchetti, S (2009): “On the similarities of capital diation & Credit Policy in Business Cycle Analysis”.
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Cifuentes, Rodrigo, Hyun Song Shin, and Gianluigi Griffith-Jones, S, E Helleiner and Ngaire Woods
Ferrucci (2005):”Liquidity Risk and Contagion,” Jour- (2010): The Financial Stability Board: An Effective
nal of European Economic Association 3, 556-566. Fourth Pillar of Economic Governance? CIGI Spe-
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Gaglianone,W P and R Schechtman (2010): “Macro Hawkins, J and M Klau (2000): “Measuring potential
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Mohanty, M and P Turner (2006):“Foreign exchange
reserves accumulation in emerging markets: what Editor’s note
are the domestic implications?”, BIS Quarterly The Journal’s publisher and editor wish read-
Review, September. Available at http://www.bis.org/ ers to note that this paper is an abridged ver-
publ/qtrpdf/r_qt0609f.pdf. sion of a Bank for International Settlements
Montoro, C and C Tovar (2010): “Reserve require- (BIS) working paper (No 336) entitled:
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ity risk: diagnosis and reform”. Presentation at EBRD Settlements.

Journal of Regulation & Risk North Asia 157


Regulation

European crosshairs focus on


short selling, OTC derivatives
Carlos Tavares of the European Securities
and Markets Authority directs a fusillade
against complex financial instruments.

With the economic crisis mutating, moniker – the European and Securities
now really is the hour of the regulator. Markets Authority (ESMA). In the text, the
This paper argues that policy makers reader will find what, in this author’s opin-
should take heed; the opacity of over- ion, is the greatest challenge for legislators
the-counter trading should come to an and regulators in the near future.
end and regulation and transparency That is, to urgently adopt the regulatory
should be extended to all corners of the reforms that have already been extensively
financial sector. diagnosed and discussed on the one hand,
while on the other hand resisting the temp-
“In light of some global positive signs . . . a ten- tation to adopt case-by-case measures with-
dency to downplay the severity of the current cri- out proper analysis. Implementing the much
sis may emerge, accompanied by a reluctance to needed regulatory reforms that have been
recognise the need for financial reforms. There is widely studied would in most cases remove
therefore a risk that urgently required regulatory the need for case-by-case measures, or at
measures are neither fully considered nor imple- least would provide the necessary grounds
mented in an appropriate way. At the same time, for a solid basis in their shaping.
emergent risks might trigger hasty decisions
about regulatory measures deemed necessary; a Global contagion
prior and full analysis of the problems involved This is particularly true in the bond and
is, however, essential.” derivatives markets. We should not forget
This quote is taken from the most recent that, although the current financial crisis had
report by the now re-christened Committee its roots in the US banking sector, it spread
of European Securities Regulators (CESR) worldwide to the whole financial system
on key trends, risks and vulnerabilities in through the – largely unregulated – bond
financial markets. CESR, the body respon- and derivatives markets (including the so-
sible for pan-European securities regula- called structured products markets).
tion and oversight recently adopted a new In 2007, these markets were around 10

Journal of Regulation & Risk North Asia 159


times the size of stock markets, to which reg- that regulatory measures on naked short
ulators devote most of their time and effort. selling should be adopted, as proposed by
This was, and indeed still is, not because the European Commission on September
regulators are negligent, but simply because 15, 2010. It is generally accepted by the aca-
most of the transactions take place in unreg- demic literature that covered short selling
ulated markets – basically over-the-counter improves the functioning of capital markets.
or OTC as they are better known – on which According to the 2010 analysis of CESR’s
regulators have no supervisory powers and Committee for Economic and Market
where trade transparency does not exist. Analysis (CEMA), allowing covered short
selling in general contributes to improved
Extended regulation, openness market liquidity, increased market efficiency
As argued by Goodhart and Tsomocos and less volatile prices. Theoretical and
(2009), it is now clear that, the situation must empirical research also shows that covered
change and that regulation and transpar- short selling restrictions may reduce market
ency should be extended to all segments of efficiency and market liquidity, and increase
financial markets. More than this, there is a the likelihood of the formation of a bubble,
growing consensus that the securities mar- especially when the market is bullish. In
kets may entail systemic risk, which is no adverse market situations (bear markets),
longer a matter just for banking regulators. the overall effect is not entirely clear.
And this is, to my view, one of the key les-
sons from this crisis. Issues with restrictions
The previous thoughts are particularly Whilst short selling restrictions may reduce
valid for the discussion on short selling and high market volatility, the decrease in market
the ongoing discussions on the credit default liquidity due to the constraints may be very
swap market. The fact is that regulators still strong when bid-ask spreads are already
know little about the over-the-counter bond wide. Also according to the CEMA’s afore-
and derivative markets and have no access to mentioned work, the review of the academic
reliable data on the respective transactions. literature shows that naked or uncovered
Even for stock markets we find regulatory short selling, in theory, is not fundamentally
gaps, for instance, in relation to the identi- different from covered short selling and, in
fication of short orders. The availability of normal circumstances, is unlikely to have
appropriate supervisory tools is therefore an detrimental effects on capital markets.
essential precondition for assessing, adopt- Nevertheless, naked short selling may
ing and enforcing regulatory measures. increase price volatility relative to covered
short selling and may have destabilising
Curb naked short selling effects in markets as in theory the number
Let us look then at the short-selling issue in of short sold shares may largely exceed the
some more detail. To summarise, we do not number of available shares. This is equiva-
see problems with covered short selling in lent of artificially multiplying the number
either bonds or equities. However, I believe of shares in circulation. A different issue is

160 Journal of Regulation & Risk North Asia


the misuse of short selling – naked or cov- (2009) and many others have called for, a
ered – to manipulate markets, for instance strong case for improving transparency in
by combining short-selling with spreading bond and derivatives markets, in particular
of negative rumours or manipulative opera- in the over-the-counter sphere, along with
tions in the cash market. accrued supervision in the latter.
Debt markets were at the origin of the
Give them the tools . . . current financial crisis. The lack of transpar-
This has to be dealt with by regulators ency in these markets, which are mainly
through the application of market abuse over-the-counter, to both investors and
rules with proper investigation and sanc- regulators may have been a decisive con-
tions. The question remaining is whether tributor to the development of bubbles
supervisors have all the necessary tools for and the mispricing of risk in those assets.
that. In my view, the answer to this question Notwithstanding the measures mentioned
is not positive, so far. The means to clearly above (on short selling of securities), a few
improve the situation are relatively straight- structural measures should be urgently
forward: disclosure rules for short positions; adopted at a pan-European level.
a“locate rule”in case of naked short orders; a
more stringent settlement regime; and pre- Post-trade transparency
and post-trade transparency in over-the- This should include as a priority, the
counter markets. CESR has already proposed need for a common regime for post trad-
a regime of disclosure of short positions both ing transparency and supervision for
for shares and sovereign bonds. bonds (including asset-backed securities)
and derivatives (including credit default
Harmonised settlement regime swaps), in parallel with the establishment
In my view, it would be desirable to com- of a European trade repository, i.e. a cen-
plement this regime by an identification tralised registry that maintains an elec-
mechanism of short orders to supervisors by tronic public database of over-the-counter
financial intermediaries, similar to the “flag- transaction records (including volumes,
ging” system in the US. This view is shared price and identity).
by the European Commission. A stringent Along the same lines, the duty to
settlement regime (one that is harmonised report to CESR’s Transaction Reporting
across Europe) is also required. Without Exchange Mechanism should be extended
it, there will generally be an incentive for to over-the-counter derivatives (for this, an
manipulation, due to the mere fact that there amendment is needed). From a supervisory
is an opportunity for delivery failure. perspective, these measures can contribute
All in all, these are more promising ways to accrued supervision of market abuse and
to prevent the potential negative effects of of fairness of price, as well as higher effi-
short selling (covered or naked) than a gen- ciency in price formation.
eral ban that risks having negative effects. The second set of measures relates to
There is, therefore as Acharya and Engle the clearing of eligible derivatives through

Journal of Regulation & Risk North Asia 161


central counterparties, which should allow are adopted in the short run along these
for a decrease in operational risk of market lines, I firmly believe that we will have drawn
participants. This should go together with an concrete lessons from the current financial
increase in the standardisation of derivatives crisis, and in doing so, create the necessary
for ease of clearing and settlement. From an conditions that will lead to better supervision
investors’ perspective, this also increases the and more stable markets in future. •
number of players quoting prices, thus lead-
ing to higher competition, price representa- References
tion and market integration. Acharya,Viral and Robert Engle (2009), “A case for (even)
Finally, the trading of standardised deriv- more transparency in the OTC markets”, VoxEU.org,
atives and structured products in organised August 29.
markets would very much enhance trans- Acharya, Viral, Thomas F Cooley, Matthew Richardson,
parency and market information available Richard Sylla, Ingo Walter (2010), “A critical assessment of
to investors. Besides trade transparency, the the Dodd-Frank Wall Street Reform and Consumer Pro-
listing in at least one regulated market would tection Act”,VoxEU.org, November. 24
imply publishing detailed regulatory infor- Committee for European Securities Regulators (2010),
mation on issuers and on products them- “Model for a Pan-European Short Selling Disclosure
selves, thus contributing to strongly reducing Regime”, CESR 10-088, March.
their frequent opacity. Goodhart, Charles & Dimitrios Tsomocos (2009),“Liquid-
If, as I dearly hope, such radical reforms ity, default, and market regulation”,VoxEU.org, Nov. 12.

J ournal of Regulation & Risk


North Asia
J ournal of reg

Reprint Service
ulation & risk
north asia

nce Volume I, Issue III,


Complia Articles & Papers
Autumn Winter 2009-2010

Issues in resolving
systemically important
impacts
financial institutions

l change
Resecuritisation Dr Eric S. Rosengren
in banking: major

financia liance and risk


challenges ahead
A framework for

Global
funding liquidity Dr Fang Du
in times of financial
comp Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
– nt from bad to worst
manageme ent
Derivatives: from
disaster to re-regulati Stephan Schoess,
products pot on
head of details a
Black swans, market Professor Lynn A. Stout
EastNet’s David Dekker,
crises and risk: the
rkets. human perspective
nce, ncial ma Measuring & managing
complia al reaction in fina
risk for innovative Joseph Rizzi
financial instrumen
Red star spangled ts
chemic banner: root causes Dr Stuart M. Turnbull
of the financial crisis
oth-
The ‘family’ risk:
amongst
Andreas Kern & Christian
a cause for concern Fahrholz
companies es. among Asian investors
be one of to offer these servicGlobal t financial change impacts compliance
will just David Smith
signs be able speak abou
ld rather
and risk
the first that will Thei-scramble is on
we saw d ers we shou s, or mon to tackle bribery David Dekker Opinion
a year ago the financial worl These days utions than bank nameWho thatexactly and corruption
About ation in it crisis instit a Penelope Tham & Gerald
form
of a trans last months the
cred
cial worl
cial
d at finan financial service
provi ders,
ties.
future activi Financial
is subject to the Foreign Corrupt
Practices Act? Deregulation Li

and in
the
the finan ge that is tored s their current and we have move
d markets remunerat
ion reform: one step Tham Yuet-Ming , non-regul
has trans
form ed
. the chan than cover
ly
how rapid n on the Ofbank
s
‘Black Swans’, stress tests
forward
Umesh Kumar & Kevin
and ‘desup ation
osive pace in scope Look at interactio tion) to
& optimised risk Marr
an expl
is much
broader were physical
management
ervisio

Contact
s of operaChallenging the value of enterprise
occurring expected. bank
s that
fall from (location and hour Internet banking. risk management
David Samuels
Professor n’
to fail or terms
causes of the William Black exam
originally to be too big then e, but
Rocky road ahead for global
payments
Tim Pagett & Ranjit
over by still in charg to a accountancy convergenc Jaswal
considere
d g taken electronic ines the
failing or bein more finan- n the banks were igm is shifti ThengAsian regulatory
e
Dr Philip Goeth mortgage frau
r are - Agai and cor-
Rubik’s Cube d epidemic
are eithe that
ns para the parad
d ns
institutio has swept
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Alan Ewins and Angus
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cially soun how banks are world wher each other witho es such as THE autho States.
in pay ologi r of this
digm shift r banks. porations) with new techn academic, paper is a
ic and othe nt lawyer and leadin
the publ around
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specia itly demonstrate
ly revolves mobile paym crime. As one lising in ‘white
ng cal failure
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Christopher Rogers
of the unsun collar’ failure tion
Since bank y to service custo impact isations Savings & of private marke and a wholesale
the abilit ng the Netw ork prov
iders
s and organ pay- Loans debac g heroes of the and t discipline
and mini bank Professor other forms
trust
mer and
deter
ongoing
risk
the futur
e the and other Black nowa le of the 1980s, Crime of credit risk. of fraud
ing a custo be part of the as In NACHA providers of his time days spend s Enforcement The Financ
n, as well SWIFT, network researching s much ial
ld
of it, shou of the organisatio such as become A to B markets have why financ released a Network
(FinCE
ent ng and new ment networks send money from traf- a tendency ial Activit study this
week on Suspic N)
managem ess of existi ng to ork functional. to become y
dys- lated Reports (SARs) that
g the riskin using/buyi allow you you for the netw Renowned ious
monitorin customers ges that e s similari- ‘control fraud for his theory financial institu federally regu-
and the more chan will charg rate. This bring y ’, Prof. Black on with tions (some
products there are are and you gene m, energ University lectures at the Federa times) file
ucts. But world that fic that such as teleco financial of Missouri the (FBI) l Bureau of
these prod s in the banking n it. industries . The He is the autho and Kansa
s City. fraud.
when they
find eviden
Investigation
and chall
enge
as we have know the ties with cable companies important a Bank is r of ‘The Best
Way to Rob ce of mortg

Editor-in-Chief
g banking e, not be liers and rgoing an to Own One: age
threatenin s will, in the futur our funds, supp is clearly unde Executives
and Politi
How Corpo
rate Epide
The bank by which to move ; they
world
135 S&L Indus cians Loote mic warni
les portfolios try.’ A prom d the The ng
default vehic balances and tor on the
causes of
inent comm FBI
enta- mortg began warning of an
our the curren
maintain crisis, Prof.
Black is a t financial age fraud in “epidemic”
of
h Asia mony their congre
Risk Nort way the US vocal critic
of the ago. in September 2004 –
ssional testi-
lation & governmen
of Regu banking crisis t has handl It also warne over five years
Journal and rewar ed the not d that if the
that have ded institu dealt with epidemic were
clearly tions sis. it would cause
duties to invest failed in their fiduci Nothi a financial
ors. ary respon ng remotely adequate cri-
d to the was done

christopher.rogers@irrna.org
The following enforcement epidemic by regulators, to
, or private law
essarily repres comm entary does cipline .” Instead, the sector “mark
ent the view not nec-
hyper-inflate epidemic produ et dis-
Regulation of the Journa d a bubble ced and
and Risk – l of that in US housin
“The new North Asia. produced a g prices
numbers on crisis so severe
rals for mortg criminal refer- caused the collapse that it
age fraud in
the US are system of the global nearly
just in many and led to unpreceden financial
Journal of of the world’ ted bailouts
Regulation s largest banks of
& Risk North .
Asia

33

162 Journal of Regulation & Risk North Asia


Asset management

Economists’ hubris: The case


of equity asset management
Capco’s Shahin Shojai, Contango Capital’s
George Feiger, and MIT Prof. Rajesh Kumar
cast doubt on current investment strategies.

This article is the fourth in the econo- to compare performances of different man-
mists’ hubris series of papers that have agers on a risk-adjusted basis. However, the
so far investigated the shortcomings of reality is that since most of the performance
academic thinking in the fields of merg- models are founded on theCapital Asset
ers and acquisitions [Shojai (2009)], asset Pricing Model (CAPM), which has not been
pricing [Shojai & Feiger (2009)], and risk very successful in providing risk-adjustment
management [Shojai & Feiger (2010)]. figures for simple stocks [Shojai and Feiger
Our intention is to probe whether aca- (2009)], they are unable to provide us with a
demic finance has made any significant reliable risk-adjusted performance figure for
and, more importantly, practical contri- each portfolio manager.
butions to the field of asset management.
This specific discipline is of great interest Magnitude of failure
to us since the wealth of a majority of the Consequently, basing one’s judgment purely
world’s future retirees will be dependent on an asset manager’s unadjusted perfor-
of how well these third-party fund/asset/ mance, irrespective of the risk to their port-
money management firms manage the folio, might not be as sacrilegious as many
assets in their care. academics have been suggesting for dec-
ades, since the denominator might have no
We should state from the outset that while relationship to reality whatsoever.
the contributions of academic finance to the More importantly, if the denominator
field of asset management cannot be denied, is inaccurate then it would mean there are
we are of the opinion that it has failed in portfolio managers who do indeed perform
its ambitions to allow investors to make very well; not just the well-known ones, but
informed decisions about who they select to those whose contributions are discounted
manage their assets. We base our judgment by the wholly questionable methodologies
on the premise that in order to allow inves- used to adjust their performance for risk.
tors make such decisions, they must be able Sadly, the magnitude of failure of these

Journal of Regulation & Risk North Asia 163


models seems to be somehow correlated losses. And, unless new ways of looking at
with the number of different asset classes the industry are developed, we will be una-
that are added to the portfolio. For exam- ble to mitigate them.
ple, while comparing vanilla-structure, pure Having set the stool out on what our
equity-based mutual funds might not be too position is vis-a-vis portfolio performance
hard, though they are still scientifically ques- evaluation models, we will now provide an
tionable when you introduce other asset overview of the literature to see how aca-
classes, especially those with more peculiar demics have been able to contribute to the
distributions, where you may find that they field of asset management. Given the vast
are simply inaccurate. array of articles in this space, we are once
again forced to focus on those small number
Playing ‘catch-up’ of articles that most other studies reference.
Consequently, we have decided to focus in We will start with a short review of the
this paper on the applicability of these mod- history of modern portfolio theory and
els for the simple asset classes that they were examine whether asset management firms
developed for, namely equities, since if we actually apply the principles developed.
find that they have difficulties with this asset We will subsequently look at the perfor-
class then their applicability to multi-asset mance evaluation methodologies and assess
class portfolios would be highly question- whether they are fit for the purpose and
able. Our objective is to prove that the previ- whether the large numbers of studies that
ous literature in this area has predominantly examine mutual fund performance help us
attempted to play “catch-up” with what is to change the way these institutions actually
actually taking place within asset manage- manage money, how they are selected by cli-
ment companies; that the models are simply ents, and how they are compensated.
unable to provide reliable risk-adjusted per-
formance data and, as a result, have skewed Modern portfolio theory
the system to benefit those who are not nec- Few can deny the tremendous contribu-
essarily the best managers. tion that Harry Markowitz has made to the
discipline of finance and in specific asset
Managers’ self-interest management. Prior to his seminal work, few
This inability to reliably compare like with undertook the necessary task of evaluating
like has also meant that some investors the risk-adjusted returns on their invest-
are unable to prevent their managers from ments [Markowitz (1952, 1959)]. Markowitz
taking actions that are in the best interest made it possible to compare different assets
of themselves. It should be said that, sadly, based on such returns.
agency costs [Jensen and Meckling (1976)] Of course, the asset pricing models that
are at their most extreme in the field of asset developed in response to his contribution,
management, where asset managers only irrespective of whether they actually work
share in the gains made by their clients as in practice or not [Shojai and Feiger (2009)],
a result of their investment policies and not were developed as a consequence of his

164 Journal of Regulation & Risk North Asia


work in the field of portfolio management. upon them by the investment consultants
The recognition that a number of less than who act as auditors on behalf of the pen-
perfectly correlated assets within a portfolio sion and insurance funds whose funds are
will have a better risk-adjusted profile than being managed. Now, we are not suggest-
a single stock helped the development of the ing that using a combination of gut instincts
Modern Portfolio Theory (MPT), the exten- and analyst recommendations is necessarily
sion of which was the identification of the a bad thing. Many successful portfolio man-
efficiency frontier and the market portfolio. agers have generated huge returns for their
investors this way.
Efficiency frontier In the retail fund management world,
If we accept that MPT works, then one such asset allocation processes are replaced
should expect most portfolio managers by a process of segmentation, which should
to try to locate portfolios on the efficiency allow the portfolio managers to differenti-
frontier and select the ones that most ate themselves from their peers and hence
closely meet their own level of risk aversion. attract new clients. Whichever investment
Sadly, however, trying to locate the effi- vehicle one looks at, the one common thread
ciency frontier has eluded most who have that they share is that they do not look for
attempted it, even those who are advocates efficiency frontiers.
of the efficient market hypothesis [Fama
and French (2004)]. Practical reality check
In reality we find that few, if any, of the Of course, this fact has not stopped finance
portfolio management companies even try academics from looking for alternatives to
to look for the efficient portfolios in the way Markowitz’s mean-variance methodol-
that theory tells us. If one looks at the insti- ogy [Lee (1977), Elton and Gruber (1974)],
tutional asset management market we find though they were found to be even less
that most use different methodologies to appealing. Elton and Gruber (1997) provide
describe a mechanism that is nothing more a rather exhaustive and useful review of the
than a glorified stock picking process. literature on MPT, but find that most fail
when placed under a practical reality check.
Gut instincts The literature seems to be useful for writing
They can call it a top-down or bottom-up future articles on the subject, but has “not
asset allocation policy, or whatever impres- had a major impact on the implementation
sive name that their marketing departments of portfolio management”.
can generate, but at the end of the day, most If we find that portfolio management
portfolio managers rely on their own gut companies do not invest in ways suggested
instincts and the recommendations of sell- by academic theoreticians, then should we
side analysts. expect to find that the tools that have been
Of course, that is assuming that they derived by them can be used to evaluate
have any say in what investments they their performance? In the next section, we
make, given the huge restrictions placed will look at some of the most widely cited

Journal of Regulation & Risk North Asia 165


methods for evaluating portfolio perfor- [Modigliani and Modigliani (1997)], which
mance and assess whether they are actually makes interpretation of the Sharpe ratio
of any use in helping us determine how well easier. Basically, it assumes the creation of a
a portfolio manager has actually done. portfolio of equities and US T-bills with the
allocation to each being determined by the
Six models volatility of the managed portfolio vis-a-vis
Although there are numerous method- the selected index. The adjusted portfolio
ologies developed for evaluating the risk- will have the same standard deviation as the
adjusted performance of a portfolio, there index, which allows for a simple comparison
are six models that are mostly quoted in aca- to determine excess returns [M2 = rP*–rm,
demic literature, though only one, or perhaps where P* is the adjusted portfolio].
two, are actually referred to by practitioners.
The first and most widely known meth- Star ranking awards
odology is the Sharpe Ratio [Sharpe (1966)], Finally, there is the ratings issued by
which divides the portfolio’s average excess Morningstar Inc., which ranks mutual funds
return over a risk free asset by the standard using a star system that most investors can
deviation of the returns. Most investment easily understand. Morningstar starts off by
management companies compare their per- dividing all the mutual funds it covers into
formance with their peers by presenting the four asset classes, such as domestic stock
Sharpe Ratio [(rP-rf)/σP]. funds, international stock funds, taxable
The second method, known as the bond funds, and municipal bond funds. It
Treynor’s ratio [Treynor (1966)], replaces the then calculates the returns generated by
total risk, standard deviation, measure with the funds in each class by dividing the load-
systematic risk, beta, since the assumption is adjusted excess return generated by each
that the portfolio will have diversified away fund by the average excess return for that
the unique/unsystematic risks of the indi- class.
vidual shares in the portfolio [(rP-rf)/βP]. It adjusts the returns for risk by work-
The third methodology is known as the ing out how many months the fund gener-
Jensen’s alpha [Jensen (1968, 1969)], which ated negative excess returns and comparing
calculates the average return on the portfolio that figure with the number of months its
in excess of what CAPM would predict [αP = asset class generated negative returns. It
rP - [rf + βP(rM-rf)] . deducts the risk figure from the return fig-
The fourth methodology is known as the ure to arrive at the rating. The funds are then
Information ratio [Treynor and Black (1973)], ranked according to where they are placed
which divides the alpha of the portfolio by and given stars. For example, the top 10 per
its non-systematic risk, the tracking error. It cent receive five stars, the next 22.5 per cent
evaluates the portfolio manager’s ability to receive four stars, etc. [Simons (1998)].
generate excess returns relative to a bench- Simons (1998) finds that the correlations
mark and their consistency [αP/σ(eP)]. between funds ranked by the Sharpe Ratio
The fifth methodology is the M2 measure and Morningstar are in excess of 98 per cent.

166 Journal of Regulation & Risk North Asia


And, according to Damato (1996) 90 per and portfolio B but I won’t let you see the
cent of new money invested in equity funds graphs, only a single number for each one.
in 1995 went to those rated four- or five- One response to the question that is posed
star, which means that investors do value is that it is a dumb question. We now have
Morningstar’s rating system and certainly computers. Why not use more information
use it to select which funds they invest in. when you make your decisions?
That is a valid response, but people still
‘Far too simple’ want a single number to make choices sim-
Pretty much all of the aforementioned mod- ple. The Sharpe ratio is a candidate. So what
els have significant difficulties in helping us is it? It is a measure that attempts to capture
evaluate the performance of a portfolio in aspects of both the risk and the expected
a way that can allow us to compare it with return of the portfolio. More precisely, it
other portfolios, which is their main objec- focuses on the difference between the return
tive. The Sharpe Ratio is far too simple a on a portfolio and that of a benchmark.
model to capture the performance of a port-
folio, yet it is probably the most cited ratio A matter of choice
among practitioners. The reason practition- You estimate the expected value of that
ers like quoting the Sharpe ratio is that, simi- difference then divide that figure by an
lar to the P/E ratio used in share pricing, it is estimate of the risk associated with that dif-
easy to calculate and also simple to manipu- ference, measured by its standard deviation.
late. Even its founder is not convinced it is There is a setting in which you can say that
able to help us determine which funds per- if portfolio A has a higher Sharpe ratio than
form better, risk-adjusted. portfolio B and you can invest in only one
of them, you should choose A. It was in that
Pick a number setting that I derived the measure, using a
Sharpe states that: “The Sharpe ratio was riskless security as the benchmark. Let me
developed to answer the following question: give you the conditions under which this is
if you had to choose one number to describe sufficient. First, an investor must care only
the desirability of a portfolio going forward about the expected return and standard
what number would I suggest? Let me take deviation of a portfolio’s return. Second, it
each aspect of that sentence in turn. First of must be possible to borrow and lend at a
all, the task is to compress everything into single riskless rate.
one number. In many, if not most, cases a
single number is not sufficient. Inappropriate measure
It is like saying, here is a probability dis- Finally, the comparisons are to be made at
tribution of the return from a portfolio next the level of the overall portfolio, with only
year; I won’t let you draw the graph but one of the candidates to be chosen. Most
you need to give me one number to indi- investment decisions fail to meet some or all
cate whether this is a good portfolio or not. of these conditions. So before basing a choice
Or if I am choosing between portfolio A on a comparison of Sharpe ratios you need

Journal of Regulation & Risk North Asia 167


to ask whether the setting is close enough to we call ‘tail risk’ — that is they take on a
the original one to make such an approach small probability of a disastrous outcome. A
good enough. In the common case in which hedge fund that is asking for a new invest-
a choice is being made concerning invest- ment is not likely to have experienced a
ment of a portion of an overall portfolio the disastrous outcome, so their ex-post results
original Sharpe ratio using a riskless security will not be representative of their ex-ante
as a benchmark is likely to be inappropriate. possible returns.
There are many reasons why you should
“Information ratio’ be reluctant to choose investments based
However, there is a variant that may be use- solely on ex-post Sharpe ratios. “We now
ful. In this version the benchmark is an index have computers. It is better to estimate more
fund or combination of such funds with the aspects of risk and return and put these esti-
same ‘style’ as the manager in question. For mates in a good portfolio optimisation pro-
example, if you are evaluating a US growth gram.”[Sharpe (2008)].
fund manager you could use as a bench- Treynor’s ratio has similar problems,
mark an index fund of US growth stocks. A with the additional difficulty of requiring
measure based on such a benchmark is often the portfolio companies to calculate betas,
called an ‘information ratio.’ Interestingly, for whose value has to be questioned for basic
a classic hedge fund the appropriate bench- equities let alone their portfolios [Shojai
mark may actually be a riskless security. In and Feiger (2009)]. As for Jensen’s alpha,
this case the original Sharpe ratio may be the main issue is that one needs to find an
useful, even if the fund is to be used only as efficient index, otherwise the performance
part of a larger portfolio. of the portfolio becomes a function of that
The key point is to recognise that the index [Roll (1978)].
Sharpe ratio and the information ratio only
include aspects of expected return and risk. Precarious situation
They both ignore any correlation of the dif- More importantly, it is difficult to determine
ference in return from that of the benchmark what the correct index should be. Many vari-
with returns in other parts of an investor’s ations to Jensen’s single-index model have
portfolio. Only if such correlations are small, been developed [Ross (1978), Grinblatt and
absent, or the same among all possible Titman (1987), Sharpe (1992), Elton et al.
choices does this make sense. (1996)]. However, none are able to help us
accurately calculate and, more importantly,
‘Tail risk’ compare the performance of portfolios.
There are also huge problems associated The situation becomes that much pre-
with the common practice of using ex-post carious when one starts introducing differ-
average returns and the ex-post variabilities ent asset classes, rather than just equities,
of returns as estimates of future expected to the portfolio, as is the case with most
returns and future risks. This is particularly hedge funds, or customisation, which is the
true for many hedge funds that have what case with institutional asset management

168 Journal of Regulation & Risk North Asia


and wealth management. In the case of more returns has higher risk, or even similar
hedge funds, they can, and many do, invest risk to another manager, when the models
in assets that have distributions that are are unable to accurately quantify it?
anything but normal. Yet, many use perfor- For example, if one finds that manager
mance evaluation models that assume nor- A has generated returns of 16 per cent per
mality. The fact is that once you introduce year for the past four years, but is found to
combinations of assets then the models are have a lower risk adjusted return, using the
simply not fit for purpose. questionable methodologies above, over
this period than manager B, who has been
Academics’ skepticism generating returns of 12 per cent, which one
If determination of risk-adjusted returns should investors choose? Academic thought
of investments is as inaccurate as we find suggests the latter, yet it could be that man-
above, then why are investors accosted by ager A continues to perform better for the
academics for choosing to invest their funds next five years.
with those managers who are found to have The fact is that since there is no scientific
simply performed better, irrespective of the way of evaluating risk-adjusted performance
risk they have, in the past and constantly try- many managers that are able to gener-
ing to tell them that past performance is no ate exceptional returns are ignored simply
guarantee of future performance. because they are more interested in gener-
If markets are not as efficient as academ- ating returns than to manipulate their data
ics believe they are, such that opportuni- to generate a lower raw return but a higher
ties for excess returns exist, and the risk of risk-adjusted one.
the manager cannot be evaluated with any
degree of accuracy, then investors are fully Performance manipulation
within their right to choose those managers Alternatively, many not so great managers
who have performed well in the past, since are able to hide their inability to generate
that is the only measure they can go with. genuine alphas by manipulating the per-
More importantly, does it really matter how formance of their portfolios to obtain higher
much more risk an asset manager is deemed risk-adjusted returns. If one accepts that
to have taken if we cannot quantify it in any argument, then all that matters is how well a
meaningful way? manager performs and investors should not
be accused of stupidity for using raw returns
Investor awakening data for deciding who manages their assets.
The risk of the manager only matters when Obviously, this simple fact has not prevented
they start losing investors’ capital during academics from suggesting that those who
downturns, at which point investors sud- simply look for managers who generate
denly become more interested in absolute greater returns need to be institutionalised.
returns, not when they and the rest of the Academics suggest that irrespective of
market are performing well. And, how can the accuracy of the risk-adjusted return cal-
you say that a manager that is generating culations investors should take risk factors

Journal of Regulation & Risk North Asia 169


into account when selecting funds. But, how among others, who find that the future suc-
can you compare those funds? For example, cess of the industry will be determined by its
one of the main methods by which mutual overall long-run performance.
funds market themselves is via segmenta- Yet, when experiential evidence is used
tion [Shojai and Preece (2001)]. This obvi- one finds that the variations can be huge
ously goes against Markowitz portfolio between people. Sadly, none of the studies
optimisation theorem [Markowitz (1952, actually take the time to ask the investors
1959)], which requires a handful of stocks themselves. For example, Hahn (2002) dem-
with negative co-variances to achieve the onstrates that investors select funds not even
diversification required for optimal portfolio on actual performance but perceived perfor-
performance. mance. It is also important to note that the
ranking is based on an asset-weighted basis,
Benchmark lack not risk-adjusted. The power of brokers will
The main reason that mutual fund man- also determine which funds are selected
agers use segmentation is that it allows by investors; hence the efforts expended
them to differentiate themselves from their by fund companies to appease the major
peers. It is also hard to then compare their brokerages.
performance, since there would no longer
be an appropriate benchmark to compare Net returns off
them against. For example, if two manag- Academics not only suggest that investors
ers have international allocations and one is should look for long-term returns, even
called the Indonesian Small-Cap Fund and though hedge funds do not have anything
the other is the Malaysian Mid-Cap Fund, remotely approaching long-term track
which indices would you use to assess their records, they also suggest that their manag-
performance, and how would you compare ers will typically not do a good job of man-
the risk-adjusted performance of the two? aging their money. For example, Wermers
(2000) found that although investment
Five-year performance managers have outperformed their market
What is most fascinating is that almost benchmarks by an average of 1.3 per cent
all scientific studies suggest that investors per year, their net returns underperform the
should invest their monies with mutual markets by one per cent.
funds that generate long-term performance, About 1.6 per cent of this 2.3 per cent dif-
and that the fund’s positioning as innovative ference is explained by transaction and man-
does not really matter. For example, Carhart agement costs, with the other 0.7 per cent
et al (2000) find that five-year performance being explained by the underperformance
is the determining characteristic for a mutual of the non-stock holdings in the portfolios.
fund’s survival in the long run (although Underperforming the markets is not lim-
one-year performance does have some ited to mutual funds. Hedge funds were
explanatory powers). Their findings are cor- also found to underperform the standard
roborated by Carpenter and Lynch (1999), market indices, although they outperform

170 Journal of Regulation & Risk North Asia


mutual funds [Ackermann et al (1999)]. exercise were for Gartmore – where Lord
More recently, the focus has turned to com- Myners was chairman at the time the report
paring passive against active fund manage- was compiled – but we have decided to test
ment and most find that investors actually that hypothesis using a number of students
come off worse when they choose the latter at the Institute of Management Technology.
[French (2008), Fama and French (2008)], or The idea, though far from scientific, would
that the excess return is mostly due to luck allow us to take more factors into account
than manager expertise [Fama and French when deciding whether a portfolio manager
(2010)]. has indeed done well during the year and
how they should be compensated.
CAPM models This is important because portfolio
Of course, it is almost impossible to deter- management companies are compensated
mine whether mutual fund managers do in two ways. The first is as a percentage of
actually consistently do badly, risk-adjusted assets under management, and this varies
if, as mentioned previously, the risk factor is widely between active and passively man-
questionable at best; and all of these studies aged funds.
try to find their risk-adjusted returns using
models that are founded on CAPM. Performance stimulus
What we suggest is, given that it is not This should act as a stimulant to the manag-
possible to compare one manager against ers since as they perform better the amount
another due to the methodological prob- of assets under management increases and
lems mentioned above, the best way to so does their compensation. Simply put, if
assess the performance of a manager is to they have a billion dollars under manage-
compare them against themselves. This idea, ment and they charge one per cent of that
called inertia, was suggested to one of the amount, their compensation is $10 million.
authors during a meeting with Lord Myners If they generate 10 per cent during the
a number of years back, when he had fin- year, the amount of assets under manage-
ished compiling his report on the UK asset ment increases to US$1.1 billion and their
management industry [Myners (2001)]. compensation also increases to US$11 mil-
lion. Many asset management firms also
Findings under wraps have a share in the upside of performance,
According to his lordship, inertia basically especially hedge funds, so they are further
compared an asset manager’s end-of-year enticed to beat the index that they are to be
performance against making absolutely no compared against.
changes to the portfolio during that year. In Their other source of income is trading
other words, compare the returns the man- revenues, which actually costs the clients,
ager generated after actively managing the since they bear the full brunt of charges.
fund against holding the portfolio unchanged Now, we do not intend to get into the debate
from January 1 to December 31 of the year. of whether some managers simply trade
We cannot divulge what the findings of this a lot to increase their income, and perhaps

Journal of Regulation & Risk North Asia 171


even soft commissions [Myners (2001), returns cannot be determined with any
Bogle (2009)]. What we do believe is that degree of accuracy, such that portfolios, and
excessive trading can result in wasting client their managers, cannot be compared in any
assets and that mechanisms should be put in meaningful way, then the best way to deter-
place to more closely align portfolio manag- mine how well or bad they did during the
ers’ compensation with those of their clients year(s) is to compare them to doing abso-
such that they are not as trigger happy as lutely nothing during that period.
some seem to be. This calculation can easily be done and
if it is found that managers are, in fact,
Rebalancing act unable to beat themselves as well as the
The fact that managers know that they can indices against which they are compared,
only benefit from trading excessively means then maybe it is time for asset manage-
that they might end up making trades that ment companies to revert to investment
they might otherwise have not had they also committee asset allocation selections for
been forced to pay part of that fee them- long-term holdings.
selves. This situation becomes exacerbated They should also allow those who are
for managers who are simply unable to unable to do well to set up hedge funds
produce genuine alpha. They make up for and hide their lack of performance behind
their performance shortfall by trading a lot to the veil of secrecy that hedge funds pro-
increase trading income. vide. Of course, if hedge fund managers
Firstly, academics miss the point of what are also evaluated in this way, then maybe
a passive fund really is. Simply because a their own compensation packages might
portfolio manager follows a simple index also be modified.
it does not mean that they do not incur
trading costs. If the portfolio needs to be Portfolio turnover
rebalanced regularly it does cost a lot to It should be noted that we are in no way sug-
rebalance, perhaps significantly more than gesting that this is a scientific way of deter-
active funds. mining how good a manager really is. What
we are suggesting is that their performance-
Rollover futures based compensation should take account of
The cheapest way would obviously be for the fact that their efforts during the year have
investors to either invest in ETFs (exchange- in fact added to, or subtracted from, what the
traded funds) [Engle and Sarkar (2002)], client could have earned had the portfolio
although they have their own pricing prob- remained genuinely passive.
lems and issues [Huang and Guedj (2009)], More importantly, we are suggesting
or, even better, to simply rollover futures that fund managers might be more careful
contracts on indices. In the case of the latter about how many times they turn a portfolio
they even save the cost of the manager and over during the year, at a huge cost to their
his or her fund management company. clients, if they know their performance will
Secondly, if we accept that risk-adjusted be compared with their own fund without

172 Journal of Regulation & Risk North Asia


the cost of trading. We decided to test this marks for their projects if they could sub-
hypothesis using a number of graduate stu- stantiate their buy or sell decisions using
dents who were asked to see if they could analyst recommendations.
beat well-known stock indices and being Interestingly, given the period, such
totally passive for three years. In our exercise, analyst recommendations were somewhat
12 groups of students were asked to select 23 easily available. It goes without saying
shares each from a given major index in the that most selected companies with whose
US, where we used the S&P 500; in Britain, names they were familiar – which could
the FTSE 100; and in Germany, the DAX. once again be considered a bias, though not
definitely, since they tend to do better – it
Desultory trading is surprising that more fund managers do
The students were allowed to change not choose their own investments using a
their allocations once a month, taking similar methodology.
into account the cost of trades and the We all know that analyst recommenda-
spreads, calculated via the figures provide tions, unless they come with access to IPOs
by Elkins McSherry. Given that the port- from their investment banking brethren, are
folios had only US$100 million in the US, not really of much benefit. Nevertheless,
£100 million in the UK, and €100 million in most students made their buy and sell deci-
Germany, we did not take account of mar- sions based on such recommendations, like
ket impact. The students rarely traded, at their professional peers, in order to hopefully
most they sold two shares and bought two have a better performance and, obviously, a
replacements a month. higher mark in their projects.
The period of the study was January 1,
2003 to December 31, 2005. We chose this Astonishing finding
period since no major crises took place as far At the end of the project, they were asked
as we could remember. to compare their performances against their
Sadly, finding a period where noth- respective indices and their original portfolio
ing major happens is not easy. Our hope is without any transactions during the three
that the students did not cheat to improve years.
the performance of their portfolios, and are The results of the study, which we repeat
quite confident that they did not. However, are anything but scientific, were that when
even if they did, the bias would actually we compared the totally passive funds with
work against us, in that their active port- the somewhat active funds we found that
folios would do better than the completely in 2003, some 75 per cent of passive funds
passive ones. beat the active funds; in 2004, around 66.67
per cent of passives beat the actives; while
Logical choice in 2005, some 58.3 per cent achieved similar
The students were allowed to choose any results.
logic they wished to select the portfolios, Overall, on average, 66.67 per cent of
and were told they would be given higher the passive funds beat the active funds

Journal of Regulation & Risk North Asia 173


during the three-year period, with an aver- managers do spend more time thinking
age outperformance of 3.89 per cent. This is about the costs they incur when they keep
quite an astonishing finding. Granted that on trading their investments, costs that are
these students are not professional money predominantly borne by the clients, then
managers, but we feel confident that many they might take more strategic decisions
money managers would also be unable to when they buy or sell the shares, or other
beat themselves if such an exercise was per- asset classes, that they invest in.
formed on their funds as well. The current model, with the serious
accusations that many of these trades
Comparative performance are made for soft commissions, per the
Of course, to test just how good or bad these Myners report, or to get access to initial
students really were in managing money, public offerings (IPOs), or free research
we compared their performance against whose benefit is highly questionable, can-
their respective indices. When we compare not be allowed to continue.
the performance of both passive and active Investors must be protected and if aca-
funds with their respective indices we find demic analyses cannot help them do that
that in 2003, about 58.30 per cent of the then may be its time to reassess how money
active funds and 75 per cent of the passive managers are compensated, and a simple
funds beat the market; in 2004, around 75 tool would be to compare them to them-
per cent of the active funds and 91.67 per selves. In this case, one really does not need
cent of the passive funds beat the market; to use risk measures that even academics
and in 2005, approximately 91.6 per cent of find to be of little benefit.
active funds and 83.3 per cent of the passive
funds beat the market. Lack of insight
Overall, on average, 74.97 per cent of the In this, the fourth article in the economists’
active funds and 83.3 per cent of the passive hubris paper series we look at the contri-
funds beat the market during the three- butions of academic thought to the field
year period. On average, passive funds had of asset management. We find that while
an excess return of 13.06 per cent over their the theoretical aspects of modern portfolio
respective indices compared to 9.04 per considerations are valuable, they offer lit-
cent for the active funds. This means that tle insight into how the asset management
they are just as good, or bad, as an average industry actually operates, how its execu-
portfolio manager. tives are compensated, and how their per-
Obviously, if we also take account of formances are measured.
management fees their performance might We find that few, if any, portfolio man-
also come in just under or over the indices, agers look for the efficiency frontier in
but the fact remains that the totally passive their asset allocation processes, mainly
funds did perform significantly better during because it is almost impossible to locate
this period. in reality, and base their decisions on a
Our proposition is that if money combination of gut feelings and analyst

174 Journal of Regulation & Risk North Asia


recommendations. We also find that the during the period used to determine their
performance evaluation methodologies compensation schemes.
used are simply unable to provide inves- By incorporating the inertia concept,
tors with the necessary tools to compare portfolio managers who are unable to gen-
portfolio managers’ performances in any erate genuine alphas might be prevented
meaningful way. The fact that these models from using trading revenues to make up for
are based on CAPM, whose own contribu- performance related income shortfalls, since
tion to asset pricing is highly questionable, they would find that they are also paying
means that their application to portfolios for them indirectly. Finally, it might finally
of assets is simply not viable. put an end to the use of excessive trades in
return for soft commissions. •
Back to basics
We suggest that since portfolios cannot be References:
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portfolios that simply perform better than “The performance of hedge funds: risk, return and
their peers, irrespective of their so-called risk, incentives, Journal of Finance, 54:3, pp. 833-874
might not be a bad idea. Bogle, J. C., 2009, “Perspectives: the end of ‘soft dol-
The performance of many successful lars’?” working paper,The Vanguard Group
portfolio managers have been wrongly dis- Carhart, M., J. Carpenter., A. Lynch., D. Musto,
counted using these models and perhaps 2000, “Mutual fund survivorship,” Working Paper,
resulted in their difficulties in attracting the University of Pennsylvania
kind of assets that they deserve, possibly Carpenter, J. N. and A.W. Lynch, 1999, “Survivorship
resulting in their decision to leave traditional bias and attrition effects in measures of performance
money management and establishing suc- persistence,” Journal of Financial Economics, 54,
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Year Ratings,” Wall Street Journal,April 6, p. C1.
Excessive trading Elton, E. J., and M. J. Gruber, 1997,“Modern Portfolio
Finally, we believe that while providing Theory, 1950 to date,” Working paper number FIN-
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under management as compensation acts Elton, E. J., and M. J. Gruber, 1974, “Portfolio theory
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costs of trading on the clients can result in uted,” Journal of Finance, 29, 1265-1273
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the inertia concept, which incorporates a paper number S-97-42, New York University
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the cross section of mutual fund returns,” Journal of Myners, P., 2001, “Myners review of institutional
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176 Journal of Regulation & Risk North Asia


Foreign exchange

Can the yuan ever become an


international reserve currency?
John H. Makin of the American Enterprise
Institute questions whether China’s cur-
rency will become fully internationalised.

China has become a global economic just, inclusive, and well managed.” Among
superpower, accounting for a third of President Hu’s assertions was the claim that
global growth in 2010. Companies both “the current international currency system is
in the United States and abroad now a product of the past.” More specifically, he
offer to invoice their Chinese custom- has been critical, along with other Chinese
ers in yuan, and the yuan is growing as officials, of the primacy of the US dollar as a
an international medium of exchange. reserve currency and its use in international
Concerns that the yuan could replace trade and investment.
the dollar as an international reserve This criticism, coupled with the obser-
currency are, however, premature. To vation that China has rapidly become the
become a global financial superpower, world’s second largest economy, has made
China would have to relinquish control the internationalisation of its currency – the
over capital outflows and the exchange renminbi (RMB), alternatively known as the
rate between the yuan and other major yuan – a widely discussed topic (For one
currencies. Chinese officials are unlikely of the more noteworthy articles, see “Yuan
to undertake such liberalisation anytime Direction”, an analysis published in the
soon. Financial Times on December 14, 2010.).

During his recent visit to the United States, Next financial superpower?
Chinese president Hu Jintao asserted that China’s rapid emergence as a global eco-
the global financial crisis reflected “the nomic superpower is well established. Who
absence of regulation in financial innova- could deny it, now that the country has
tion” and the failure of financial institu- become the world’s second-largest econ-
tions “to fully reflect the changing status of omy? Perhaps more importantly, China
developing countries in the world economy accounted for about a third of global growth
and finance.” President Hu called for an in 2010, the year of global economic recov-
international financial system that is “fair, ery. China’s share of global growth last year

Journal of Regulation & Risk North Asia 177


was nearly equal to the share of all advanced other convertible currencies. Since such
economies combined. In 2009, as the only transactions generate what amount to yuan
growing major economy, China accounted denominated receivables, global companies
for almost all global growth – just below 90 may also find it advantageous to generate
per cent. India accounted for the rest. Just yuan payables to affect a hedge for their
a decade ago, China, rapidly growing as it yuan receivables. They can do this by bor-
was, accounted for just about a tenth of the rowing with bonds denominated in yuan,
growth in global output. Clearly China today issued in China or elsewhere. Caterpillar,
is an economic superpower. Now, many are a US company that produces earth-mov-
asking if it is ready to become a financial ing equipment, issued a one-billion-yuan
superpower too? bond offering in November 2010. Similarly,
McDonald’s undertook yuan-denominated
Financial primacy borrowing in August 2010.
As part of its quest for financial primacy, over For companies like McDonald’s and
the past year the Chinese government has Caterpillar that undertake substantial
cautiously experimented with steps toward business operations in China, yuan-
internationalisation of the yuan. China has denominated borrowing makes sense.
encouraged international trade conducted It provides a natural hedge, as already
in yuan. In June 2010, China expanded noted, for the yuan receivables generated
the yuan settlement scheme that allowed by allowing Chinese customers to make
imports and exports to be invoiced and paid payments in yuan, while underscoring
in yuan. the companies’ commitment to expanding
According to the Financial Times arti- their operations in China.
cle referred to earlier, the People’s Bank
of China says that trade settled in yuan Role of Hong Kong
totalled about 340 billion yuan between The Chinese government has permit-
June and November. While that is a sub- ted banks based in Hong Kong – which
stantial sum, given that such trade set- is sometimes called China’s laboratory
tlement was virtually zero a year ago, the for yuan internationalisation – to accept
absolute level (the equivalent of about deposits from residents denominated in
US$50 billion) is modest. yuan. Something of a rush has developed
among Hong Kong–based Chinese to
Yuan denominated borrowing add to their yuan-based deposits. Hong
There are good reasons to expect a grow- Kong shops widely accept yuan for pay-
ing role for the yuan as a medium of ment in goods.
exchange in coming years. Global compa- Hong Kong residents, of course, may
nies aiming to expand business in China only convert up to US$2,500 per day into
can offer to invoice their Chinese custom- Chinese currency, but many have multi-
ers in yuan, thereby saving them the cost ple accounts along with computer-driven
and inconvenience of paying in dollars or instructions to convert US$2,500 worth of

178 Journal of Regulation & Risk North Asia


Hong Kong dollars into yuan daily. Since the full currency convertibility by ending the
Hong Kong dollar is pegged to the US dollar, strict controls on private capital outflows.
conversion into yuan amounts to a vote in
favour of China’s currency versus the dollar. Historical analysis
Beyond that, cash machines issue yuan along Consider some history. After World War II,
with Hong Kong dollars, further underscor- the rapid emergence of the United States as
ing the growing role of China’s currency as a a global superpower carried with it the dol-
medium of exchange in Hong Kong. lar’s ascent over sterling as the world’s pre-
These developments suggest that the eminent currency. The dollar became the
yuan’s role as an international medium of dominant reserve currency accumulated by
exchange and unit of account has begun a central banks around the world. The Bretton
period of rapid growth, from a starting point Woods system, whereby gold and dollars
of virtually zero use as recently as a year ago. were used as international reserves, devel-
oped out of a dollar shortage after World War
Global reserve currency? II and was fostered further by the peg that set
Given the sound economic reasons for this the dollar’s value against the price of gold at
development, the practice of invoicing in $35 per ounce.
yuan and borrowing and lending denomi- The system broke down in August 1971,
nated in yuan will probably continue to as the United States ended the dollar’s peg
grow, especially among international com- to gold, but the dollar’s role as a global cur-
panies with extensive and growing dealings rency has continued in a world of mostly
in China. floating exchange rates. The United States’
All this said, it would be a mistake to large share in global trade, along with the
assume – as some, including President Hu, pre-eminence of dollar-based financial mar-
have done recently – that China’s rapid kets, has continued to support this role.
emergence as an economic superpower
and the limited use of its currency as both Preconditions
a medium of exchange and unit of account While China certainly has emerged as a
necessarily entail emergence of the yuan as a global economic superpower, alongside the
global reserve currency. United States, it is too early to tell whether
the yuan can serve as a global reserve
Historical precedent currency.
While China’s prominence in global trade Such a role requires that three basic con-
has led to an increased role for the yuan ditions be satisfied by the currency’s supplier:
as a global medium of exchange and an It must provide and guarantee full convert-
invoicing currency, as well as to more yuan- ibility for the currency for all international
denominated borrowing and lending by transactions, including capital transactions;
global companies operating in China, the It must fully respect the property rights of all
yuan’s emergence as a global reserve cur- holders of its currency inside and outside its
rency cannot begin until China establishes national borders; and finally, it must eschew

Journal of Regulation & Risk North Asia 179


further controls on global capital flows and trade of goods and services is inconsistent
avoid persistent currency intervention. with its laggard role in global capital mar-
Without the latter condition, reserve kets, save as an importer of capital under
currency systems break down, as the controlled conditions. China is also an
Bretton Woods system did in 1971, importer of foreign currencies, heavily buy-
because it is impossible to foresee what ing major currencies to prevent apprecia-
exchange rates are appropriate in a con- tion of the yuan. Those purchases leave the
stantly changing global environment. Chinese government struggling to store
China currently meets none of these con- wealth by way of international investments
ditions. yuan convertibility is limited to that are unavailable to China’s skilful private
transactions tied to trade in goods and investors.
services and is largely prohibited for capi- China’s restrictions on capital outflows
tal account transactions. may end up denying China’s financial insti-
tutions a full role in yuan-denominated
A long process financial intermediation, just as America’s
The Chinese government closely regulates post-1965 controls on capital outflows
the use of the yuan even for cross-border helped foster the growth of the euro-dollar
settlements and is not ready to relinquish market.
its control over that process, let alone its Euro-dollar and dollar denominated
control over the exchange rate between accounts offered by financial intermediar-
the yuan and other major currencies. As ies outside the United States –substantially
President Hu has said, making the yuan a benefited the non-US banks that fostered
full-fledged international currency“will be a their growth and ultimately contributed to
fairly long process.” a dismantling of the US controls on capi-
The pace at which the Chinese govern- tal outflows that were imposed in 1965.
ment allows the internationalisation of the Perhaps the euro-yuan market will emerge
yuan to develop will depend on the benefits outside of China to expedite growth of
that process confers on China. Parallel ben- the yuan’s role as a global medium of
efits will emerge for the global economy if exchange and invoicing currency for trade
China’s move toward full yuan convertibility and financial flows.
enhances unfettered capital flows into and
out of the country, alongside free flows of Yuan capital flows
goods and services. Euro yuan borrowing and lending facili-
It is probably fair to say that full yuan ties might be offered by, say, JPMorgan or
convertibility, as yet a highly uncertain pros- Deutsche Bank, growing at a pace far in
pect, is a necessary condition for China to excess of that desired by Chinese authori-
emerge as a true global power, with a finan- ties. Perhaps the potential for such growth
cial sector that matches the prominence of will help convince China’s regulators, wary
its production sector. of a loss of control given unfettered inter-
Presently, China’s prominence in global national yuan capital flows, that faster

180 Journal of Regulation & Risk North Asia


movement toward full convertibility of the contributes to heavy pressure for the cur-
yuan, including a removal of restrictions rency to appreciate as an index of its desir-
on capital outflows, would be in China’s ability as a store of value.
interest.
Even if a thriving euro-yuan market Growing pressures
develops inside the global financial system, Actually the pressure for yuan appreciation
widespread accumulation of unhedged is, as already noted, a by-product of the artifi-
yuan balances or expediting of unhedged cial shortage of yuan in global currency mar-
international yuan flows will not likely occur kets that results from Chinese government
until the yuan is established as a viable global restrictions on capital outflows, that is, the
store of value. Such a stature for a national purchase of assets abroad by private sector
currency – like that enjoyed by sterling for a Chinese investors. Many of those investors
century before World War II, and by the US are sorely disadvantaged by a lack of ways
dollar since World War II – requires full con- to store and further enhance the wealth they
vertibility at a minimum and confidence in are rapidly accumulating as a by-product of
the stability of the future purchasing power China’s rapid economic growth.
of that currency. Looking ahead, China’s currency will
probably continue to develop as both an
Inflation hedge international medium of exchange and a
Presently, the yuan is an inconvertible cur- unit of account. Global enterprises can and
rency that is depreciating against Chinese probably will continue to expand the flow
goods and services at the current Chinese of exports and imports invoiced in yuan
inflation rate of more than five per cent on while simultaneously expanding yuan-
a year-over-year basis and more than 10 denominated borrowing and lending facili-
per cent at an annualised rate over the past ties. There are sound economic reasons for
three months. this development.
It is difficult to imagine why anyone,
including a Chinese firm or household, Government intervention
would wish to use yuan-denominated However, further development of the yuan
cash or financial assets as a means to as an international reserve currency accu-
store purchasing power either inside or mulated alongside dollars and gold by cen-
outside China, especially since China’s tral banks will proceed at a much slower
inflation rate means that most yuan bal- rate. The aforementioned Financial Times
ances inside China are actually losing article reported that the Chinese govern-
purchasing power. ment has concluded currency swap agree-
That is the result of an inflation rate ments – in effect, a limited role for the yuan
over and above the nominal interest rate as a reserve currency – with central banks in
(about 2.5 per cent) paid on yuan balances. eight countries for a total value of just over
Many observers are mistakenly viewing US$120 billion.
the apparent excess demand for yuan that Under these agreements, China will

Journal of Regulation & Risk North Asia 181


lend specified yuan amounts to the central appreciating, it injects yuan into China’s
banks for a short period of time. This figure economy at a pace fast enough to push up
is dwarfed by the US$6-$8 trillion of global inflation.
reserve assets held by central banks, the big-
gest part of which is the US$2.8 trillion held Aggressive purchases
by the Chinese. To complain that such inflation is the fault
The role a national currency can play as of the United States, when the offending
an international reserve asset has evolved growth of the Chinese money supply is a
over time as global traders find it convenient direct result of China’s aggressive purchase
and less costly to denominate trade in goods of dollars in the foreign exchange market,
and financial assets in a familiar currency is somewhat disingenuous. China has dis-
that originates in a country with large, liquid, played buyer’s remorse concerning its dollar
and open capital markets. acquisitions. In 2009, China’s central bank
governor Zhou Xiaochuan called for the
Demise of Bretton Woods creation of a new synthetic reserve currency
The United Kingdom fulfilled this role for as an alternative to the dollar.
the one hundred before World War II and, Simultaneously, China’s sovereign
as already noted, the United States has ful- wealth fund has sought to accumulate
filled the role since then. However, the gold- reserve assets other than the dollar assets
exchange standard, which saw the dollar that have resulted from heavy intervention
co-exist as a reserve asset alongside gold to prevent yuan appreciation. Such acquisi-
until 1971, broke down when the interna- tions include assets denominated in euros
tional supply of dollars rose so rapidly that it as well as investments in global hedge funds
was impossible for the United States to con- that provide more diversification across dif-
tinue to peg the dollar to the price of gold at ferent asset classes than they do across dif-
US$35 per ounce. ferent currencies.
Subsequently, the system of floating
exchange rates evolved, within which the Asian trading currency
dollar continues to play a role as an interna- China’s desire for a substitute for dollars in
tional reserve asset. That role is a by-product its reserve accounts, coupled with an appar-
of the tendency for export countries, such ent desire to increase the international role
as China, to resist currency appreciation to of its currency, is intriguing, especially in the
encourage growth of the export sector. context of China’s recent more aggressive
geopolitical stance in Asia.
Yuan injection As a primary trading partner for many
If, as a by-product of that policy, the stock of Asian nations, the Chinese at times appear
dollars held by foreign central banks, includ- to be thinking of an expanded role for the
ing the Chinese, rises too rapidly, inflation yuan as an Asian trading currency that sub-
may result. When China’s monetary author- stitutes for the dollar. Still, the Chinese push
ity purchases dollars to keep them from for yuan internationalisation, which includes

182 Journal of Regulation & Risk North Asia


the reserve currency role, may be difficult for of value as well as a medium of exchange
China to pursue. Internationalisation of a and unit of account, highly unlikely in the
national currency tends to be more a “pull” near term.
process than a“push”process. That said, it will be interesting to see if
As Research Director Dr Paola Subacchi China’s new leadership who will take up
stated in a recent analytical paper for the power at the end of 2012, seek to expedite
British policy institute, Chatham House: the international convertibility of the yuan by
“Beijing is openly aware of the fact that relaxing controls on capital outflows. If that
there is no road map to guide this [yuan turns out to be the case, a full global role for
internationalisation] process.” Full-fledged the yuan as international money may be in
reserve currency roles tend to be borne out the cards. •
of the economic and financial role played
by the countries whose central banks issue References
those currencies. Andrew Browne, “China’s President Lays Ground-
While China’s rapid economic growth work for Obama Talks,” Wall Street Journal Asia,
and burgeoning role in international trade January 17, 2011.
suggest the yuan is a logical candidate for Yuan Direction,” an analysis published in the Financial
invoicing and financing international com- Times on December 14, 2010.
merce, especially in Asia, its ambivalence Paola Subacchi, “One Currency, Two Systems: Chi-
about free capital flows makes a full-fledged na’s Renminbi Strategy,” Chatham House briefing
international role for its currency, as a store paper, October 2010.

J ournal of Regulation & Risk


North Asia

Editorial deadline for


Vol III Issue II, Summer 2011

June 15, 2011

Journal of Regulation & Risk North Asia 183


Sovereign debt

How Spain can avoid a


repetition of the Irish error
Prof. Charles W. Calomiris & Desmond
Lachman dispense radical economic advice
to Spain to avert another European tragedy.

In seeking solutions to the Eurozone relative to GDP, as neither had engaged in


sovereign debt crisis, the more manage- unsustainable spending or dishonest public
able Irish and Spanish cases should be accounting practices during the pre-2007
distinguished from the much less tracta- boom. In contrast to Greece, both countries
ble Greek situation of egregious budget also enjoy much healthier political systems
profligacy. Years of fiscal irresponsibility and lower levels of corruption and tax eva-
make it almost certain that Greece will sion; and both countries also boast records of
default on its sovereign debt and exit global success for key domestic enterprises.
from the European Union in the absence Such a policy initiative by Spain would
of a massive fiscal transfer by Brussels. also seem to be in the long-term interest of
European and global financial stability.
Greece’s public debt (already approaching an
unsustainable 150 per cent of GDP and still Extreme housing bubble
rising) simply cannot be repaid. By provid- Rather than fiscal profligacy, the root
ing ample liquidity, the EU-IMF assistance of the economic malaise in Ireland and
to Athens thus far has postponed the col- Spain was their extreme housing bubbles,
lapse of Greece’s public finances, but it will which both saw housing price apprecia-
not avoid its eventual need for restructuring. tion twice that experienced in the United
Indeed, by plunging the Greek economy States. The housing booms were financed
into the deepest of economic recessions, the by bank lending, largely financed from
austerity program is worsening the country’s non-deposit wholesale borrowing in
debt service ability. international debt markets.
The struggles of Ireland and Spain do The bursting of those bubbles spawned
not reflect fiscal recklessness. That should serious losses for their banks, despite the fact
allow for a much more favourable resolution that, in Spain, those losses remain largely
than in the Greek case. Neither country had unrecognised. Spain’s unrecognised losses
large pre-existing amounts of sovereign debt include massive amounts of mortgages that

Journal of Regulation & Risk North Asia 185


are underwater, as well as “evergreened” viability, Spain needs to learn from this sorry
loans to real estate developers on which tale. So what should Spain do?
losses remain largely unrecognised, accord- First and foremost, Spain must stop lis-
ing to Moody’s. The ending of the property tening to the EU and the IMF and start lis-
booms in Ireland and Spain also substan- tening to the debt markets, whose drumbeat
tially eroded these countries tax bases, which of rising sovereign interest rates requires
adds to their fiscal deficits. an urgent response. This would seem to be
particularly the case in light of Spain’s heavy
Ireland’s mistakes financing needs in 2011 and the depress-
Ireland has managed to make what should ing effect of rising Spanish interest rates on
have been a manageable banking insol- its banks’ profit margins. Spain must avoid
vency problem into an irresolvable pub- the IMF-European Financial Stabilisation
lic finance problem. It did so by agreeing Facility (EFSM) bailout trap and instead
to have its government provide a blanket move expeditiously to hatch a four-part plan
guarantee for practically all the liabilities of with the over-arching objective of maintain-
its failed banks. And it is now being bullied ing its sovereign solvency to avoid an Irish-
into maintaining those ruinous guarantees style disaster.
by its European partners and the IMF in
return for multilateral assistance in rolling Calomiris-Lachman fix
over its debts. First and foremost, the Bank of Spain
In an act of egregious political callous- should immediately use its independent
ness, Ireland’s European partners have effec- authority to shut down both insolvent and
tively thrown the Irish economy under the severely undercapitalised Spanish savings
bus. They have done so by effectively sacri- banks (cajas). Even large institutions like
ficing Ireland’s long-term economic viability Bancaja and Caja Madrid, if their true con-
in order to postpone the recognition by the dition is sufficiently weak, should be closed.
European banking system of its losses on Such an approach will prevent Spain from
debts of Irish banks. endangering its own fiscal sustainability
Unfortunately for Ireland, a number of or the health of its large banks by bearing
important European countries have huge the cost of further losses going forward or
banking system exposures to Irish debt, by encouraging healthy Spanish banks
which amount to over nine per cent and 14 to acquire insolvent cajas. The European
per cent of GDP for the United Kingdom and Central Bank should lend its support by
Belgium respectively. As Patrick Honohan, giving healthy Spanish banks full access
the Irish central bank governor has acknowl- to liquidity facilities during the process of
edged, the Irish government agreed to the shutting down the failed cajas.
bargain because they saw no other viable Second, this will only work if Spain stops
means of financing their short-term fiscal co-operating with European obfuscation of
deficits without EU and IMF support. loan losses, and stops relying on selective
For its own sake and for that of the euro’s disclosure of unrealistic“stress test”scenarios

186 Journal of Regulation & Risk North Asia


for its banks. Such stress tests have been much greater bargaining power for receiving
thoroughly rejected by the financial markets. the short-term assistance it needs from pri-
Mortgage losses at cajas, and likely losses to vate and public lenders.
creditors of failed cajas, should be recognised While many policymakers today are
and publicised, and portfolio information frightened of transparency and bank clo-
must be disclosed in detail for both healthy sures, the historical record is clear: only by
and unhealthy banks. Such an approach credibly recognising banking system losses
would make it clear how large losses are can governments put an end to financial
likely to be, and which creditors are likely to markets uncertainties. This has been the
suffer losses. successful historical approach to dealing
with banking crises for centuries. For exam-
High requirements ple, in 1900, the legendary Russian finance
Recognising losses now and being clear minister, Sergei Witte, allowed some banks
about their incidence among creditors of to fail, protected others, and was able to
the cajas will greatly calm market concerns raise the funds needed to provide liquidity
about systemic risk, and focus attention protection to the survivors easily in interna-
where it is warranted on a few weakened tional markets, putting an end to Russia’s
European creditor banks. The necessary banking crisis.
regulatory interventions to recognise bank
losses will also encourage the housing mar- Historical precedents
ket to clear, which is essential to resolving More recently, Argentina brought its bank-
ongoing financial uncertainty. ing crisis to an end in 1995 through the
To their credit, the Bank of Spain has transparent recognition of losses, the clo-
imposed high provisioning requirements on sure of failed banks, and the willingness to
mortgage loans, compared to other coun- impose losses on uninsured creditors. By
tries. However, a policy of regulatory forbear- way of contrast, Ireland’s policy this year of
ance has discouraged foreclosures and has withholding information and avoiding bank
prevented home prices from finding their closures and creditor losses produced bank
bottom. Home prices have been allowed to runs that led to the withdrawal of one third
decline by only around 15 per cent after their of its banks’deposits.
approximate 200 per cent run-up during the Third, long-term reforms of labour mar-
bubble years. kets and cuts in pensions, which are already
Such a policy initiative by Spain would underway, should be accelerated and inten-
also seem to be in the longer run interest of sified. Stuck within the euro straitjacket
European and global financial stability. The that precludes devaluation, such reforms
risk of contagion to Spain would be mini- are desperately needed to restore interna-
mised once it is clear that Spain will not be tional competitiveness. Spain’s dual labour
complicit in an Irish-style destructive bar- market (consisting of protected workers
gain to absorb the large loan losses on the whose wages are rigid and a smaller group
European banks’ books. Spain will also have of unprotected workers) has forced a small

Journal of Regulation & Risk North Asia 187


percentage of workers to absorb a dispro- maintaining sovereign creditworthiness is
portional amount of the variation in employ- challenging without positive short-term
ment demand over the business cycle. That growth prospects.
is not only unfair, it is unworkable for a Spending reforms that focus on long-
country with a 20 per cent unemployment run declines in spending as a share of GDP
rate that is desperately in need of substantial are desirable, but short-run fiscal austerity
wage adjustment. programmes that drive more people out of
Spain boasts many globally successful work or increase the tax burdens on firms
enterprises, as well as substantial capabili- or consumers will not restore international
ties to export and to attract foreign capital. investors’confidence.
If labour and pension reforms are enacted, Now is the time for Spain to take its
Spain’s competitiveness will be restored, destiny into its own hands and, in doing so,
its current account deficit will reverse, and restore the viability of at least a large part of
Spain will have no trouble maintaining a the Eurozone economy. •
sustainable foreign balance.
Fourth, Spain should persevere with Editor’s note
long run budget consolidation mainly The publisher and editor of the Journal wish
through spending reforms. Spain should to thank Prof. Calomiris, Mr. Lachman and
resist tax increases or draconian addi- economics21.org for allowing the JRRNA to
tional short-term spending cuts, which are reproduce an abridged version of this article.
counter-productive for restoring growth. As Copyright remains the sole preserve of the
Greece’s unfortunate experience has shown, authors and economics21.org

J ournal of Regulation & Risk


North Asia
J ournal of regu

Call for papers


lation & risk
north asia

ce Volume I, Issue III,


Complian Articles & Papers
Autumn Winter 2009-2010

Issues in resolving
systemically important
impacts
financial institutions

change
Resecuritisation Dr Eric S. Rosengren
in banking: major

financial ance and risk


challenges ahead
A framework for

Global
funding liquidity Dr Fang Du
in times of financial
compli Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
t– men
from bad to worst
manage
Derivatives: from
disaster to re-regulatio Stephan Schoess,
products potent n
head of details a kets.
Black swans, market Professor Lynn A. Stout
EastNet’s David Dekker,
crises and risk: the
human perspective
nce, l mar Measuring & managing
in financia risk for innovative Joseph Rizzi
complia reaction Red star spangled
financial instruments

chemical banner: root causes Dr Stuart M. Turnbull


of the financial crisis
oth-
The ‘family’ risk:
amongst
Andreas Kern & Christian
a cause for concern Fahrholz
companies es. among Asian investors
be one of to offer these servicGlobal t financial change impacts compliance
will just David Smith
signs be able speak abou
d rather
and risk
the first that will The-scramble is on
we saw d ers we shoul moni Opinion
banks, or that to tackle bribery David Dekker
a year ago the financial worl These days tions than
and corruption
About in a nameWho exactly is subject to
formation credit crisis financial institu Penelope Tham & Gerald
of a trans last months the e providers,
world at tored financial servicand future activities.
the Foreign Corrupt
Practices Act? Deregulatio Li

and in the
formed
cial
the finan ge that is current
Financial
have move
d markets remuneratio n reform: one step
Tham Yuet-Ming n, non-regulat
has trans chan covers their how rapidly we the Ofbank s forward
ion
sive pace. the in scope than
er Look at
ction on
‘Black
to
Swans’, stress tests
& optimised risk
Umesh Kumar & Kevin
Marr and ‘desupe
an explo
is much
broad
occurring expected. bank
s that
were physical
intera tion)
of operaChallenging the value of
fall from (location and hours Internet banking. enterprise risk managemen
management
David Samuels rvision ’
to fail or t Professor
causes of the William Black exam
originally to be too big by terms then e, but
Rocky road ahead for global
payments
Tim Pagett & Ranjit
taken over in charg accountancy convergence Jaswal
considered electronic s were still is shiftin
The g to a ines the
r failing or being more finan-
are Again the bank igm Asian regulatory
Rubik’s Dr Philip Goeth mortgage fraud
are eithe s that para- parad
the cor-
ns and
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epidemic

Contact
institution mentioned (physical perso has swept
the United that
a huge s
financial d, resulting in by as
Alan Ewins and Angus
regarded e we ut the bank Ross
cially soun how banks are world wher each other witho s such as THE author States.
in pay ologie of this paper
digm shift banks. porations) with new techn academic, is a leadin
ic and other ement lawyer and
the publ d involv ents. regulator former bankin g and they implici
es aroun mobile paym
specia g cal failures tly demonstrate
y revolv crime. As one lising in ‘white three criti-
ing largel e customers, los- of the unsun collar’ failure of regulation
Since bank providers s and organisatio
ns Savings & of private marke and a wholesale
the ability
to servic impact Loans debacl g heroes of the and
trust and mining the Network the bank other pay- Professor other t discipl
mer and deter ongo ing risk the future and Black nowad e of the 1980s, Crimes forms of credit risk. ine of fraud
ing a custo be part of the as In T, NACHA providers of his time ays spend Enforcement The Financ
d n, as well as SWIF e network researching s much ial

Christopher Rogers
A to B released a Network
of it, shoul of the organisatio g and new such networks becom markets have why financ study this (FinCE
nt money from traf- a tendency ial Activit week on Suspic N)
manageme ess of existin /buying ment to send ork functional. to become y
dys- lated Reports (SARs) that
the riskin using allow you you for the netw ri- Renowned ious
monitoring customers es that e brings simila y
‘control fraud’ for his theory financial institut federally regu-
and the more chang will charg ate. This , Prof. Black on with ions (somet
products cts. But there are are and you gener m, energ University lectures at the Federa imes) file
world that fic that as teleco of Missouri the (FBI) l Bureau of
these produ in the banking n it. indus tries such . The financial He is the author and Kansa
s City.
when they
find eviden
Investigation
nges know with anies of ‘The Best
and challe as we have not be the ties cable comp g an important a Bank is Way to Rob fraud. ce of mortga
g banking , iers and rgoin to Own One: ge
threatenin s will, in the future our funds, suppl is clearly unde Executives
and Politic
How Corpo
rate Epidem
The bank by which to move they world 135 S&L Indust ians Looted ic warning
les portfolios; ry.’ A promi the The
default vehic balances and

Editor-in-Chief
tor on the nent comm FBI
our causes of
the curren enta- mortga began warning of an
maintain crisis, Prof.
Black is a t financial ge fraud in “epidemic”
of
h Asia mony their congre
Risk Nort way the US vocal critic
of the ago. in September 2004 –
ssional testi-
lation & government
of Regu banking crisis has handle It also warned over five years
Journal and reward d the that
that have
clearly ed institutions not dealt with it would if the epidemic were
duties to invest failed in their fiducia sis. Nothin cause a financi
g remotely
ors. ry respon adequate was al cri-
d to the epidem done to
enforcement, ic by regulat
The followi or ors, law
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et

christopher.rogers@irrna.org
nt the view nec- hyper- , the epidem dis-
Regulation of the Journa inflated a bubble ic produced
and Risk – l of that in US housin and
“The new North Asia. produced a g prices
numbers on crisis so severe
rals for mortga criminal refer- caused the collaps that
ge fraud in system e of the global it nearly
the US are
just in many and led to unprecedente financial
Journal of of the world’s d bailouts of
Regulation largest banks.
& Risk North
Asia

33

188 Journal of Regulation & Risk North Asia


Sovereign debt

The European Union debt


crisis:Worrisome delusions
Prof. Charles Wyplosz of the Geneva
Graduate Institute believes the ECB’s cur-
rent attitude to sovereign debt is myopic.

Lorenzo Bini-Smaghi, a member bank accounts (this is what Argentina did


of the European Central Bank (ECB) during its 2001 corralito); this is not the sort
Executive Board, has produced a brilliant of thing that true democracies do. Default,
defence of the no-default strategy cur- he argues, would be nothing more than a
rently being pursued by the Eurozone “quick fix”that produced much worse conse-
authorities. This paper argues that quences than the alternative policy, namely
instead of ruling out highly plausible years of tight fiscal policies and structural
outcomes, the ECB should explain how reforms.
it would react if defaults happen. By not
making adequate preparations, it may be Shortcomings in reasoning
raising the odds on a bad scenario. These are mostly solid arguments though
it would be interesting to understand why
In the December 16 edition of the Financial democracies cannot default and what
Times, Lorenzo Bini-Smaghi penned a col- structural reforms have to do with fiscal
umn vehemently opposed to any notion discipline and, if they do, how soon their
of a sovereign debt default among those beneficial effects can be felt. The weakness
members of the Eurozone struggling to re- in the argument is that it contains no seri-
adjust their economies and public finances ous effort at considering the“bad luck”– but
in the wake of the 2008 banking crisis. Bini- likely – outcome of sovereign debt resched-
Smaghi’s arguments justifying his and the uling. He writes as if what the ECB wants is
ECB’s stance are quite straightforward and what will happen.
can be summarised thus: Public debts are In fact, for nearly a year now, policymak-
widely-held instruments so that a default ers, including the ECB, have been running
would harm domestic banks and domestic behind events.
citizens. Default would possibly trigger bank Initially Greece was told not to ask for
runs and force governments to take extreme International Monetary Fund (IMF) assis-
administrative measures like the freezing of tance and to make do with a promised

Journal of Regulation & Risk North Asia 189


loan of €10 billion extended by the ECB his logic makes sense. But nothing is sure in
and Eurozone member nations. Eventually this life. Instead of ruling out highly plausible
a €110 billion loan was granted with the outcomes, the ECB should explain how they
IMF, showing how far off the mark policy- will react if defaults were to happen.
makers were. Default would be a terribly messy situ-
ation. Policy responses – which would have
Fear of contagion to be put in place extremely rapidly; over a
Worse, perhaps, this loan was not to be called weekend in the best of cases – will be cru-
by its real name – a bailout. Rather, calling it cial in shaping the gravity of any default’s
for what it was would have run against the implications. This is the reason why the ECB
spirit of the Treaty’s no bailout clause – and needs to think ahead on this.
quite possibly the letter of the Treaty as well. Lorenzo Bini-Smaghi recalls examples
The reason given for this new contribu- of botched defaults but is remarkably silent
tion to eurospeak was that the 180-degree on what he would do if he were to face such
reversal of previously set principles aimed a situation. Planning for the worst is surely
at avoiding contagion and defaults. But both preferable to arguing for only consider-
will happen. ing the best. At the very least, six complex
Contagion is a real and present dan- questions must be dealt with as a matter of
ger, with many believing a debt default will urgency.
occur sooner rather than later. The ECB,
which once vowed never to buy public Redemptions speed-up
debts outright, has done so on a large scale A first question is whether Eurozone
since May 2010 – a matter Bundesbank member states can face down the markets.
President Axel Weber was publicly opposed We know that public debt redemptions
to, and one which ultimately informed will accelerate during 2011. According to
his decision to step down early from his the IMF, the financing needs of Greece,
Bundesbank position. Ireland, Portugal and Spain over the last
quarter of 2010 and 2011 – most of which
Need for a ‘Plan B’ will come due in the first two quarters of
This effectively ending his candidacy for 2011 – add up to €320 billion. Add Italy
the role of President of the ECB after Jean and you get €712 billion.
Claude-Trichet’s term expires in November.
Indeed, actions taken by the ECB, far from Fierce opposition
alleviating matters, have resulted in the cen- It is understandable that the ECB has called
tral bank asking for recapitalisation. for an enlargement of the European Financial
The ECB’s asking for more capital is a Stability Fund (EFSF) which can provide up
fairly clear admission that it is no longer rul- to €440 billion. But this request has resulted
ing out sovereign default. If Lorenzo Bini- in fierce opposition by the Heads of State.
Smaghi is right and Europe weathers today’s The IMF can add some money at some
storm without a sovereign debt rescheduling, notice, but this is limited.

190 Journal of Regulation & Risk North Asia


In short, it is unlikely that we have the European default – but there is no reason
means to quiet down market concerns if they why it should not be the case.
lead to a refusal of providing fresh money. The same authors find that the costs of
Thus, how markets behave during the default are “significant but short lived” and
coming months is a litmus test on ECB that they “seem to shorten the life expec-
actions and those of the Eurozone mem- tancy of governments and officials in charge
ber countries currently struggling under a of the economy”. This last point may explain
huge burden of public debt. However, recent why policymakers tend to delay the day of
downgrades by the rating agencies, how- reckoning and, in doing so, raise the even-
ever, belie the official optimism still emenat- tual costs of defaults.
ing from the ECB. Europeans may see themselves as
unworthy of defaults but their current
Anti-default strategy behaviour fits pretty well the general pattern.
The second question concerns the strategy Third is the question of how Eurozone
of avoiding defaults. Officially, creditors are member states can organise defaults if and
not to face “haircuts” until 2013 when the when they become unavoidable.
new fund will come into existence, following
unanimous ratification of a “minor” Treaty Acceptable patterns
change. This sort of ratification is far from The current approach is to impose pat-
certain and markets are most unlikely to wait terns of behaviour on member states that
until 2013. are deemed to be acceptable. Greece and
Lacking a collective mechanism, each Ireland have been severely constrained in
member country will be left to fend for itself. their policy choices by a combination of
This is not just a recipe for bushfire conta- sticks – heavy political pressure – and carrots
gion, it also guarantees the kind of messy – the loans. Both have worked with surpris-
management that Bini-Smaghi offers as a ing effectiveness probably because these are
reason for ruling out defaults. Put differently, small countries.
by not making adequate preparations we But if a country is eventually forced to
raise the odds of a very bad scenario. default, will the process also be subject to
collective monitoring? The usual process
Debt defaults are not rare involves negotiations with the creditors.
This is surprising. Sovereign defaults are Can the Eurozone countries whose banks
not rare events, nor are they black-or-white and citizens are creditors, advise defaulting
events. Most sovereign defaults are partial authorities? Or should each country be left
as they take the form of debt restructuring free to tease out the best deal that it can?
that result in limited haircuts. Borenstein
and Panizza (2008) identify 20 such defaults Domino effect
over 1981-2004, almost one per year. None The fourth question is whether one coun-
of them occurred in Europe – we have to try’s default will trigger others; if so, we need
go back to the interwar period to find a to identify steps that ring-fence the first

Journal of Regulation & Risk North Asia 191


defaulter to prevent this. We know that pour- billion and €80 billion and it could be forced
ing money on the problem has not worked to add much more if larger countries such as
so far. Nor has the imposition of tough fiscal Spain and Italy join those countries already
stabilisation measures on Greece first, and under considerable debt distress.
Ireland next, succeeded in convincing poten- A moderate haircut of, say, 20 per cent
tial target governments to do what it takes could thus lead to losses that exhaust the
to placate market concerns. We don’t even ECB’s enlarged capital base, thus precipitat-
know whether this is possible. ing further crisis. More capital can be added,
of course, but do we understand the impli-
Systemically important banks cations for its independence or future role
Fifth is the scary prospect that defaults in directing monetary policy should a worse
would put a number of financial institu- case scenario come into being?
tions, some of them systemically impor-
tant, in jeopardy. Smokescreen
Bini-Smaghi explicitly argues that avoid- Undoubtedly, policymakers will respond
ing bank failures is a good reason to bail out that they cannot discuss openly these
governments. His view is that it is cheaper, issues for fear of pouring oil on a burning
which may well be the case. fire. This is probably true, but one can hope
But what about moral hazard? The offi- that they are actively working on these
cial answer seems to be that the solution is a complicated issues and will be ready when
toughening of the Stability and Growth Pact, and if needed.
but many observers believe that the pact has Maybe publicly denying the problems pro-
lost all credibility and that, anyway, it cannot vides a smokescreen for internal work on
be made to work. Plan B. Maybe, but then maybe not. •

A repeat of Ireland References


A related issue is political. German taxpay- Eduardo Borensztein and Ugo Panizza,“The Costs of
ers hate bailing out their own banks but they Sovereign Default”, IMF Working Paper WP/08/238,
seem to hate even more bailing out profli- October 2008.
gate foreign governments. Financial Times (2010) “Europe cannot default its
At any rate, if sovereign defaults cannot way back to health”, December 16.
be avoided and if some banks will fail as a
consequence, how can we avoid a repeat Editor’s note
of the Irish story; the fact that bank bailouts The publisher and editor of the Journal of
ineluctably lead to sovereign debt crises? The Regulation and risk – North Asia, are grateful
final issue: the ECB is asking for an additional to VoxEU – www.voxeu.org – and Professor
€5 billion in capital, to bring its total to about Charles Wyplosz for permitting the Journal
€10 billion. It has been widely reported that to reproduce an abridged version of this
the ECB has purchased or exchanged pub- article, which was originally published on
lic bonds for an amount that is between €60 VoxEu’s website.

192 Journal of Regulation & Risk North Asia


Fiscal policy

Fiscal policy in the US and


European Union ‘misguided’
Nobel Laureate Prof. Paul Krugman
advances a new economic model to deal
with the aftershocks of the banking crisis.

Debt is the crux of current policy the stage for the crisis, and the overhang of
debates among advanced economies. debt continues to act as a drag on recovery.
Some argue for fiscal expansion to avoid The current preoccupation with debt harks
recession and deflation. Others claim that back to a long tradition in economic analysis,
you can’t solve a debt-created problem from Fisher’s (1933) theory of debt deflation
with more debt. This paper explains the to Minsky’s (1986) back-in-vogue work on
core logic of a new model by Eggertsson financial instability to Koo’s (2008) concept
and Krugman in which debt shocks and of balance-sheet recessions.
policy reactions can be examined. Yet despite the prominence of debt in
popular discussion of our current economic
Relying on heterogeneous agents, the model difficulties and the long tradition of invoking
naturally produces the paradox of thrift but debt as a key factor in major economic con-
also finds new supply-side paradoxes, those tractions, there is a surprising lack of models
of toil and flexibility. The model suggests that – especially models of monetary and fiscal
most economists have been misconstruing policy – of economic policy that correspond
the issues and that actual policy in the United at all closely to the concerns about debt that
States and European Union is misguided. dominate practical discourse.
If there is a single word that appears Even now, much analysis (including my
most frequently in discussions of the eco- own) is done in terms of representative-
nomic problems now afflicting both the US agent models, which by definition can’t deal
and European Union countries, that word with the consequences of the fact that some
is surely “debt.” Between 2000 and 2008, people are debtors while others are credi-
household debt rose from 96 per cent of US tors. New work that I’ve done with Gauti
personal income to 128 per cent. In Britain Eggertsson (Eggertsson and Krugman 2010)
it rose by 55 per cent to 160 per cent, and seeks to provide a simple framework that
in Spain from 69 per cent to 130 per cent. remedies this failing. Minimal as the frame-
Sharply rising debt, it is widely argued, set work is, I believe that it yields important

Journal of Regulation & Risk North Asia 193


insights into the problems the world econ- is, a lower price level will actually reduce
omy faces right now – and it suggests that demand for goods and services.
much of the conventional wisdom govern- More broadly, large deleveraging shocks
ing actual policy is wrong-headed under land the economy in a world of topsy-turvy,
current conditions. where many of the usual rules no longer
We envision an economy very much apply. The traditional but long-neglected
along the lines of standard New Keynesian paradox of thrift – in which attempts to save
models – but instead of thinking in terms of more end up reducing aggregate savings –
a representative agent, we imagine that there is joined by the “paradox of toil” – in which
are two kinds of people,“patient”and“impa- increased potential output reduces actual
tient”; the latter borrowing from the former. output, and the “paradox of flexibility” – in
There is, however, a limit on any individual’s which a greater willingness of workers to
debt, implicitly set by views about how much accept wage cuts actually increases unem-
leverage is safe. We can then model a crisis ployment. Where our approach really seems
like the one we now face as the result of a to offer clarification, however, is in the analy-
“deleveraging shock.” For whatever reason, sis of fiscal policy.
there is a sudden downward revision of
acceptable debt levels – a“Minsky moment.” Implications for fiscal policy
This forces debtors to sharply reduce their In the current policy debate, debt is often
spending. If the economy is to avoid a slump, invoked as a reason to dismiss calls for
other agents must be induced to spend expansionary fiscal policy as a response to
more, say by a fall in interest rates. unemployment; you can’t solve a problem
created by debt by running up even more
Liquidity trap debt, say the critics. Households borrowed
But if the deleveraging shock is severe too much, say many people; now you want
enough, even a zero interest rate policy the government to borrow even more?
may not be low enough. So a large delev- What’s wrong with that argument? It
eraging shock can easily push the econ- assumes, implicitly, that debt is debt – that
omy into a liquidity trap. Fisher’s (1933) it doesn’t matter who owes the money. Yet
notion of debt deflation emerges imme- that can’t be right; if it were, debt wouldn’t
diately and naturally from this analysis. If be a problem in the first place. After all, to
debts are specified in nominal terms and a a first approximation debt is money we owe
deleveraging shock leads to falling prices, to ourselves – yes, the US has debt to China
the real burden of debt rises – and so does etc, but that’s not at the heart of the problem.
the forced decline in debtors’ spending, Ignoring the foreign component, or looking
reinforcing the original shock. at the world as a whole, the overall level of
One implication of the Fisher debt effect debt makes no difference to aggregate net
is that in the aftermath of a deleveraging worth – one person’s liability is another per-
shock the aggregate demand curve is likely son’s asset. It follows that the level of debt
to be upward, not downward-sloping. That matters only because the distribution of that

194 Journal of Regulation & Risk North Asia


debt matters, because highly indebted play- that the current conventional wisdom about
ers face different constraints from players what policymakers should be doing is almost
with low debt. completely wrong. •
And this means that all debt isn’t created
equal – which is why borrowing by some References
actors now can help cure problems created Eggertsson, Gauti and Krugman, Paul (2010), “Debt,
by excess borrowing by other actors in the Deleveraging, and the Liquidity Trap”, mimeo
past. This becomes very clear in our analysis. Fisher, Irving, (1933),“The Debt-Deflation Theory of
In the model, deficit-financed govern- Great Depressions,” Econometrica,Vol. 1, no. 4.
ment spending can, at least in principle, Koo, Richard (2008), The Holy Grail of Macroeco-
allow the economy to avoid unemployment nomics: Lessons from Japan’s Great Recession,Wiley.
and deflation while highly indebted private- Minsky, Hyman (1986), Stabilizing an Unstable
sector agents repair their balance sheets, and Economy, New Haven:Yale University Press.
the government can pay down its debts once
the deleveraging crisis is past. Editor’s note
In short, one gains a much clearer view The publisher and editor wish to thank
of the problems now facing the world, and VoxEU (www.voxeu.org) and Prof. Krugman
their potential solutions, if one takes the role for allowing the Journal to reproduce an
of debt and the constraints faced by debtors abridged version of this article which origi-
seriously. And yes, this analysis does suggest nally appeared on the VoxEu website.

J ournal of Regulation & Risk


North Asia
J ournal of regu

Reprint Service
lation & risk
north asia

ce Volume I, Issue III,


Complian Articles & Papers
Autumn Winter 2009-2010

Issues in resolving
systemically important
impacts
financial institutions

change
Resecuritisation Dr Eric S. Rosengren
in banking: major

financial ance and risk


challenges ahead
A framework for

Global
funding liquidity Dr Fang Du
in times of financial
compli Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
t– men
from bad to worst
manage
Derivatives: from
disaster to re-regulatio Stephan Schoess,
products potent n
head of details a kets.
Black swans, market Professor Lynn A. Stout
EastNet’s David Dekker,
crises and risk: the
human perspective
nce, l mar Measuring & managing
in financia risk for innovative Joseph Rizzi
complia reaction Red star spangled
financial instruments

chemical banner: root causes Dr Stuart M. Turnbull


of the financial crisis
oth-
The ‘family’ risk:
amongst
Andreas Kern & Christian
a cause for concern Fahrholz
companies es. among Asian investors
be one of to offer these servicGlobal t financial change impacts compliance
will just David Smith
signs be able speak abou
d rather
and risk
the first that will The-scramble is on
we saw d ers we shoul moni Opinion
banks, or that to tackle bribery David Dekker
a year ago the financial worl These days tions than
and corruption
About in ders, a nameWho exactly is subject to the Foreign
formation credit crisis financial institu Penelope Tham & Gerald
of a trans last months the d at financial
service provi ties.
future activi Financial
Corrupt Practices
Act? Deregulatio Li

and in
the
ed
cial worl
the finan ge that is tored s their current and we have move
d markets remuneratio
n reform: one step n,
Tham Yuet-Ming
non-regulat
has trans
form
sive pace.
the chan
in scope
than cover
Look at
how rapid
ly
on the
Ofbank s
‘Black Swans’, stress tests
& optimised risk
forward
Umesh Kumar & Kevin
Marr and ‘desupe ion
broader interaction tion) to
an explo
is much
occurring expected. bank
s that
were physical of operaChallenging the value of
fall from (location and hours Internet banking. enterprise risk managemen
management
David Samuels rvision’
to fail or t Professor
causes of the William Black exam
originally to be too big by terms then e, but
Rocky road ahead for global
payments
Tim Pagett & Ranjit
taken over electronic still in charg g to a accountancy convergence Jaswal
considered g or being more finan- banks were igm is shiftin The Asian regulatory mortgage fraud ines the
are either failin s that are Again the the parad and cor-
Rubik’s Cube Dr Philip Goeth
epidemic
para- ns

Contact
institution mentioned (physical perso has swept
the United that
a huge s
financial d, resulting in by as
Alan Ewins and Angus
regarded e we ut the bank Ross
cially soun how banks are world wher each other witho s such as THE author States.
in pay ologie of this paper
digm shift banks. porations) with new techn academic, is a leadin
ic and other ement lawyer and
the publ d involv ents. regulator former bankin g and they implici
es aroun mobile paym
specia g cal failures tly demonstrate
y revolv crime. As one lising in ‘white three criti-
ing largel e customers, los- of the unsun collar’ failure of regulation
Since bank isations Savings & of private marke and a wholesale
the ability
to servic
g the impa ct
ork prov iders
s and organ pay- Loans debacl g heroes of the and t discipl
trust and determinin risk Netw future the bank and other
Professor other
Black nowad e of the 1980s, Crimes forms of credit risk. ine of fraud
mer and ongoing In the NACHA
ing a custo be part of the well as
as SWIF
T, ork provi ders of his time ays spend
s much Enforcement The Financ
ial
d n, as e netw researching

Christopher Rogers
A to B released a Network
of it, shoul of the organisatio g and new such networks becom markets have why financ study this (FinCEN)
nt money from traf- a tendency ial Activit
y Reports (SARs)week on Suspicious
manageme ess of existin /buying ment to send ork functional. to become
the riskin using allow you you for the netw ri- Renowned dys- lated
financial institut that federally regu-
monitoring customers es that e brings simila y
‘control fraud’ for his theory
and the more chang will charg ate. This , Prof. Black on with ions (somet
products cts. But there are are and you gener m, energ University lecture the Federa imes) file
world that fic that such as teleco financial of Missouri s at the
(FBI) when l Bureau of
these produ in the banking n it. industries . The He is the author and Kansa
s City. they find eviden Investigation
and challe
nges
as we have know the ties with cable companies impo rtant a Bank is of ‘The Best
Way to Rob fraud. ce of mortga
g banking , not be iers and rgoing an to Own One: ge
threatenin s will, in the future our funds, suppl is clearly unde Executives
and Politic
How Corpo
rate Epidem
The bank by which to move they world 135 S&L Indust ians Looted ic warning
les portfolios; ry.’ A promi the The
default vehic balances and

Editor-in-Chief
tor on the nent comm FBI
our causes of
the curren enta- mortga began warning of an
maintain crisis, Prof.
Black is a t financial ge fraud in “epidemic”
of
h Asia mony their congre
Risk Nort way the US vocal critic
of the ago. in September 2004 –
ssional testi-
lation & government
of Regu banking crisis has handle It also warned over five years
Journal and reward d the that
that have
clearly ed institutions not dealt with it would if the epidemic were
duties to invest failed in their fiducia sis. Nothin cause a financi
g remotely
ors. ry respon adequate was al cri-
d to the epidem done to
enforce ment, or private ic by regulat
The followi ors,
ng
essarily represe commentary does not cipline.” sector “mark law
nec- hyper- Instead, the epidemic et dis-

christopher.rogers@irrna.org
nt the view produc
Regulation of the Journa inflated a bubble ed and
and Risk – l of that in US housin
“The new North Asia. produced a g prices
numbers on crisis so severe
rals for mortga criminal refer- caused the collaps that
ge fraud in system e of the global it nearly
the US are
just in many and led to unprecedente financial
Journal of of the world’s d bailouts of
Regulation largest banks.
& Risk North
Asia

33

Journal of Regulation & Risk North Asia 195


Risk models

Reliance on financial models


risks repeat of 2008 fiasco
Dr. Jon Danielsson of the London School of
Economics warns of the inherent dangers of
over-reliance on financial modelling.

Financial models are widely blamed failure process in normal times to the failure
for underestimating and thus mispric- process in crisis times. That all the pre-crisis
ing risk prior to the crisis. This paper models were missing was the presence of a
analyses how the models failed and crisis in the data sample.
questions their prominent use in the This is not true. The models are not up
post-crisis reform process. It argues that to the task. While statistical risk and pricing
over-relying on market data and statisti- models may do a good job when markets
cal forecasting models has the potential are calm, they lay the seeds for their own
to further destabilise the financial system destruction – it is inevitable that such mod-
and increase systemic risk. els be proven wrong. The riskometer is a
myth (Danielsson 2009).
Statistical pricing and risk-forecasting mod-
els played a significant role in the build-up Models, momentum and bubbles
to the financial crisis in 2007/2008. For The vast majority of risk models are based
example, they gave wrong signals, under- on the following assumptions: Take a chunk
estimated risk, and mispriced collateralised of historical observations of the data under
debt obligations. I am therefore surprised study; create a statistical model providing the
by the frequent proposals for increasing the best forecasts; validate the model out of the
use of such models in post-crisis reforms sample, but with historical data known to
– and I am not alone (see for example, the data modeller.
Leijonhufvud 2011). If the models per- The above approach to modelling may
formed so badly, why aren’t we questioning be quite appropriate in the short run when
their increased prominence? there are no structural breaks in the data,
This may be because of the view that so we can reasonably assume that data fol-
we can, somehow, identify the dynamics lows the same stochastic process during
of financial markets during crisis by study- the entire sample period. Recent exam-
ing pre-crisis data; that we can get from the ples include the low-volatility periods of

Journal of Regulation & Risk North Asia 197


1994-1997 and 2003-2007. Even in such out in an vicious feedback loop between fall-
best-case scenarios, modelling is likely to ing asset prices, higher risk and increasing
deliver inferior forecasts. Data mining is demands for capital, leading to sales of risky
rife; modellers tailor the model to the data assets, further exasperating difficulties, and
in sample, resulting in the model perform- leading to more demands for capital and
ing well in the sample used for model vali- reduced risk-taking.
dation but badly with new data. The risk forecast models provide an
equally poor signal after a crisis has passed.
Positive feedback loop Presumably, at that time investment oppor-
The main problem, however, is that such tunities are ample. However, backward-
modelling affects the behaviour of model looking statistical risk forecast models still
participants. If market participants perceive perceive risk as being high because observa-
risk as being low and returns high because tions from the crisis remain in the estimation
that is what happened in the past, we get sample for a long time after a crisis passes.
a positive feedback between continually
increasing prices and decreasing risk. This Disingenuous complaints
process is reinforced because of momentum Since risk forecasts are a major input in the
effects induced by models. determination of bank capital (calculation
This was one of the main factors behind of risk-weighted assets), so long as risk is
the asset price bubble before the recent cri- perceived as high, risk-taking by banks is
sis. Eventually this goes spectacularly wrong. curtailed, such as lending to high-risk small
Over time, market prices lose connection and medium enterprises. This process is
with fundamentals, and the bubble bursts. reinforced by current financial regulations, in
Prices collapse and perceived risk increases particular Basel II and remains in the Basel
sharply. Statistically there is a structural break III proposals.
in stochastic processes governing prices, It is somewhat disingenuous for political
invalidating pre-crisis forecast models. leaders to complain about lack of bank lend-
ing, when an important factor is the finan-
External constraints cial regulations passed by themselves. These
This process is reinforced by endogenous issues are exasperated by the quality of mar-
changes in the behaviour of market partici- ket data since risk and pricing models are
pants, e.g. because of external constraints. estimated with a recent sample of such data.
For example, margin requirements dur- Market prices reflect the value of assets at
ing times of financial turmoil can lead to any given time, but that does not mean they
a downward spiral in prices, induced by provide a good signal of the state of the econ-
ever-increasing margins, as discussed by omy or are a good input into forecast models.
Brunnermeier and Pedersen (2008). The reason is that market prices reflect the
Similarly, as noted by Danielsson et al constraints facing market participants.
(2011), financial institutions are subject to The presence of external constraints,
capital requirements and thus may be caught such as margin requirements and capital of

198 Journal of Regulation & Risk North Asia


the type discussed above, can cause prices useful answer in the future. At the moment
to be driven to much lower levels than they such models are few and far between.
otherwise would because of the feedback The problem of model reliability has
loop between the constraint, prices and risk. been widely recognised following the crisis.
Since then there have been few, if any meth-
Doubts about data odological improvements of note in practical
In such scenarios, market prices reflect the risk forecasting techniques.
constraints faced by market participants, so Given the widespread recognition of the
that high risk and low prices at times when lack of reliability in risk forecast models in
constraints are binding are unlikely to per- the build-up to the crisis, their prominence
sist when constraints bind less. Therefore, in the post-crisis and regulatory reform pro-
data in times of crises provides a poor guide cess is surprising.
to the future, even future crises because the
nature of the constraints is likely to change. Bonuses: risk sensitivity
Similarly, pre-crisis data is not very informa- Many of the proposals for reform of bank
tive about what happens in crises. bonuses call for more risk sensitivity. If the
The consequence of these issues is that underlying risk models are unreliable and
the stochastic process governing market even subject to manipulation, as is usually the
prices is very different during times of stress case, basing regulations on compensation in
compared to normal times. We need differ- financial institutions on risk forecast models
ent models during crisis and non-crisis peri- might seem rather counter-productive.
ods and we need to be careful in drawing Similarly the calculation of bank capi-
conclusions from non-crisis data about what tal in Basel II and Basel III is based on risk
happens in crises and vice versa. models because the capital ratio is calcu-
lated by capital divided by risk weighted
How models fail assets. For this reason, the introduction of
This means that when we most desire reli- the leverage ratio (with total assets) in Basel
able risk forecasts, i.e. during market turmoil III is welcome.
or crises, the models are least reliable because Furthermore, many approaches to
we cannot get from the failure process dur- macroprudential regulations are based on
ing normal times to the failure process dur- systemic risk measurements. To the extent
ing crises. At that time the data sample is such endeavours rely on market data and
very small and the stochastic process differ- statistical models, policy based on those
ent. Hence the models fail. measurements is likely to be flawed.
From a modelling point of view, this Crisis will not happen where people
suggests that it may be questionable to use are looking.
fat-tailed procedures, such as extreme value The challenge facing policy-makers is
theory, to assess the risk during crises with even worse because they cannot look every-
pre-crisis data. Techniques such as Markov where and will have to focus their attention
switching with state variables may provide a on where they think systemic risk is most

Journal of Regulation & Risk North Asia 199


likely to arise. At the moment, a lot of atten- risk models. Because of the way they are
tion is focused on the causes of the previous constructed in practice, such models tend
crisis, like the liquidity mismatches peculiar to be systematically wrong, over-forecasting
to the last decade. risk during crises and under-forecasting risk
However, the next crisis will not come at other times.
from where we are looking. Just like last time For these reasons, over-relying on
where the danger of conduits and special market data and statistical forecasting
investment vehicles caught everybody by models has the potential to further desta-
surprise, so will the next crisis come from an bilise the financial system and increase
area we are not looking at. After all, bankers systemic risk. •
seeking to assume risk will look for it where
nobody else is looking. References
Brunnermeier, M and LH Pedersen (2008), “Market
Conclusion Liquidity and Funding Liquidity”, Review of Financial
Economic models have recognised the Studies, 22:2201-2238. Danielsson (2009) “The myth
inherent challenges caused by intelligent of the riskometer”,VoxEU.org, 5 January. Danielsson,
agents reacting to model predictions ever J, HS Shin and J-P Zigrand (2011), “Balance Sheet
since the pioneering work of Bob Lucas. Capacity and Endogenous Risk”, working paper,
Most practical models for price and risk www.riskresearch.org.
forecasting by the industry and supervisors Leijonhufvud, Axel (2011), “Nature of an economy”,
do not incorporate such features, reflecting CEPR Policy Insight 53 and VoxEU.org, February 4.
the state of the art of macro models’ prera-
tional expectations. Editor’s note
The presence of endogenous risk, and The publisher and editor would like to thank
the resulting feedback effects between agent VoxEU – www.voxeu.org – and Professor
behaviour and model predictions, coupled Charles Wylopsz for allowing the Journal to
with the low information content in market reproduce an abridged version of this arti-
prices when agents are subject to external cle which originally appeared on VoxEu’s
constraints undermine the reliability of most website.

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200 Journal of Regulation & Risk North Asia


Credit default swaps

The economic consequences


of naked credit default swaps
In this paper, Columbia University’s Dr.
Rajiv Sethi and Dr. Yeon-Koo Chi question
the economic usefulness of naked CDS’s.

The role of naked credit default swaps prime example of harmful finance. In sharp
(CDS’s) in the global crisis is an ongoing contrast, John Carney believes that any
source of controversy. In this paper, the attempt to prohibit such contracts would
authors seek to add some formal analy- crush credit markets, Felix Salmon thinks
sis to this debate in view of recent moves that they benefit distressed debtors, and
by the European Parliament to curtail Sam Jones argues that they smooth out the
the use of CDS’s in the European Union. cost of borrowing over time, thus reducing
Our model, utilised for the benefit of interest rate volatility.
this paper, finds that speculative side
bets – naked credit default swaps – can Long, short sides
have a significant impact on economic One reason for this continuing contro-
fundamentals, including the terms of versy is that arguments for and against
financing, the likelihood of default, and such contracts have been expressed infor-
the scale and composition of investment mally, without the benefit of a common
expenditures. analytical framework within which the
economic consequences of their use can
There is arguably no class of financial trans- be carefully examined.
actions that has attracted more impassioned Since naked credit default swaps neces-
commentary over the past couple of years sarily have a long and a short side and the
than naked credit default swaps. Robert aggregate payoff nets to zero, it is not imme-
Waldmann has equated such contracts with diately apparent why their existence should
financial arson, Wolfgang Münchau with have any effect at all on the availability
bank robberies, and Yves Smith with casino and terms of financing or the likelihood of
gambling. George Soros argues that they default. And even if such effects do exist, it is
facilitate bear raids, as does Richard Portes not clear what form and direction they take,
(2010) who wants them banned altogether, or the implications they have for the alloca-
and Willem Buiter considers them to be a tion of a society’s productive resources.

Journal of Regulation & Risk North Asia 201


In a recent paper (Che and Sethi 2010), When credit default swaps are unavailable,
the co-authors have attempted to develop the investors with the most optimistic beliefs
a framework within which such questions about the future revenues of a borrower are
can be addressed and to provide some pre- natural lenders: they are the ones who will
liminary answers to this most pressing of part with their funds on terms most favour-
issues. We argue that the existence of naked able to the borrower. The interest rate then
credit default swaps has significant effects depends on the beliefs of the threshold
on the terms of financing, the likelihood investor, who in turn is determined by the
of default, and the size and composition of size of the borrowing requirement.
investment expenditures. The larger the borrowing requirement,
the more pessimistic this threshold investor
Three identifiers will be (since the size of the group of lenders
Our model identifies three mechanisms has to be larger in order for the borrowing
through which these broader consequences requirement to be met). Those more opti-
of speculative side bets arise, these being: mistic than this investor will lend, while the
collateral effects; rollover risk, and project rest find other uses for their cash.
choice. A fundamental (and somewhat
unorthodox) assumption underlying our Naked protection
analysis is that the heterogeneity of inves- Now consider the effects of allowing for
tor beliefs about the future revenues of a naked credit default swaps. Those who are
borrower is due not simply to differences most pessimistic about the future prospects
in information, but also to differences in the of the borrower will be inclined to buy naked
interpretation of information. protection, while those most optimistic will
Individuals receiving the same informa- be willing to sell it. However, pessimists also
tion can come to different judgments about need to worry about counterparty risk – if
the meaning of the data. They can therefore the optimists write too many contracts, they
agree to disagree about the likelihood of may be unable to meet their obligations in
default, interpreting such disagreement as the event that a default does occur, an event
arising from different models rather than that the pessimists consider to be likely.
different information. Hence the optimists have to support
their positions with collateral, which they do
Fundamental driver by diverting funds that would have gone to
As in prior work by John Geanakoplos borrowers in the absence of derivatives. The
(2010) on the leverage cycle, this allows borrowing requirement must then be met
us to speak of a range of optimism among by appealing to a different class of investors,
investors, where the most optimistic do not who are neither so optimistic that they wish
interpret the pessimism of others as being to sell protection, nor so pessimistic that they
particularly informative. We believe that this wish to buy it. The threshold investor is now
kind of disagreement is a fundamental driver clearly more pessimistic than in the absence
of speculation in the real world. of derivatives, and the terms of financing are

202 Journal of Regulation & Risk North Asia


accordingly shifted against the borrower. As contractual obligations because of a rev-
a result, for any given borrowing require- enue shortfall can roll over the residual debt,
ment, the bond issue is larger and the price thereby deferring payment into the future.
of bonds accordingly lower when inves- As many economists have previously
tors are permitted to purchase naked credit observed, multiple self-fulfilling paths arise
default swaps. naturally in this setting (see, for instance,
Calvo 1988, Cole and Kehoe 2000, and
‘Covered’ CDS’s Cohen and Portes 2006). If investors are
This effect does not arise if credit default confident that debt can be rolled over in the
swaps can only be purchased by holders future, they will accept lower rates of inter-
of the underlying security. In fact, it can est on current lending, which in turn implies
be shown that allowing for only “covered” reduced future obligations and allows the
credit default swaps has much the same debt to be rolled over with greater ease.
consequences as allowing optimists to buy But if investors suspect that refinancing
debt on margin: it leads to higher bond may not be available in certain states, they
prices, a smaller issue size for any given bor- demand greater interest rates on current
rowing requirement, and a lower likelihood debt, resulting in larger future obligations
of eventual default. and an inability to refinance if the revenue
While optimists take a long position shortfall is large.
in the debt by selling such contracts, they
facilitate the purchase of bonds by more pes- Key question
simistic investors by absorbing much of the A key question then is the following: how
credit risk. In contrast with the case of naked does the availability of naked credit default
credit default swaps, therefore, the terms of swaps affect the range of borrowing require-
lending are shifted in favour of the borrower. ments for which pessimistic paths (with sig-
The difference arises because pessimists can nificant rollover risk) exist? And, conditional
enter directional positions on default in one on the selection of such a path, how are the
case but not the other. terms of borrowing affected by the presence
of these credit derivatives?
Self-fulfilling pessimism For reasons that are already clear from
While this simple model sheds some light the baseline model, we find that pessimis-
on the manner in which the terms of financ- tic paths involve more punitive terms for
ing can be affected by the availability of credit the borrower when naked credit default
derivatives, it does not deal with one of the swaps are present than when they are not.
major objections to such contracts: the pos- Moreover, we find that there is a range of bor-
sibility of self-fulfilling bear raids. To address rowing requirements for which a pessimistic
this issue it is necessary to allow for a mis- path exists if and only if such contracts are
match between the maturity of debt and the allowed. That is, there exist conditions under
life of the borrower. This raises the possibil- which fears about the ability of the borrower
ity that a borrower who is unable to meet to repay debt can be self-fulfilling only in the

Journal of Regulation & Risk North Asia 203


presence of credit derivatives. It is in this pre- emergence of self-fulfilling paths in which
cise sense that the possibility of self-fulfilling firms are unable to rollover their debt, even
bear raids can be said to arise when the use when such trajectories would not arise in
of such derivatives is unrestricted. the absence of credit derivatives. And it
can influence the project choices of firms,
Policy perspective leading not only to lower levels of invest-
The finding that borrowers can more easily ment overall but also in some cases to the
raise funds and obtain better terms when selection of riskier ventures with lower
the use of credit derivatives is restricted does expected returns.
not necessarily imply that such restrictions James Tobin (1984) once observed that
are desirable from a policy perspective. A the advantages of greater “liquidity and
shift in terms against borrowers will gener- negotiability of financial instruments” come
ally reduce the number of projects that are at the cost of facilitating speculation, and
funded, but some of these ought not to have that greater market completeness under
been funded in the first place. Hence the such conditions could reduce the functional
efficiency effects of a ban are ambiguous. efficiency of the financial system, namely its
However, such a shift in terms against ability to facilitate “the mobilisation of sav-
borrowers can also have a more subtle effect ing for investments in physical and human
with respect to project choice: it can tilt man- capital . . . and the allocation of saving to their
agerial incentives towards the selection of more socially productive uses.”
riskier projects with lower expected returns.
This happens because a larger debt obliga- Financial engineering
tion makes projects with greater upside Based on our analysis, one could make
potential more attractive to the firm, as more the case that naked credit default swaps
of the downside risk is absorbed by creditors. are a case in point. This conclusion, how-
The central message of our work is ever, is subject to the caveat that there
that the existence of zero-sum side bets exist conditions under which the pres-
on default has major economic repercus- ence of such contracts can prevent the
sions. These contracts induce investors who funding of inefficient projects.
are optimistic about the future revenues of Furthermore, an outright ban may
borrowers, and would therefore be natural be infeasible in practice due to the emer-
purchasers of debt, to sell credit protection gence of close substitutes through financial
instead. This diverts their capital away from engineering.
potential borrowers and channels it into col- Nevertheless, it is important to recog-
lateral to support speculative positions. nise that the proliferation of speculative
As a consequence, the marginal bond side bets can have significant effects on
buyer is less optimistic about the borrow- economic fundamentals such as the terms
er’s prospects, and demands a higher inter- of financing and patterns of project selec-
est rate in order to lend. This can result in tion, as well as the incidence of corporate
an increased likelihood of default, and the and sovereign default. •

204 Journal of Regulation & Risk North Asia


References Portes, Richard (2010),“Ban naked CDS”, eurointel-
Calvo, Guillermo A (1988), “Servicing the Public ligence.com, 18 March.
Debt: The Role of Expectations”, American Eco- Tobin, James (1984),“On the Efficiency of the Finan-
nomic Review, 78(4):647-661. cial System,” Lloyds Bank Review, 153:1-15.
Che, Yeon-Koo and Rajiv Sethi (2010), “Economic
Consequences of Speculative Side Bets: The Case Editor’s note
of Naked Credit Default Swaps”, Columbia mimeo The publisher and editors of the Journal of
available at SSRN. Regulation & Risk – North Asia would like to
Cohen, Daniel and Richard Portes (2006), “Toward thank Professor Rajiv Sethi; Professor Yeon-
a Lender of First Resort”, IMF Working Paper Koo Chi of Columbia University; the Santa
WP/06/66. Fe Institute; and VoxEU, for allowing the
Cole, Harold L and Timothy J Kehoe (2000), “Self- Journal to publish an abridged version of this
Fulfilling Debt Crises,” Review of Economic Studies, paper. Copyright for the article remains the
67(1):91-116. sole preserve of Professor Sethi; Professor
Geanakoplos, John (2010), “The Leverage Cycle” Yeon-Koo Chi, Columbia University; the
in Daron Acemoglu, Kenneth Rogoff, and Michael Santa Fe Institute; and VoxEU. The original
Woodford (eds.), NBER Macroeconomics Annual document can be found at: http://www.
2009, 24:1-65, University of Chicago Press. voxeu.org.

J ournal of Regulation & Risk


North Asia

Advertising deadline for


Vol III Issue II Summer 2011

June 20, 2011

Contact Chris Rogers


christopher.rogers@irrna.org

Journal of Regulation & Risk North Asia 205


Securitisation

Collateralised debt obligation


detox for the European Union
Author of ‘Traders, Guns and Money’
Satyajit Das bemoans the current European
Central Bank’s debt facility structure.

In the first half of 2010, angst about government’s targeted rate of 13.7 per cent.
European sovereign debt receded and This despite large tax increases, including a
market volatility eased. In the second half massive rise in the value-added tax (VAT)
of 2010, concerns about Greece, Ireland, rate to 23 per cent. Faced by a collapsing
Spain and Portugal returned to dominate economy, rising unemployment, increased
headlines – as they still do in the first numbers of Greeks leaving the country, and
quarter of 2011. Greece passed its ini- social unrest, the Athens government even
tial inspections on its restructuring plan announced a cut in corporate tax rates from
from the supervising troika composed 24 per cent to 20 per cent.
of the European Central Bank (ECB),
European Union (EU) and International Cure worse than disease
Monetary Fund (IMF)). In truth, there How this will help correct the budget defi-
was no choice, as money had to be made cit remains a mystery – a matter the United
available to enable Greece to continue to Kingdom’s Chancellor of the Exchequer,
function as a viable economic entity. George Osborne, should take under con-
sideration as he too tries to square the circle
Despite the remedial medication issued by of reducing the deficit whilst maintaining
the troika, the Greek economy slipped into adequate state social provisions in an effort
deep recession, thus impeding the recov- to avoid a Greek-style tragedy.
ery plan. As the government implemented The “cure” may be worse than the dis-
harsh austerity measures, the Greek econ- ease. After implementing similar austerity
omy shrank by around three to four per cent. measures, Ireland’s nominal gross domestic
The government is far behind on its product (GDP) has fallen by nearly 20 per
programme to shrink its budget deficit cent. The budget deficit as a percentage of
from more than 13 per cent down to eight GDP has doubled to 14 per cent from seven
per cent. Tax revenues are weak, growing a per cent while Government debt as a per-
measly 3.3 per cent, well below the Greek centage of GDP has increased to 64 per cent

Journal of Regulation & Risk North Asia 207


from 44 per cent at the start of the crisis. It Europe announced its version of economic
is forecast to go to over 100 per cent having “shock and awe”. Steps include a €110 bil-
been around 25 per cent during the boom lion package for Greece, a €750 billion“safety
years. net”for all Eurozone members, ECB funding
The cost of bailing out Ireland’s bank- to vulnerable European banks, particularly in
ing system has risen and may reach 20-30 peripheral countries, and ECB purchases of
per cent of its GDP. And, naturally, Ireland’s around €60 billion of bonds issued by some
credit rating has fallen. of the troubled countries.
In late September 2010, Ireland
announced that in the second quarter the Key indicators
economy contracted by 1.2 per cent, against By late September 2010, risk margins on
expectations for 0.4 per cent growth, rais- Greek, Irish, Portuguese and Spanish debt
ing renewed concerns about European (relative to German government bonds) was
sovereign risk. Similar scenarios are being above the levels prior to the announcement
played out in Spain and Portugal – with even of the European rescue plan. In short, the
Belgium now joining the fray as it struggles problems remain largely unresolved.
to deal with its own deficit in the absence of European sovereign debt problems are
a national government. likely to remain prominent. Economic data,
like growth, unemployment, budget posi-
Weak underlying demand tion, and debt issuance will be key indicators
Slowing growth in North America and on the trajectory of the crisis.
China complicates the problems. Even Increasingly attention may focus on the
Germany’s recent strong growth appears to European Financial Stability Facility (EFSF),
be petering out. The effects of a weak Euro, a key component of Europe’s financial con-
government stimulus packages and exports tingency plan. Klaus Regling, head of the
of machinery as many industries retooled to EFSF and known informally as the Chief
lower production costs may have run their European Bailout Officer (CEBO), had a
course. Real underlying demand remains brief stint at Moore Capital, a macro-hedge
weak. fund, consistent with the fact that the EFSF is
Negative or low growth, savage budget placing a historical macroeconomic bet.
cuts and economic restructuring will need to
continue for years. Despite the Greek Prime Triple-A rating
Minister’s impossible MBA spin that the In order to finance member countries as
crisis represents a “historic opportunity”, it needed, the EFSF will need to issue debt.
remains to be seen whether this is feasible. The major rating agencies have awarded the
The willingness of government to impose fund the highest possible credit rating, AAA.
and citizens to bear the decline in living The EFSF structure echoes the ill-fated
standards necessary to avoid a debt restruc- Collateralised Debt Obligations (CDOs) and
turing remains uncertain. Structured Investment Vehicles (SIVs).
In an effort to resolve the problems, The Moody’s rating approach explicitly

208 Journal of Regulation & Risk North Asia


draws the analogy and uses CDO rating seriously place much value on any such
methodology in arriving at the rating. guarantee.
The €440 billion (US$520 billion) res-
cue package establishes a Special Purpose Imperfect modelling
Vehicle (SPV), backed by individual guaran- Unfortunately, the Global Financial Crisis
tees provided by all 19-member countries. illustrated that modelling techniques for
Significantly, the guarantees are not joint rating such structures are imperfect. The
and several, reflecting the political neces- adequacy of the cushion is unknown. If one
sity, especially for Germany, of avoiding joint peripheral Eurozone member has a problem
liability. The risk that an individual guarantor then others will have similar problems. If
fails to supply its share of funds is covered by one country requires financing, guarantors
a surplus “cushion”, requiring countries to of the EFSF will face demands at the exact
guarantee an extra 20 per cent beyond their time that they themselves will be financially
shares. A cash reserve will provide additional vulnerable.
support. The rating analysis published by the
agencies highlights subtle but extremely
Attachment point significant features in the structure designed
Given the well-publicised and deep finan- to ensure the desired AAA rating. Where a
cial problems of some Eurozone members, Eurozone member draws on the facility, the
the effectiveness of the cushion is crucial.The amount of funds on-lent by EFSF will be
arrangement is similar to the over-collater- adjusted by the following deductions: a 50
alisation used in CDOs to protect investors basis point service fee; a percentage equal to
in higher quality AAA-rated senior securi- the net present value of EFSF’s on-lending
ties. Investors in subordinated securities, margin. For example, the Greek financing
ranking below the senior investors, absorb package had a margin of 300 basis points.
the first losses up to a specified point (the This would translate into a deduction of
attachment point). Losses are considered around 13-14 per cent (depending on the
statistically unlikely to reach this attachment discount rate applied).
point, allowing the senior securities to be
rated AAA. The same logic is utilised in rat- Reserve-specific loans
ing EFSF bonds. Both the above constitute a fungible general
If 16.7 per cent of guarantors are unable cash reserve (‘the Reserve’) which will sup-
to fund the EFSF, lenders to the structure will port all EFSF debt: And finally, an additional
be exposed to losses. Coincidentally, Greece, reserve specific to each loan made by EFSF
Portugal, Spain and Ireland happen to rep- (‘the Buffer’) will be created. The exact meth-
resent around this proportion of the guar- odology of determining this buffer has not
anteed amount. Greece whilst a Eurozone been disclosed but will determined by sev-
member will not participate in EFSF’s lend- eral factors. The first factor will be the bor-
ing programmes as a provider of guarantees rower and it credit condition. The second
for the obvious reason that nobody would will be the position EFSF itself and the level

Journal of Regulation & Risk North Asia 209


of credit support available for its existing Buffer have to be invested in securities that
obligations. may earn less than the interest paid by EFSF
The Reserve and Buffer are to be invested on any issue.
in liquid AAA-rated government, suprana-
tional, or agency securities to be available as Structural ‘tweaking’
credit support for the EFSF’s obligations. The In order to attain the coveted AAA rating, the
requirement for the Reserve and Buffer sig- EFSF structure has been subtly “tweaked”.
nificantly reduces the amount of funds avail- For example, Moody’s states that“the Buffer
able from the EFSF. is to be sized so that the remaining portion of
the debt issue that is not fully backed by cash
Reduced lending will be fully covered by contributions from
Standard & Poor’s (S&P) estimated that Aaa-rated member states.”
after adjusting for the guarantee over-col- In essence this appears to confirm that
lateralisation and the exclusion of Greece the EFSF’s rating relies heavily on the sup-
from the European Financial Stability Facility port of the guarantees of AAA countries –
programme, the EFSF can raise up to €350 currently Germany, France, the Netherlands,
billion (roughly 20 per cent lower than the Austria, Finland and Luxembourg. In real-
announced amount). After adjustment for ity, this means that significant reliance is
the fact that borrowing governments can- being placed on the larger parties such as
not guarantee EFSF bonds and deduction of Germany, France and the Netherlands.
the Reserve and Buffer, the potential avail- If the European Financial Stability Facility
able for EFSF lending is further reduced. is drawn upon and increasing reliance is
Assuming a Reserve of around, say, 13.5 per placed on cornerstone guarantors such as
cent and a Buffer of 10 per cent, this would Germany and France, it is not clear whether
reduce the amount available to around €270 politically it will be possible for these coun-
billion (about 39 per cent lower than the tries to continue the facility beyond its origi-
announced amount). nal three-year maturity. Interestingly, S&P
state that: “ . . . we consider it likely that its
Additional cost mandate would be extended if market con-
Assuming an equivalent reduction in the ditions remained unsettled.”
IMF component of the package, the total
amount available is around €460 billion. Downgrade risk
The EFSF’s ability to lend compares to the For investors, there is a risk of rating migra-
forecast budget financing needs of Greece, tion, that is, a downgrade of the AAA rat-
Ireland, Portugal and Spain of more than ing. If the cushion is reduced by problems
€500 billion in the period 2009 to 2013. of an Eurozone member, then there is a risk
The structure outlined also increases the that European Financial Stability Facility
cost of the funding for borrowers drawing securities may be downgraded. Any such
on the EFSF facility. This additional cost is ratings downgrade would result in losses to
generated by the fact that the Reserve and investors. Recent downgrades to the credit

210 Journal of Regulation & Risk North Asia


rating of Portugal and Ireland highlight being used. The facility also has a very short
this risk. Given the precarious position of maturity, three years till 2013. The impor-
some guarantors and their negative rating tance of these factors in the grant of the pre-
outlook, at a minimum, the risk of ratings liminary rating is unknown.
volatility is significant.
The rating agencies indicated that if ‘Bolster to confidence’
a larger Eurozone member encountered Ratings agency S&P correctly inferred
financial problems, then the rating and that the “EFSF has been designed to bol-
viability of the EFSF might be in jeopardy. ster investor confidence and thus contain
Investors may be cautious about investing in financing costs for Eurozone member
EFSF bonds and, at a minimum, may seek a states.” The agency indicated that if its
significant yield premium. The ability of the establishment achieved this aim then the
EFSF to raise funds at the assumed low cost EFSF would not to need to issue bonds.
is not assured. However, if as pressures mount and mar-
It is not clear whether the Reserve and ket access becomes problematic for some
Buffer can be invested in AAA rated secu- Eurozone members, then the EFSF and its
rities issued by EFSF guarantors. In the structure will be tested.
absence of any such prohibition, the struc- Ironically, the actual structure of credit
ture has double exposure to the Guarantors enhancement encourages troubled coun-
via the guarantee itself as well as the invest- tries to access the facility early to ensure its
ments. If there is no such prohibition then availability. The structure embodies an accel-
the EFSF may also well end up financing the erating“negative feedback loop”.
Guarantors. As market conditions deteriorate, mar-
ket access becomes limited and countries
Past mistakes revisited draw on the EFSF facility (eliminating them
The EFSF securities presumably qualify as from the guaranty pool), increased financial
high-grade sovereign obligations against pressure will be exerted on the AAA-rated
which little or no capital will have to be held Eurozone countries. The need to maintain
by banks. In addition, the securities presum- adequate coverage to preserve the EFSF’s
ably will qualify as high quality collateral that AAA rating on existing debt will mean that
can be used as security to raise funds or be the Buffer will increase and the capacity of
held as “highly liquid” reserves. Prior to the the EFSF to lend may become impaired.
global financial crisis, AAA-rated structured
securities were deemed to be of a high qual- Structural doubts
ity but proved to be highly problematic. Moody’s rating analysis indicates that in
The potential circularity of the arrange- the event that a large number of countries
ments is interesting and has attracted mini- simultaneously lose market access and draw
mal scrutiny. At this stage, the EFSF have on the facility, the current lending capacity
indicated that they don’t plan to issue any of the EFSF would likely be overwhelmed.
debt, as they do not anticipate the facility Moody’s believes that it would be unlikely

Journal of Regulation & Risk North Asia 211


that the EFSF would start issuing under deems the car cannot crash. In the best case,
those circumstances. The EFSF’s structure the measures taken by the EU and ECB will
raises significant doubts about its credit wor- force deeply indebted European countries to
thiness and funding arrangements. In turn, take steps to bring their economic houses in
this creates uncertainty about the support for order, allowing an orderly debt restructuring.
financially challenged Eurozone members The EFSF and other facilities will also under-
with significant implications for markets. write the ability of vulnerable countries to re-
The real rationale of the European finance maturing debt and finance budget
Bailout package and the EFSF is different requirements.
to that generally assumed. The measures
are not designed to assist Greece or the Greek position
other troubled countries. In reality, they are Banks and other lenders can also build up
designed to support banks that have lent reserves and capital to absorb any write-offs
heavily to them. that are required in such a restructuring. If
successful this would minimise losses and
Massive exposure limit disruption in the global economy.
The exposure of Germany and France The position of Greece highlights the
to troubled European countries remains underlying logic. According to the EU’s pro-
around US$1 trillion. According to the Bank jection, Greek debt will increase from €270
for International Settlements, as at the end billion in 2009 to €337 billion in 2014, from
of 2009, French banks and German banks 113 per cent of its GDP to 149 per cent, even
had lent US$493 billion and $465 billion with the successful execution of the eco-
respectively to Spain, Greece, Portugal and nomic actions required.
Ireland. Default or restructuring would Given that Greece cannot sustain its cur-
result in large losses to the banks, poten- rent level of debt, it is unclear how it will be
tially triggering a return to the apocalyptic able to carry 25 per cent additional debt (€67
conditions of late 2008. billion) with an economy that is expected to
shrink by five per cent during that period.
Car ‘crash test’ Discussions about losses lenders to these
European banks remain vulnerable. The countries will have to bear are already evi-
recent bank stress tests did not seriously test dent. In extending guarantees of borrowings
likely losses in case of sovereign debt restruc- by its troubled banks, Ireland indicated that
turing and realistic falls in commercial real junior or subordinated lenders might not
estate prices. receive the face value of their investments.
The tests did not apply to the bulk of As in any debt restructuring, it is unlikely that
bank’s holdings, only testing around 20 lenders will be able to avoid losses entirely.
per cent of the sovereign bonds held, mak-
ing the test of limited value. The definition Einstein logic
of capital was generous. It was effectively a Major economies have over the past dec-
car “crash test” where the testing authority ades transferred debt from companies to

212 Journal of Regulation & Risk North Asia


consumers and finally onto public balance sharing dirty needles, the risk of infection for
sheets. The reality is that a problem of too all has drastically increased. The European
much debt cannot be solved with even more bailout is primarily a debt shuffling exercise
debt. Deeply troubled members of the Euro- which may be self defeating and unwork-
zone cannot bail out each other as the signif- able. George Bernard Shaw observed that
icant levels of existing debt limit the ability to “Hegel was right when he said that we learn
borrow additional amounts and finance any from history that man can never learn any-
bailout. As Albert Einstein noted: “You can- thing from history”. The resort to discredited
not fix a problem with the kind of thinking financial engineering to solve the European
that created it.” sovereign debt problems highlights the ina-
bility to learn from history and the paucity of
Cross contamination ideas and willingness to deal with the real
A huge amount of securities and risk now issues. •
is held by central banks and governments,
which are not designed for such long-term Editor’s note
ownership of these assets. There are now no The publisher and editor would like to thank
more balance sheets that can be leveraged to Satyajit Das for allowing the Journal to pub-
support the current levels of debt. lish an abridged version of this paper. We
The effect of the European bailout and also wish to remind readers that copyright
the EFSF is that stronger countries’ bal- for the article remains the sole preserve of
ance sheets are being contaminated. Like Satyajit Das.

www.edit24.com
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Journal of Regulation & Risk North Asia 213


Bank capital

Capital in large financial


institutions can’t be measured
Interfluidity’s Steve Waldman dismisses the
ability of large complex financial institu-
tions to accurately measure, report capital.

Bank capital cannot be measured. one expects liquidation value to be much less
Think about it! “Large complex finan- than “going concern” value, because fixed
cial institutions” (LCFIs) report lever- capital intended for a particular production
age ratios and “tier one” capital and all process cannot easily be repurposed and has
kinds of aromatic stuff. But those num- to be taken apart and sold for scrap. But the
bers are only guesses. For contemporary assets of a financial holding company are
LCFIs, reasonable confidence intervals business units and financial positions, which
surrounding estimates of bank capital can be sold if they have any value.
would be greater than 100 per cent of Yes, liquidation hits intangible“franchise”
their reported values. In English, we can- value and reputation, but those assets are
not distinguish “well capitalised” from mostly excluded from bank balance sheets,
insolvent banks, even in good times, and and they are certainly excluded from “tier
regardless of their formal statements. one”capital calculations. The orderly liquida-
tion of a well-capitalised financial holding
Lehman’s is a case-in-point. On September company ought to yield something close
10, 2008, Lehman Bros reported 11 per cent to tangible net worth, which for Lehman
“tier one”capital and very conservative“net would have been about $24 billion
leverage“. Four days later, Lehman declared So Lehman misreported its net worth,
bankruptcy. Despite reported sharehold- right? Not according to the law. From the
ers’ equity of US$28.4 billion just prior to Valukas Report, Section III.A.2: Valuation
the bankruptcy, by July 2009 the net worth – Executive Summary: The Examiner did
of the holding company in liquidation was not find sufficient evidence to support a
estimated to be worth anywhere from neg- colourable claim for breach of fiduciary
ative $20 billion to $130 billion, implying a duty in connection with any of Lehman’s
swing in value of between $50 billion and valuations. In particular, in the third quar-
$160 billion. ter of 2008 there is evidence that certain
That is shocking. For an industrial firm, executives felt pressure to not take all of the

Journal of Regulation & Risk North Asia 215


write-downs on real estate positions that Obviously, there are transaction costs associ-
they determined were appropriate; there ated with managing a liquidation, but those
is some evidence that the pressure actually would be minimal relative to the scale of
resulted in unreasonable marks. these losses.
It might be reasonable to attribute a few
Lehman’s non-guilt billion dollars of losses to forced closure of
But, as the evidence is in conflict, the derivative position under circumstances
Examiner determines that there is insuf- that were undoubtedly gamed by rivals and
ficient evidence to support a colourable counterparties. But not tens of billions, at least
claim that Lehman’s senior management not without some prominent counterparties
imposed arbitrary limits on writedowns of showing very large gains! Inefficient trades
real estate positions during that particular and cynical “fire sale” marks simply cannot
quarter. In other words, the definitive legal explain a hole of that magnitude. Markets
account of the Lehman bankruptcy has did very poorly after Lehman’s bankruptcy,
concluded that while executives may have but contrary to popular belief, Lehman was
shaded things a bit, from the perspective of never forced into “fire sales” of its assets. It
what is actionable within the law, Lehman’s was and remains in orderly liquidation.
valuations were legally indistinguishable
from accurate. Assets recovery
Yet, the estimate of net worth computed In July 2009, more than nine months after
from these valuations turned out to be off the bank fell, Lehman’s liquidator reported
by 200 per cent or more. Advocates of the that only a “fraction” of the firm’s assets
devil and Dick Fuld – the former CEO of had been sold and the process would last
Lehman’s – will demur here. Yes, Lehman’s at least two years. Perhaps the pessimistic
“event of default” meant many derivatives estimates of Lehman’s value were made
contracts were terminated prematurely and during the spring 2009 nadir in asset prices,
collateral on those contracts was extracted and Lehman’s claimed net worth looks
from the firm. But closing a marked-to- more reasonable now that many assets
market derivatives position does not affect a have recovered.
firm’s net worth, only its exposure. But if Lehman’s assets were so pro-
foundly affected by the early 2009 plunge
Short-term changes that an accurate September capitalisation
There may be short-term changes in report- of $28 billion shifted into the red by billions
able net worth as derivatives accounted of dollars, how is it plausible that Lehman’s
as hedges and not marked-to-market are competitors took much more modest hits
closed, but if the positions were in fact during that period? Unless the sensitivity
hedges, unreported gains on other not- of Lehman’s assets to its final year’s mar-
marked-to-market assets should eventually kets was higher than all of its peers, either
offset those charges. Again, the long term Lehman’s assets were misvalued before the
change in firm net worth should be zero. asset price collapse, or its competitors assets

216 Journal of Regulation & Risk North Asia


were misvalued during the collapse. We can reduces the likelihood that shareholder
get lost in details and petty arguments, but wealth will be expropriated by usurious
the bottom line is simple. The capital posi- liquidity providers or a bankruptcy, and con-
tions reported by LCFIs are so difficult to servative accounts do not impair the real
compute that the confidence interval sur- earnings stream that will be generated by
rounding those estimates is greater than non-financial operations.
100 per cent even for a “conservatively lev- This logic inverts for complex financials.
ered”bank. On the books, Lehman was well Financial firms raise and generate liquid-
capitalised, not only under the standards of ity routinely. Many of their assets are suit-
the time, but also under existing Basel III able as collateral in repo markets. Large
standards. commercial banks borrow freely in the
Federal Funds market and satisfy liquidity
Profitable self-flattery demands in part simply by issuing depos-
Yet put to a market test, in an orderly liquida- its that are not immediately withdrawn. For
tion and not a fire sale, Lehman’s was very large financial firms, access to liquidity is
deeply insolvent. Errors in reported capital rarely contingent upon a detailed audit by
are almost guaranteed to be overstatements. a potential liquidity provider.
Complex, highly leveraged financial firms
are different from other kinds of firm in that Importance of ‘confidence’
optimistically shading asset values enhances Instead, access to liquidity, and the ability to
long-term firm value. Yes, managers of all continue as an operating firm, is contingent
sorts of firms manage earnings and valu- upon the “confidence” of peer firms and of
ations to flatter themselves and maximise regulators. Further, the earnings of a finan-
performance-based compensation. cial firm derive from the spread between its
And short-term shareholders of any firm funding cost and asset yields. Funding costs
enjoy optimistic mis-statements coincident are a function of market confidence, so the
with their planned sales. But long-term value of a financial firm’s real future earnings
shareholders of non-financial firms prefer increases with optimistic valuation.
conservative accounts, because in the event For a long-term shareholder of a large
of a liquidity crunch, firms must rely upon financial, optimistically shading the firm’s
external funders who will independently position increases both the earnings of the
examine the books. The cost to shareholders firm and the“option value”of the firm in dif-
of failing to raise liquidity when bills come ficult times. It would be a massive failure of
due is very high. corporate governance if Citi’s Jamie Dimon
or Goldman’s Lloyd Blankfein did not pre-
Asymmetric loss function varicate a little to make their firms’ books
There is, in the language, an “asymmetric seem a bit better than perhaps they are,
loss function”. Long-term shareholders within legal and regulatory tolerances.
are better off with accounts that understate So, for LCFIs, capital cannot be measured
strength, because conservative accounting precisely enough to distinguish conservatively

Journal of Regulation & Risk North Asia 217


solvent from insolvent banks, and capital which capital might be computed. When
positions are always optimistically padded. we“measure”capital, we select a model and
then compute. If we were to randomly select
‘Schrödinger’s Banks’ among potential models (even weighted by
Given these facts, and I think they are regulatory acceptability, so that a compliant
facts, even “hard” capital and leverage model is much more likely than an iffy one),
restraints are unlikely to prevent misbe- we would generate a probability distribution
haviour. Can anything be done about this? of capital values. That distribution would be
Are we doomed to some post-modern very broad, so that for large, complex banks
quantum mechanical nightmare wherein negative values would be moderately prob-
‘Schrödinger’s Banks’ are simultaneously able, as would the highly positive values that
alive and dead until some politically- actually get reported.
shaped measurement by a regulator forces
a collapse of the superposition of states, Narrow the range
inevitably to solvency by government fiat? If we want to make capital measurable in any
Yes , we are so doomed, unless and until practical sense, we have to dramatically nar-
we simplify the structure of the banks. Let’s row the range of models, so that all compli-
understand our predicament more pre- ant models produce values tightly clumped
cisely. When I say that “confidence intervals around the number we’ll call capital. But
surrounding measures of bank capital are every customised derivative, non-traded
greater than 100 per cent”, what does that asset, or unusual liability in a bank’s capital
mean? Capital does not exist in the world. structure requires modelling. The interac-
It is not accessible to the senses. When we tion between a bank holding company and
claim a bank or any other firm has so much its subsidiaries requires multiple modelling
“capital”we are modelling its assets and lia- choices, especially when those subsidiaries
bilities and contingent positions and coming have cross-holdings. A wide variety of con-
up with a number. tingent liabilities – of holding companies
directly, of subsidiaries, of affiliated or spun-
No ‘true’ model off entities like SIVs and securitisations – all
Unfortunately, there is not one uniquely require modelling choices.
“true” model of bank capital. Despite the Given the heterogeneity of real-world
prescriptions of the Basel committee and arrangements, no “one-size-fits-all” model
International Financial Reporting Standards can be legislated or regulated to ensure a
(IFRS) and myriad domestic accounting consistent capital measure. We cannot have
and regulatory standard setters, there is no both free-form, “innovative” banks and
unique true value of bank equity. Thousands meaningful measures of regulatory capital.
of estimates and arbitrary choices must be If we want to base a regulatory scheme on
made to compute the capital position of formal capital measures, we’ll need to cir-
a modern bank. There is a broad, multidi- cumscribe the structure and composition of
mensional “space” of defensible models by banks so that they can only carry positions

218 Journal of Regulation & Risk North Asia


and relationships for which we have stand- Risk weighting, while defensible in theory,
ard regulatory models. “Banks’ internal risk requires that an arbitrary and questionable
models” or “internal valuations of Level 3 weight be attached to every bank asset, dra-
assets”don’t cut it. They are gateways to reg- matically increasing the model uncertainty
ulatory postmodernism. inherent in capital measurement.
The Basel II innovation of allowing
Model complexity institutions to use bank-internal models
Bank regulation by formal capital has a to generate risk-weights contributes more
proud and reasonably successful history, but uncertainty and introduces a positive bias in
the practice has been rendered obsolete by bank capital measures. Both risk-weighting
the complexity of modern financial institu- and deference to bank-internal models con-
tions. The assets and liabilities of a tradi- tinue in Basel III. At the margin, Basel III
tional commercial bank had straightforward, may be an improvement on Basel II, in that
widely acceptable book values. For a simple its tighter definitions and higher standards
bank, discretionary modelling is required could force banks to make changes that shift
only to set credit loss reserves, and the range the distribution of plausible estimates of cap-
of estimates that bank officers, external audi- ital slightly upward. But banks will remain
tors, and regulators would produce for those very leveraged by any measure.
reserves was usually pretty narrow.
But model complexity overwhelms and A matter of faith
destroys regulatory capital as a useful meas- Big banks that have survived the crisis have
ure for large complex financial institutions. grown even larger and more complex.
We need either to resimplify banks to make Proper risk-weights remain unknowable.
them amenable to the traditional approach, Despite Basel III, whether a bank is solvent
or come up with other approaches more or not at any given time will remain a mat-
capable of reigning in the brave new world ter of faith, convention, and implied gov-
of banking. Unfortunately, this is a lesson we ernment support rather than a matter of
can expect to learn again. economic fact.
Following the financial crisis of 2008, Of course bank capital is only a means
“strengthening” capital and leverage re- to an end. What we really hope to achieve
quirements became the core preoccupa- from high levels of capitalisation are time
tion of regulators. Basel III both increases consistency (greater aversion by bank man-
the quantity of regulatory capital banks agers and shareholders to trading near-term
will be required to hold tightens the defi- profits for long-term “tail risk”) and private
nition of capital (really the definition of risk-bearing.
which claims need not be treated as liabili- Those goals require not just marginal
ties for the purpose of computing capital). solvency, but that equity represent a sizable
The Basel framework has magnified enor- share of total firm assets and be credibly at
mously the difficulty of measuring capital, risk of permanent loss. Basel III just doesn’t
since it focuses on “risk-weighted capital”. get us there. •

Journal of Regulation & Risk North Asia 219


Financial crisis

Lambs to the slaughter: Real


causes of the financial crisis
American Enterprise Institute stalwart Peter
J. Wallison gives his own unique interpreta-
tion on the causes of the 2008 bank crisis.

What caused the financial crisis? Even government became a willing buyer of an
though the Dodd-Frank Act (DFA) has unprecedented number of subprime and
been signed into law, this is still an other high-risk mortgages. This created a
important question. If we do not attribute housing bubble of unprecedented size and
the crisis to the right cause, we could well duration, but only the taxpayers were tak-
stumble into another crisis in the future; ing the risks necessary to create this financial
and if the DFA was directed at the wrong disaster.
cause, we should consider its repeal. A
Brookings Institution paper issued in Important paper
late 2009 develops an interesting and Last November, two highly respected
plausible idea: the “great moderation” Brookings Institution scholars, Martin Neil
– the quiet period of almost continuous Baily and Douglas J. Elliott, published a
growth between 1982 and 2007 – caused paper entitled, ‘Telling the Narrative of the
investors, managers and regulators to Financial Crisis: Not Just a Housing Bubble’.
believe that we had come to understand It is an important paper for two reasons:
how the economy worked and how to First, it recognises that a narrative – a
tame the business cycle. story that explains an event – influences
the legislation or other public policy actions
This mistaken view in turn caused a decline that follow.
in the normal aversion to risk, creating a Second, as implied by the title of their
housing bubble and the financial crisis. This paper, Brookings’ Baily and Elliott devel-
is a compelling narrative and accounts for oped their own narrative for what caused
much of the risk-taking that was observed in the financial crisis, and they use it to argue
the period leading up to the crisis, but in the that the crisis was not caused by government
end it is no more than an interesting theory. housing policies.
The reality is that, in pursuit of a social This paper considers whether the Baily-
policy to increase home ownership, the US Elliott narrative is a better explanation of the

Journal of Regulation & Risk North Asia 221


financial crisis than the housing policies of especially in regard to Fannie Mae and
the US government. Freddie Mac.This narrative is popular among
Writing in 2009, before the enactment of conservatives, particularly since it argues for
the DFA, Baily and Elliott began their essay a scaling back of government interventions
by recognising the importance of narratives. in the economy and suggests less regulation,
“Major crises,”they note,“such as the recent not more. The second narrative is that “Wall
financial crisis, usually end up being under- Street created the crisis by reckless behaviour,
stood by the public in terms of some simple greed, and arrogant belief in its own abil-
narrative, which then heavily influences the ity to understand and manage excessively
choices politicians make. We believe there complex investments … “ This narrative is
are three major story lines still vying for popular with the left, but is accepted much
acceptance by the public and that whichever more widely than that, including by a broad
one comes to dominate could strongly affect populist sentiment that sees large banks and
public policy.” large corporations as at the root of many of
the country’s economic problems. Many in
Stark reminder the media have also adopted this position.
They observe in particular: “one of the ear- The housing part of the crisis is viewed as
liest theories of the Great Depression was principally resulting from financiers pushing
that it sprang from the crash on Wall Street, naïve consumers into taking on mortgages
which came to be associated with financial bigger than they could handle and which
manipulation by bankers and rich specula- were structured to hide large fees and inter-
tors.This created much of the impetus for the est rates that would jump after a few years.”
separation of commercial and investment
banking and the creation of the Securities Shades of the New Deal
and Exchange Commission and associated This narrative, one might add, is easily rec-
laws to protect investors.” These words are ognisable as a lineal descendant of the ideas
a reminder, not only of the importance of that motivated the New Deal. The third nar-
narratives in shaping policy responses, but rative, and the one Baily and Elliott endorse,
also that certain impulses and ideas are car- is that “the crisis was a very broad-based
ried forward over generations and resurface event with a wide range of people and
when those who have accepted them find institutions bearing responsibility, includ-
the right opportunity. ing many outside the United States … Wall
Street financial institutions failed to put in
Three narratives place or enforce the sound risk management
Baily and Elliott identify three distinct nar- processes and restraints that were needed …
ratives that have been used to explain the [and] government regulators did not ade-
financial crisis. The first is the view that quately oversee these institutions, includ-
government housing policies caused the ing, importantly, Fannie Mae and Freddie
crisis by inflating a housing bubble and mis- Mac … Some of the federal government’s
managing the resulting risks and problems, actions to encourage home ownership also

222 Journal of Regulation & Risk North Asia


overshot and provided incentives for reck- that narrative one is a better explanation of
less behaviour.” the financial crisis than narratives two and
The DFA, adopted after the Baily-Elliott three. In other words, government housing
paper was published, demonstrates that they policy caused the financial crisis, not too lit-
were correct about the importance of narra- tle regulation, not predatory lending and not
tives. Congress enacted and the President excessive risk taking. To be sure, all those
signed legislation that rather faithfully things occurred – they always will – but none
reflected a combination of narratives two of them was significant enough to cause a
and three. Anyone who followed the debate worldwide financial crisis.
that preceded the enactment of the DFA saw
Congress directly responding to elements of Community Reinvestment Act
both narratives. If we come to believe that these were the
causes of the crisis, we will simply be invit-
Naïve home buyers ing another crisis to creep up on us while
The Consumer Financial Protection Bureau we are looking the wrong way. A strik-
(CFPB) was certainly written into the act ingly clear example of this possibility is the
because the Democrats who controlled the introduction in Congress in late September
process believed – or said they did – that 2010 of a bill to extend the Community
“naïve consumers” were duped into buying Reinvestment Act (CRA) – which currently
homes they could not afford to create fees applies only to insured banks and sav-
for the mortgage originators and the“finan- ings and loans (S&Ls) – to the rest of the
ciers”(this closely follows narrative two). This financial system. The CRA requires insured
is clearly the modern analogue of the New banks and S&Ls to make loans (primarily
Deal-era view that the Great Depression mortgages) to borrowers in their service
was caused by financial manipulation and areas who are at or below 80 per cent of
the abuse of investors. the median income where they live. Banks
Similarly, the stringent regulation and must show that they are making such loans
supervision prescribed by the DFA for the irrespective of whether the loans meet the
largest bank holding companies and other bank’s usual credit standards.
systemically relevant firms were a reaction to
the view that regulation had not been tough Repeat performance?
enough and had allowed too much risk- As I will discuss later in this paper, that
taking to occur. This response can be seen requirement contributed to the large num-
as the result of the general view that private ber of subprime and other risky loans that
decision-making and markets need some failed in the financial crisis. If the narrative
government supervision or they will veer we adopt for what caused the financial crisis
into crisis (basically, narrative three). does not regard these loans as contributing
There are, of course, elements of truth factors – and narratives two and three cer-
in both these narratives, but that will not tainly do not – then the conditions that gave
be discussed here. This paper simply argues rise to the crisis will eventually be repeated.

Journal of Regulation & Risk North Asia 223


There is much more to narrative one than Other perfect storm explanations are
Baily and Elliott describe, but before intro- unsatisfactory for this reason. However,
ducing those points I will first outline in Baily and Elliott introduce a new idea that
detail the case that Baily and Elliott make for addresses this problem rather neatly and
their narrative three, which I believe is the distinguishes narrative three from many
most sophisticated and important alterna- others. Their idea is this: “The principal
tive to the idea that government housing underlying cause of the behaviours listed
policies created the financial crisis. above was a major reduction in the risk pre-
mium [the additional interest rate required
Main actors implicated because of additional risk] resulting from 25
The principal characteristic of narrative three years of strong performance by the finan-
is its comprehensiveness. All the main actors cial markets, encouraged by and associated
in the financial system are implicated: Wall with the ‘great moderation’ in the macro-
Street did not put in place sound risk man- economy, whereby business cycles seemed
agement processes; government regulators almost to vanish.”
did not properly or effectively oversee these
processes or the banks, investment banks, The ‘great moderation’
and Fannie Mae and Freddie Mac; the rat- Thus, Baily and Elliott are identifying a
ing agencies’ models were flawed and the deeper cause of the financial crisis than has
agencies themselves had conflicts of inter- generally been outlined in conventional
est, allowing complex and ultimately toxic perfect-storm explanations, an element
instruments to be released into the financial that in effect underlies the more superficial
market; borrowers obtained mortgages under actions that have been cited as causes. That
false pretences, and unregulated mortgage cause, explained in narrative three, was a
brokers took advantage of unsophisticated general relaxation in the usual fear of risk;
buyers; and homebuyers mistakenly believed this was induced by the “great moderation”
housing prices would always go up. – a period of general prosperity and growth
that prevailed with few interruptions for the
The ‘perfect storm’ quarter century from 1982 to 2007.
This approach – that virtually everyone was During this period, they argue, “many
responsible for the financial crisis – is sus- people, both experts and non-experts,
ceptible to the objection that it is blaming believed that central banks and govern-
the crisis on a lot of random errors that all ments around the world had learned the
happened to occur at the same time. This is secrets necessary to tame the business
the central conceptual problem with nar- cycle … People learned to take risks. Not
ratives that cite multiple factors as causes: only would one expect on average to be
as “perfect storm” descriptions, they do not rewarded, as the textbooks tell us, but actual
explain why all the various errors occurred experience showed it almost always paid off
together, except by chance, and what would much more handsomely and with less pain
have happened if they had not. than the theories said. Individuals learned a

224 Journal of Regulation & Risk North Asia


similar thing with housing … Since home- existed and could have burst in a painful way
owners were usually highly levered through – the argument is whether those bubbles
mortgage debt [that is, they made low down would have been more like the stock mar-
payments when they bought their homes], a ket crash of 1987 or the Long-Term Capital
fairly steady and decent return [on a home [Management] failure, both of which hurt,
investment] became a very attractive lev- but neither of which dramatically damaged
ered return … This increased willingness to the economy … However, we believe there
take risks worked in dangerous combina- would have been a painful recession due
tions with the ‘easy money’ conditions of the to the bursting of the more comprehensive
mid-2000s.” financial bubble, even if housing had played
a significantly more minor role.”
Unhealthy process In other words, the housing bubble
So the heart of the argument for narrative was not unique; it was caused by the same
three is that the long period of growth in underlying problem – the failure of nearly
the economy, without any serious financial everyone to perceive the risks of high lever-
crises, taught investors, corporate managers, age. Rather than blaming the government
and consumers that the risks of excessive for creating a huge housing bubble, Baily
leverage were limited; they could acquire and Elliott blame investors, corporate man-
assets and make investments with very little agers, regulators and homebuyers for fail-
money of their own and profit a lot when the ing to understand the risks involved when
assets appreciated in value. investors and consumers used high leverage
This unhealthy process was exacerbated to carry assets or buy homes with low down
by Federal Reserve policies that made large payments or adjustable-rate mortgages.
amounts of credit available to support risk
taking. These elements account for most if Calm before the storm
not all of the errors made by banks, rating After laying this foundation, the Baily-Elliott
agencies, investors and consumers in narra- paper provides a number of examples that
tive three. A major implication of this argu- are intended to demonstrate that the gen-
ment is that it turns the housing bubble into eral perception of risk had fallen to unprec-
just one of a number of bubbles that could edented lows by 2006 and 2007, before the
have, and probably would have, developed financial crisis. They note the many credit
if the housing bubble had not deflated first. losses that occurred after the housing bub-
ble burst, including commercial real estate,
Unique driver? ordinary business loans, and credit cards.
“A key policy question,” Baily and Elliott “This does not rule out the possibility,” they
write, “is whether the housing bubble was write,“that housing started the problem and
the unique driver of the crisis or whether the blow was so strong that it took down the
we might have had a damaging crisis even other sectors. However, it is strongly sugges-
if housing had played a more minor role tive that the imbalances in the other sectors
… Few would dispute that other bubbles were also very large prior to the housing

Journal of Regulation & Risk North Asia 225


bubble bursting, reinforcing the notion of at least a trigger for the crash that became
a more comprehensive bubble made up of the financial crisis – was only one aspect
many sectorial bubbles … The problem did of a much broader economy – and society-
not have to begin with housing.” wide increase in leverage and risk-taking.
Moreover, if housing was the precipitat- Accordingly, the government’s role in pro-
ing cause of the crisis, Baily and Elliott argue, moting home ownership, whatever it was,
sectors of the economy unrelated to hous- was not the central cause of the financial
ing would not have been among the first crisis. “Put another way,” the authors write,
to fall. One example is the leveraged loan returning the question to its public policy
market, which had no apparent exposure focus, “if we find ourselves in the future in
to housing. If the housing bubble had not another situation of widespread, excessive
burst when it did, they argue, other bubbles risk-taking, preventing problems in the
would have grown so large that they would housing sector is unlikely to be enough to
have been equally destructive when they prevent severe financial and economic prob-
ultimately burst. lems when the bubble bursts.” In the next
section, I will outline why the housing bub-
Credit market laxity ble was not just any bubble, why it was a sine
Finally, according to Baily and Elliott, it is qua non – a“but for”cause – of the financial
not clear that government policy was a crisis, and why it was sufficient to cause the
necessary element of the housing bubble; crisis without any excessive risk taking by
conditions in the credit markets were suf- market participants.
ficiently lax that the housing bubble could
have grown to the size it did without any Government role
government help. Using market data, Baily Housing policy: Since much of the Baily-
and Elliott show, among other things, that Elliott paper is about bubbles, and whether
price-to-earnings ratios of US stocks were the recent housing bubble was any more
very high by historical standards in 2006- significant than other bubbles that might
2007, that spreads over treasury rates of have been created by a market that had lost
the sovereign bonds of emerging-market its fear of risk, any response should begin by
countries and US high-yield corporate examining the dimension of the housing
bonds were at historic lows, and that the bubble that began to deflate in 2007. Figure
International Monetary Fund’s calculation 1, page 231, is a chart prepared by the New
of the average volatility forecast built into York Times and based on the work of Robert
option pricing for a wide range of assets J. Shiller. It shows the extraordinary growth
was at a low point in the 2003-2007 period. of the 1997-2007 bubble, especially when
compared to previous bubbles.
Crash trigger Two things stand out about the most
All of this data support the key point of recent bubble: it was much larger in real
the Baily-Elliott argument that the hous- terms than any previous housing bubble,
ing bubble – which appears to have been and it lasted more than twice as long as

226 Journal of Regulation & Risk North Asia


any previous bubble, especially the two that the music stopped, these people were left
occurred before 1980 and 1990. The most without a method of refinancing, and the
recent bubble involved increases in real (not delinquencies and defaults began.
nominal) home prices of 80 per cent over As Warren Buffett observed: “When the
10 years, while the earlier ones involved tide goes out, you can see who’s swimming
increases of about 10 per cent before they naked.” Baily and Elliott describe how a bub-
deflated. Asset bubbles in other sectors ble finally collapses as follows:“The work on
might be comparable, but none is likely to bubbles by Shiller and others makes clear
involve an asset that is one-sixth of the US that a bubble can grow for a very long time
economy, and none – as I will show – was before it hits a natural limit. Such a limit will
composed to such a large degree of weak always be reached, because a key part of the
and high-risk assets. dynamic of a bubble, like a Ponzi scheme, is
that it needs to suck in increasing amounts
Low ‘teaser’ rates of money in order to continue … leaving the
Why did this bubble last so long? This is bubble vulnerable to any piece of bad news
an important question; bubbles get more that causes questions about the excessive
destructive the longer they last because valuation.”This is an accurate portrayal, and
people who believe that prices will con- it emphasises the fact that bubbles natu-
tinue to rise stretch further and take more rally end when those who are adding funds
risks (use more leverage) to acquire assets become nervous about excessive valuations.
that they believe will increase in value. This
is exactly what happened in housing, as Social policy, ‘affordable’ loans
more and more people took out adjustable- In the case of the 1997-2007 bubble, how-
rate mortgages with low “teaser” rates, or ever, one of the major contributors was not
mortgages with low or no down payments, motivated by profit or concerned about
so they could afford the monthly payment risk. It was the US government, following a
on homes that they thought were going to social policy – using government’s financial
rise in value. and regulatory power to boost home own-
ership by increasing the credit available to
Self-feeding low-income borrowers. This was done, first,
A bubble, as Baily and Elliott point out in by requiring Fannie Mae and Freddie Mac to
their paper, feeds on itself because as long acquire increasing numbers of “affordable”
as it lasts it disguises the risks that are being housing loans. An affordable housing loan
taken by those buying the inflating asset. In was one made to a borrower at or below the
the housing bubble, for example, there were median income in the area where the bor-
few losses from this risk-taking until the rower lived.
bubble burst because those who could not This was required in legislation that
afford to pay for their homes could always Congress adopted in the early 1990s, the
refinance by using the higher appraised Housing and Community Development Act
value of the home in a rising market. When of 1992. Initially, the act required that 30 per

Journal of Regulation & Risk North Asia 227


cent of all loans Fannie and Freddie acquired and thus under-priced the risks. The result
had to be affordable, but the Department of by 2008, according to research by the AEI’s
Housing and Urban Development (HUD) Edward Pinto, was a telling distribution of
was given authority under the act to increase subprime and other high-risk loans in the
these requirements. It did so repeatedly from US financial system. As shown in table 2,
1995 until 2007, so that by 2007, some 55 per page 232, two-thirds of the subprime and
cent of all loans Fannie and Freddie acquired other high-risk loans were held or guar-
had to be affordable, with a sub goal of 25 anteed by government entities or entities
per cent for low-low income borrowers who required by the government to acquire, guar-
were at or below 60 per cent of the area antee, or insure the loans.
median income (see table 1, page 231). This makes it very clear that the great
bubble of 1997-2007 did not develop natu-
Fannie, Freddie vs. FHA rally as an ordinary bubble; it was driven
In effect, Fannie and Freddie were put into by a government social policy intended to
competition with the Federal Housing increase home ownership in the United
Administration (FHA), which also was re- States. For this reason, that bubble cannot
quired to insure mortgages for borrowers be classified as just another bubble among
at or below the median income, and with many that the Baily-Elliott paper describes.
insured banks, which were required under Not only was it larger than any other
CRA to make loans to borrowers who were known bubble in its dollar amount, but also
at or below 80 per cent of the median income because of its provenance as an artefact of
in the banks’service areas. government policy it lasted well beyond the
It should be obvious that when Fannie time when other bubbles would naturally
and Freddie, FHA, and all insured banks are have collapsed.
trying to find the same borrowers – those
who are at or below the median income Delinquencies, defaults
(or 80 per cent of the median income in For this reason alone, it was more
the case of CRA) where they live – bor- destructive than any other bubble in history
rowers who could meet the standards for when it finally burst and, because of the
prime loans (a substantial down payment, low quality of the mortgages it contained,
unblemished credit, a steady job, and an resulted in an unprecedented number of
income that would support a mortgage) delinquencies and defaults. Table 3 on page
might be difficult to find. But all these lend- 232 shows the delinquency rates on the 27
ers were required by law or regulation to million subprime and Alt-A mortgages that
make the loans, so they had to settle for were in the bubble before the financial cri-
lower-quality loans than they would prefer sis. The bubble was more destructive than
or had customarily required. others for yet another reason.
Moreover, in competing with one While it is certainly true that as bub-
another, they paid more for these loans than bles grow older their asset quality declines,
they were worth on a risk-adjusted basis this phenomenon is seldom forced and

228 Journal of Regulation & Risk North Asia


exacerbated by government policy. Without There is clearly a relationship, as one
the government’s active involvement, it is would expect, between the quality of the
doubtful that the 1997-2007 bubble would mortgages in the bubble and the bubble’s
have contained as many as 27 million sub- destructiveness when it deflates. Without
prime and Alt-A loans. If the bubble had Fannie and Freddie and the CRA obligations
developed naturally, in the ordinary way, it of insured banks, the number of subprime
could conceivably have contained the 7.8 and other high-risk mortgages in the finan-
million loans that were eventually securi- cial system would have been, at most, only
tised by Countrywide (the largest originator half the 27 million it eventually became.
and issuer of securities backed by subprime It is impossible to know what would have
mortgages, or PMBS), as well as other origi- happened if the bubble had burst when only
nators and the Wall Street banks. 25 per cent of the mortgages in the United
States were subprime or otherwise high-
Cream of a bad crop risk, but clearly the damage to the financial
But even then the quality of the mortgages system and the economy would have been
in these PMBS issuances would have been much lower.
higher than those that Countrywide and For example, in the housing bubble that
the others ultimately contributed to the ended in 1979, when almost all loans were
recent bubble. This is because the govern- traditional mortgages, foreclosure starts
ment agencies or government regulated in the ensuing slump peaked at just 0.87
entities like Fannie and Freddie could afford percent in 1983. In the next bubble, which
to subprime mortgages they needed; they ended in 1989 and primarily involved tradi-
acquired the cream of a bad crop, and that tional mortgages, foreclosure starts reached
drove Countrywide and other securitises 1.32 per cent in 1994. But in 2009, when half
further out on the risk curve to find mort- of all outstanding mortgages were subprime
gages they could securitise. Without com- or otherwise high-risk, foreclosure starts
petition from Fannie and Freddie and the jumped to a record of almost five per cent by
banks under CRA, the PMBS ultimately the middle of 2010.
securitised would have been far less “toxic”
when the bubble collapsed. Negative publicity
And this was at a time when the banks
Clear relationship were going slow on foreclosures because
In any event, these PMBS were less than government programmes were encourag-
one-third of the high-risk mortgages out- ing the renegotiation of delinquent mort-
standing. If the FHA is included, because its gages, and banks did not want either the
role was to make subprime loans, we can capital write downs or the bad publicity that
increase the total to almost half of all the comes with large numbers of foreclosures.
high-risk loans – still only 25 per cent of all What we know is that almost 50 per cent
mortgages outstanding in the United States of all mortgages outstanding in the United
in 2008. States in 2008 were subprime or otherwise

Journal of Regulation & Risk North Asia 229


deficient and high-risk loans. The fact that these government programmes. The hous-
two-thirds of these mortgages were on the ing bubble that finally burst in 2007 was
balance sheets of government agencies, or driven by a US government social policy that
firms required to buy them by government was intended to increase home ownership
regulations, is irrefutable evidence that in the United States and was thus not sub-
the government’s housing policies were ject to the usual limits on the length and size
responsible for most of the weak mortgages of asset bubbles.
that became delinquent and defaulted in As such, it was far larger and lasted far
unprecedented numbers when the housing longer than any other bubble in modern
bubble collapsed. times, and, when it deflated, the vast num-
ber of poor-quality mortgages it contained
Housing data defaulted at unprecedented rates. This drove
Under these circumstances, one does not down US housing values and caused the
have to reach for reduced fear of risk as the weakening of financial institutions around
explanation for the financial crisis. It is right the world that we know as the financial cri-
there in the housing data. Baily and Elliott sis. Market participants were certainly taking
make a strong case for explaining the finan- risks as the bubble grew, and it may well be,
cial crisis as the result of a general decline as Baily and Elliott posit, that this private risk
in risk aversion because of the effect of the taking was greater than in the past.
great moderation – the period from 1982 to
2007 when it seemed that we understood Unwitting group
the causes of financial crises and had found But the facts show that the bubble was
a way to avoid or mitigate them. inflated by a government social policy that
The evidence for a general weakening in created a vast number of subprime and
risk aversion coming out of this period is pay Alt-A mortgages that would not otherwise
more than their private-sector competitors have existed. And the risks associated with
for the plausible. But the Baily-Elliott nar- this policy – which could produce losses of
rative assumes that the 1997-2007 housing more than US$400 billion at Fannie and
bubble was also caused by this factor, and Freddie alone – were being taken by only
that seems implausible. one unwitting group … the US taxpayers. •
The extraordinary lengths to which the
government went to force private-sector Editor’s note
lending that would not otherwise have The publisher and editors of the Journal
occurred – through affordable-housing re- would like to thank Peter J. Wallison and the
quirements for Fannie and Freddie as well as American Enterprise Institute for allowing
demands on FHA and on the banks under the JRRNA to reproduce an abridged ver-
CRA – shows that the housing bubble that sion of this paper. Copyright for the article
ended in 2007 was not a natural occurrence remains the sole preserve of Mr. Wallison and
or the result of mere risk aversion. If it had the AEI.The original document can be found
been, there would have been no need for at: http://www.aei.org/outlook/101004

230 Journal of Regulation & Risk North Asia


FIGURE 1
Figure 1 A History of Home ValuesA HISTORY OF HOME VALUES
BOOM
200 200
A History of Home Values
190 The Yale economist Robert J. Shiller created an index of American housing prices going back to 1890. It is based 190
on sale prices of standard existing houses, not new construction, to track the value of housing as an investment
180 over time. It presents housing values in consistent terms over 116 years, factoring out the effects of inflation. 180

The 1890 benchmark is 100 on the chart. If a standard house sold in 1890 for $100,000 (inflation-adjusted to
170 170
today’s dollars), an equivalent standard house would have sold for $66,000 in 1920 (66 on the index scale) and
$199,000 in 2006 (199 on the index scale, or 99 percent higher than 1890).
160 160
DECLINE AND RUN-UP Prices dropped BOOM TIMES Two gains in recent
150 as mass production techniques appeared decades were followed by returns to levels 150
early in the 20th century. Prices spiked consistent since the late 1950s. Since
140 with post-war housing demand. 1997, the index has risen about 83 percent. 140
WORLD GREAT WORLD 1970s 1980s
WAR I DEPRESSION WAR II BOOM BOOM
130 130

120 120

110 110

100 100

90 90

80 80

70 70

60 60

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

SOURCE: Robert J. Shiller, Irrational Exuberance, 2d ed. (Princeton, NJ: Princeton University Press, 2005).

Table 1 A History of Home Values


1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Low & Moderate
Housing Goal 40 42 42 42 42 50 50 50 50 52 53 55 56
Fannie Actual 45 45 44 46 50 51 52 52 53 55 57 56 54
Freddie Actual 41 43 43 46 50 53 50 51 52 54 56 56 51
Special Affordable
Goal 12 14 14 14 14 20 20 20 20 22 23 25 27
Fannie Actual 15 17 15 18 19 22 21 21 24 24 28 27 26
Freddie Actual 14 15 16 18 21 23 20 21 23 26 26 26 23
Underserved Goal 21 24 24 24 24 31 31 31 31 37 38 38 39
Fannie Actual 25 29 27 27 31 33 33 32 32 41 43 43 39
Freddie Actual 28 26 26 27 29 32 31 33 34 43 44 43 38

Source: Federal Housing Finance Agency, The Housing Goals of Fannie Mae and Freddie Mac in the Context of the Mortgage Market:
1996–2009 (Washington, DC, February 1, 2010), available at www.fhfa.gov/webfiles/15408/Housing%20Goals%201996-2009%2002-01.pdf
(accessed November 1, 2010).

Journal of Regulation & Risk North Asia 231


Table 2 Subprime And Alt-A Loans By Type, June 30, 2008
Entity Number of Subprime or Unpaid Principal Amount
Alt-A Loans
Fannie Mae and Freddie Mac 12 million $1.8 trillion
Federal Housing Administration and Other 5 million $0.6 trillion
Federal Agencies
Community Reinvestment Act and HUD 2.2 million $0.3 trillion
Programs
Total, Federal Government 19.2 million $2.7 trillion
Private-Label Issuers 1
7.8 million $1.9 trillion
Total 27 million $4.6 trillion

Note: Countrywide and many others; Wall Street firms represent about 25 percent of the total.
Sources: See the following works by Edward Pinto: “Sizing Total Exposure to Subprime and Alt-A Loans in U.S. First Mortgage Market as
of 6.30.08” (memorandum, updated April 21, 2010), available at www.aei.org/docLib/Pinto-Sizing-Total-Exposure.pdf, which accounts for
all 27 million high-risk loans; “Sizing Total Federal Government and Federal Agency Contributions to Subprime and Alt-A Loans in U.S.
First Mortgage Market as of 6.30.08” (memorandum, updated April 21, 2010), available at www.aei.org/docLib/Pinto-Sizing-Total-Federal-
Contributions.pdf, which covers the portion of these loans that were held or guaranteed by federal agencies and the four large banks and
Countrywide that made these loans under the Community Reinvestment Act; and “High LTV, Subprime and Alt-A Originations over the
Period 1992–2007 and Fannie, Freddie, FHA and VA’s Role” (memorandum, updated April 21, 2010), available at www.aei.org/docLib/Pinto-
High-LTV-Subprime-Alt-A.pdf, which covers the acquisition of these loans by government agencies from the early 1990s, when the process
of reducing underwriting standards began. See also Edward Pinto,“Government Housing Policies in the Lead-up to the Financial Crisis: A
Forensic Study” (discussion draft, August 14, 2010), available at www.aei.org/docLib/Pinto-Government-Housing-Policies-Crisis.pdf.

Table 3 Delinquency Rates For Subprime And Alt-A Mortgages

Total Delinquency Rate


Loan Type (Thirty-Plus Days and in Estimated Number of Loans
Foreclosure)
High-Rate Subprime (including Fannie/
6.7 million 45.0%
Freddie private MBS holdings)
Option ARM 1.1 million 30.5%
Alt-A (including Fannie/Freddie/FHLBs
2.4 million 23.0%
private MBS holdings)
Fannie Subprime/Alt-A/Nonprime 6.6 million 17.3%
Freddie Subprime/Alt-A/Nonprime 4.1 million 13.8%
Government (FHA, VA FHLBs) 4.8 million 13.5%
Nonagency Subprime and CRA Type
1 million N/A
Loans (not high rate)

Total Number of Loans 26.7 million

Source: Derived from chart 53 in Edward Pinto,“Government Financial Policies in the Lead-up to the Financial Crisis: A Forensic Study”
(Washington, DC: AEI, November 2010), available at www.aei.org/paper/100155.

232 Journal of Regulation & Risk North Asia


Compliance

Sarbanes Oxley regulation


in current financial markets
Gavin Sudhakar highlights disparities
between the legislative intent of SOXs and
emerging trends observed in US agencies’
interpretation of SOX regulation.
GIVEN the financial impact to the share- whistleblowers to come forward freely as
holders and based on the emerging legal a protected activity and reveal corporate
trends observed in the SOX allegations accounting irregularities beforehand to
rulings, the argument stands true in appropriate authorities, internally or exter-
inferring that the legislative disparity is nally. Under the context of developing mod-
mainly due to the lack of statute totality ern employment law, Congress empowered
and its sound enforceability in a complex the Department of Labor (DoL) to enforce
corporate conglomerate structure. this statute and ensure rule of law with due
process in all SOX allegations.
In the light of Enron and WorldCom
accounting scandals, Congress enacted Public allegations
SOX Regulation Act as a direct response An argument of disparity in legislative
to corporate greed and corruption in the intent and legal trends observed in DoL/
boardrooms of America. The main intent of Administrative Agency and Federal Court
the Congress was to uphold public trading judicial interpretation of SWPA [Statutory
company shareholders’ interests and regain Whistleblower Protection Act] in SOX
public confidence in the financial market. It allegations is the main focus of this article.
was also the intent to promote transparency In addition, this argument takes an unbi-
and accountability in all corporate financial ased approach towards corporate employ-
transactions at senior management level. ers and employees by keeping the spirit of
This legislative compliance oversight the Act intact.
initiative passed the House and Senate On the basis of lawmakers’ recent public
Committee with a unanimous bipartisan allegations against DoL’s enforcement of this
majority and, on July 30, 2002, President Bush Act and inspired by the Mayer Brown law-
signed this Act into a law. In this Regulation yer’s webinar, the current view on the statute
Act, Congress made special provisions under shows a clear disparity between the legisla-
Section 806 (SWPA), to encourage corporate tive intent and judicial statute interpretation.

Journal of Regulation & Risk North Asia 233


According to the DoL’s case records on will analyse the recent SOX allegation cases
SWPA as stated in the Wall Street Journal for extrapolating the applicable legal stand-
article, shows that “the government has ards.This section will set the stage to uncover
ruled in favour of corporate whistleblowers three areas of narrow SOX legal standards
only 17 times out of 1,273 complaints filed as applied by an Administrative Law Judge
since 2002.” (ALJ), an Administrative Review Board
(ARB) and Federal District Courts (FDCs).
Potential loopholes These narrow standards have generated sev-
In response to these allegations, DoL stated eral controversial articles in recent years and
that “we are confident we are correctly contributed to the legislative disparity argu-
enforcing the statute, and do not believe ment, namely: 1) procedural timeliness of
the text of statute as written supports the the complaint: 2) protected activity defence
broader reading that employees of subsidi- and: 3) employer’s clear and convincing evi-
aries are automatically covered.” dence standards.
As outlined in the case law section of
this article, that there are too many poten- Procedural timeliness
tial loopholes and safe havens found in the In recent years, the Occupational Safety
statute as written and the DoL’s struggle in and Health Standards (OSHA)/DoL have
applying consistent legal standards in all taken tougher stands with respect to 90
SOX allegation case decisions. In addition, days statute-of-limitation on the retali-
it has been a judicial nightmare to provide a ation action complaint. This was clearly
clear applicable framework for SWPA, par- elaborated in the case of Rollins v. American
ticularly in the context of providing justice to Airlines (AA), Inc. Based on the case facts,
both employers and employees. ALJs in this case determined that the date
DoL’s emerging legal standards and case of the complaint should have been within
approval/dismissal statistics show the bur- 90 days of the initial date of the employer’s
den and uphill battle whistleblowers and alleged retaliatory action.
employers have to bear in order to put forth
a clear and convincing case with preponder- Lack of material proof
ance of evidence to support. ALJs in this case rendered their decision in
favour of AA’s summary dismissal request
Corrupt, greedy officials as Rollins failed to produce material evi-
Even though the intent of the Congress by dence details proving the timeliness of filing
enacting this regulation was to promote his complaint.
stability in the financial market by punish- The DoL’s strict enforcement of this
ing a few corrupt and greedy corporate offi- 90-day statute limitation provides no
cials, the spirit of this Act is lost between few enhanced statutory protection in case(s)
genuine SOX allegations and huge margins similar to Rollins. In support of the legisla-
of disparity. tive disparity argument, this 90-day statutory
The following two sections of this article limitation and intent of the US Congress is

234 Journal of Regulation & Risk North Asia


highly questionable. Under the context of is inconsistent with similar employment
the employment law, it is highly unreason- statutes. Congress should consider levelling
able for claimants such as Rollins to produce the protected activity standards in line with
a preponderance of material evidence within other similar employment statutes in order
the 90-day limitation. In the best interest of to establish a prima facie case.
claimants such as Rollins, Congress should Employers have a provision to defend
consider relaxing SWPA statutory limitation their actions under this regulation with clear
in consistence with the other employment and convincing evidence doctrine, which
law statutes. states that the discharge would have resulted
irrespective of the protected activity element
Protected activity defence consideration.
In order to prove protected activity prima In the case of Roger Fredrickson v. The
facie defence under SWPA, whistleblow- Home Depot USA, Inc, the fact was elabo-
ers have to show with preponderance of rated that the complainant had failed to
evidence that the protected activity pre- establish a prima facie case, and hence
texting was the underlining reason for the respondent Home Depot filed for a Motion
employer’s retaliatory actions. This eviden- for Summary Decision seeking dismissal
tiary requirement is clearly articulated in the of the complaint. Further, the respondents
case Welch v. Cardinal Bankshares Corp. In claimed in the motion that “complainant
this 2003 case, David Welch an employee of cannot prevail, even if he were to establish
Cardinal Bankshares Corp, filed a complaint a prima facie case because the respondent
that Cardinal’s violation of the employees’ demonstrated a legitimate business reason
protected activity under SWPA by termi- for the unfavourable job action, which it
nating his employment was a pretext. On would have taken in the absence of alleged
further appeal by Cardinal to ARB, ALJ’s protected activity.
decision was revised due to legal error and
Welch’s initial complaint was denied. Balanced protection framework
ARB’s narrow legal standard applied to Hence summary decision was granted to
Welch’s protected activity defences clearly Home Depot. ALJ’s narrow legal stand-
defines the preponderance of material evi- ard applied with this clear and convinc-
dence he has to produce in order to prevail ing defence does contribute towards the
is highly unreasonable. In support of the legislative disparity. The imbalance in the
legislative disparity argument, the protected narrow standards justifies the whistleblow-
activity defence stands out as a mere wind- ers concerns about the viability and totality
fall in case(s) similar to Welch. of SWPA regulation as a protected activ-
ity defence in the cause of action. Congress
Clear, convincing evidence should consider expanding and clarifying
In order to establish a prime facie case, Welch the pretext context in a burden shifting prima
has to proof reasonable belief standards to facie case(s) to provide a balanced protection
meet the protected activity element which framework for the claimants.

Journal of Regulation & Risk North Asia 235


This section will uncover the emerg- convincing evidence that it had discharged
ing trends observed by applying wider legal Livingston for insubordination.
standards across SOX allegations. This sec- The wider, “reasonable belief” standards
tion will address four main emerging contro- applied in this case state that in order for
versial legal standards applied in recent years, an employee to reasonably believe that the
namely: 1) Reasonable belief standards; 2) employer’s conduct constituted a violation in
Right to a jury trial; 3) Covered Employer as law, the employee must not only show that
subsidiary or agent; 4) Subject to Arbitration; he believed the conduct at issue constituted
5) Remedies for whistleblower and attor- violation, but also that a reasonable person in
ney’s fees for favourable claimants. his position would have believed the same.
Congress’ intent to provide much deeper
‘Reasonable belief’ standards and wider protection under SWPA does not
The protected activity element of a whistle- mean that the huge burden Livingston has
blower prima facie case requires proof that to carry in order, demonstrates the prima
the plaintiff “reasonably believed” that the facie case under reasonable belief subjective
employer’s conduct constituted a viola- and objective standards. DoL’s wider legal
tion. “This standard was the ground for standard applied with this reasonable belief
dismissal in 62 per cent of all dispositive standard does contribute towards the legis-
decisions in 2008.” lative disparity.
The underlining standards applied for
this high percentage of dispositive decisions Right to a jury trial
as addressed in the case below requires that Through the recent district federal court
the claimant’s reasoning must be “objective decisions, the subject of whistleblowers’con-
and subjective”in belief and the“belief must stitutional rights with respect to “right to a
pertain to an existing violation, i.e. not only jury trial” was clarified. As addressed in the
the violation has happened in the past but is following case, the federal court concluded
also currently in progress.” that SWPA,“by its terms, does not provide a
The standards also requires that the“vio- right to jury trial.” In addition, courts applied
lation is about to happen in the future is an a three-prong test to reject whistleblow-
insufficient defence” from a whistleblower ers’ Seventh Amendment US constitutional
standpoint. This is clearly elaborated in the rights to a jury trial, namely: 1) analogous
case of Mark Livingston v. Wyeth, Inc. claim at common law; 2) remedy sought
and, 3) public right.”
Insubordination In the case of Robert Schmidt & Thomas
The district court presiding over this case Walsh v. Levi Strauss, Robert Schmidt and
ruled summary judgment in favour of Wyeth Thomas Walsh (Plaintiffs) demanded a jury
stating that“Livingston could not reasonably trial under SWPA. Levi Strauss (Levi) argued
have believed that Wyeth was violating the “that there is no right to a jury trial conferred
securities laws.” This district court also con- by either or the Seventh Amendment of US
cluded that Wyeth had shown by clear and Constitution.” The issue before the court was

236 Journal of Regulation & Risk North Asia


whether Plaintiffs were entitled to a jury trial between matters that could be conclusively
on their SWPA complaint pursuant to the determined by the Executive and Legislative
Seventh Amendment. The court concluded branches and matters that are inherently
that SWPA does not provide a right to trial judicial.”
by jury because the words “jury trail” do not The court here compared public rights with
appear anywhere in the text of the statute. adjudication rights provided by Congress to
In addition this court rejects jury trail request the Secretary of Labor as unconstitutional.
based on the remedy defence stating that It also stated that “if a claim that is legal in
“the provision for damages under SWPA nature asserts a “public rights”, then the
does not necessarily equate to a provision for Seventh Amendment does not entitle the
a right to a jury trial.” parties to a jury trial if Congress assigns its
adjudication to an administrative agency or
Restitutionary relief specialised court of equity.” In the end , the
The court further concluded that“SOX stat- court rejected Plaintiffs’request for a jury trial
ute provides for restitutionary relief, equita- under SWPA, stating constitutional rights
ble in nature, and that there is no Seventh do not apply in adjudicated claims. That the
Amendment right to a jury trial since the statute language failed to address constitu-
statute provides for initial review by an tional rights with respect to “right to a jury
administrative agency.”In comparison to the trial”, contributed to the legislative disparity
common law and SWPA, the court stated argument.
that “wrongful discharge suit exhibits the
classic elements of a tort cause of actions ‘Agent’ rule in place
and SWPA claim is analogous to one that DoL case records as shown in a Wall Street
would be brought in a court of law prior to Journal article state that the judicial wider
the merger of the courts of law and equity.” standards applied on SOX allegations does
not cover subsidiary and employers’ over-
Historically recognised distinction seas engagement as a covered employer
From a remedy sought standpoint the court under SWPA. In recent years, ALJ’s decision
stated that“although not all awards of mon- has clarified covered and non-covered sub-
etary relief must necessarily be legal relief, sidiaries. With the “agent” rule in place, it is
the remedy sought by the respondents in much clearer which of today’s subsidiaries
that case did not warrant an exception to are likely to be covered employers, so many
the general rule that the damages sought subsidiaries may not be raising this defence
were legal.”As such SWPA remedies covers in the future.
reinstatement, compensatory damages, back This high standard applied with respect
pay and legal fees, which are not considered to principal and agency relationship con-
as an exception for a jury trial. When it comes tributes to the legislative disparity argu-
to public rights the court stated that accord- ment. During recent years, the corporate
ing to the“public rights doctrine is grounded “veil piercing” doctrine has played a major
in a historically recognised distinction role in SOX allegations. Based on corporate

Journal of Regulation & Risk North Asia 237


law principles and as discussed in the limited Guyden (Guyden), an employee, brought
liability section, “disregarding the corporate SOX allegations against her employer Aetna,
entity” in some circumstances the principle Inc (Aetna), which stated that she was ter-
does become liable for its subsidiaries’ legal minated as director of internal auditor in
actions. Hence the courts have reconsidered retaliation for reporting accounting irregu-
the subject of covered subsidiaries in the larities. Aetna, in response, demanded of the
context of“Corporate Law”and the doctrine District Court of Connecticut a motion to
of veil piercing in granting subsidiaries as an compel arbitration and to dismiss Guyden’s
integral corporate entity in SOX allegations. allegation. Guyden appealed this motion to
the Court of Appeals (CA) and based on the
Applicability complications case facts, the CA had to“determine whether
The concept of applying an integrated statutory claim is arbitrable under the Federal
employment test is clearly elaborated in Arbitration Act (FAA).”
the case of O’Mahony v. Accenture Ltd. A CA stated that SWPA’s“primary purpose
foreign subsidiary has created further com- was to provide a private remedy for aggrieved
plications with respect to applicability of employees, not to publicise alleged corpo-
SWPA in a foreign land. Since most of the rate misconduct.”CA concluded by affirming
major public trading companies are global in the district court ruling that the SOX allega-
nature, in order to maintain their competi- tions are arbitrable and demanded specific
tive edge and brand reputation, companies arbitration process, which in turn does not
are enforcing strong SOX compliance and infringe upon Guyden’s statutory rights.
ethics policies, and programmes exist across Pre-authorised arbitration agreement does,
their operations. The notion that SWPA does however, infringe upon a whistleblower’s
not apply in a foreign land defence as a“safe statutory rights and hence this contributes
haven” has been overruled by district courts towards legislative disparity.
in recent years. Lack of statute language sup-
porting covered foreign subsidiaries and the Arbitrary guidelines
legal standards applied have contributed to Section 806 outlines the availability of brief
the legislative disparity argument. remedies that favour the whistleblower. The
statute provides arbitrary guidelines to DoL
Whistleblower claims and federal courts when they conclude that
In recent legal trends observed in the SOX the charged party has violated the SWPA.
allegation, issues related to arbitration Whistleblowers’ relief or remedies to the
agreement under SWPA were clarified by allegation includes “making the employee
the federal courts. Even though SWPA “is whole, reinstatement of the complainant to
silent regarding arbitration, federal district that person’s former position with the sen-
courts and ALJs concur in the recent alle- iority status that the complainant would
gation that whistleblower claims are arbi- have had but for the discrimination, back
trable.” This issue was addressed in the pay with interest, and compensation for any
case, Guyden v. Aetna, Inc, in which Linda special damages sustained as a result of the

238 Journal of Regulation & Risk North Asia


discrimination, including litigation costs, supported means.”Especially, attorney’s fees
expert witness fees, and reasonable attor- “petition must specify the date on which the
ney’s fees.” attorney’s time was expended, the amount
The remedies and relief standards of hours expended, and a specific description
applied are elaborated in the case of of the tasks undertaken by the attorney dur-
Hagman v. Washington Mutual Bank Inc, in ing the time.”ARB also stated that Hagman
which Theresa Hagman (Hagman) brought counsel’s “contingency fee arrangement”
a retaliation claim against her former with Hagman is not covered under SWPA.
employer, Washing Mutual Bank (WaMu)
under SWPA, which stated that WaMu has No punitive damages
violated SWPA by terminating her employ- ARB based the attorney’s fee on the facts
ment. ALJ in this case rendered in the favour of calculations shown by Hagman’s attor-
of Hagman based on the case facts and ney’s awards and reasonable industry attor-
orders WaMu to “immediately reinstate her ney’s standard fees and costs. In the context
former position as vice-president, pay back of employment law, the SWPA statute does
pay with interest, compensatory remedies, not have any provision for punitive damages.
attorney’s fees and reimburse fair value of Due to ambiguity and vague statute lan-
stock options plus interest.” guage as written with respect to remedies
and relief, prevailing whistleblower and
Dysfunctional environment representing attorneys are at the mercy of
Hagman in return objects and rejects the the courts to determine their ultimate relief.
ALJ’s reinstatement order, and stated that On the other hand, employers are at similar
“reinstatement is not a viable option.” mercy of the courts to determine the claim-
Hagman requested in lieu of reinstatement a ant’s payout. This ambiguity in remedy and
“front pay or an equivalent remedy.”Through fee standards contributes towards the legis-
appeal, ARB in this case concluded that the lative disparity argument.
“reinstatement is the preferred and pre-
sumptive remedy to make whole employ- Conclusion
ees who have been discharge in violation of Publicly-traded companies form the founda-
SWPA. Due to existing dysfunctional work tion of the global economy and their success
environment conditions and excessive hos- and compliance is crucial to their share-
tile employment relationship, ARB in this holders. The SWPA is necessary to protect
case ordered for the front pay/loss of earning the corporate whistleblowers from injustice
for 10 years in favour of Hagman. from corporate retaliation. Yet Congress has
Under SWPA, whistleblowers are enti- put the burden on the administrative agen-
tled to recover remedies as prevailing party cies and federal courts for speculating on its
for the “litigation costs, expert witness fees, intent. Given the complex governance struc-
and reasonable attorney’s fees.”ARB in this ture in global public trading companies, it is
case applied strict standards in calculat- the responsibility of Congress to clarify and
ing fees, based on “reasonable and properly enhance the scope and boundaries of SWPA

Journal of Regulation & Risk North Asia 239


to uplift the spirit of this Act. It is also the financial value to the shareholders“if any”is
responsibility of the Congress not to hinder yet to be appraised, and“whistleblowers are
the entrepreneurial spirit in the corporate left dangling” to fight for their constitutional
conglomerate, but to create a competitive rights. In the light of the Enron scandal,
market for innovative minds to prosper in a Congress enacted a SOX regulatory body.
free enterprise world. “But when ex-SEC head William
Lawmakers are responsible and account- Donaldson tried to regulate hedge funds, he
able for success or failure of any Act, and the was blocked by Bush’s advisers at the White
burden remains on them to maintain a bal- House which forced him to quit his position.”
ance view in making an Act into a working In the recent Bernard Madoff fraud Ponzi
law. Through the emerging legal standards scheme, Harry Markopolos (Markopolos)
observed in SOX allegations, it is clear that the whistleblower in this case stated that: “I
the administrative agencies and federal gift-wrapped and delivered the largest Ponzi
courts have played a major role in clarifying scheme in history to SEC, and somehow
and shaping the Act. they couldn’t be bothered to conduct a thor-
ough and proper investigation.”
Silent approach In response, SEC chief executive Chris-
Even though the judicial role played in topher Cox testified before Congress stating
shaping this Act is questionable, until now that due to budget and resource constrains,
Congress has taken a “silent approach” to the SEC did not have the bandwidth to
this desperate reaction for amending the Act. investigate every whistleblower tip. This dis-
If protecting the rights of a whistleblower parity between the SWPA’s lawmaking and
remains a“genuine interest”of Congress, the enforcement left shareholders in disarray.
statistics should disprove the huge disparity
in its intent as seen. This legislative dispar- Congressional backup
ity led to the fact that the DoL was forced It is the responsibility of Congress to give
to define legal standards with limited clarity enough authority and financial means to
from Congress. support regulatory bodies. As SWPA pro-
The legal standards applied for victims’ tects whistleblowers against retaliation for
remedies are based on vague interpretation SEC rules violation, the SEC should have
of administrative agency and federal courts a major involvement in implementing the
systems. Blaming and finger pointing at the SOX Act. In order to maintain checks and
judicial branch should not take precedence balances between SEC regulation and DoL
in application of the law. in SOX allegations, a strong SEC presence
Congress should consider every whistle- will ultimately uphold the whistleblower’s
blower’s “genuine” whistle in a corporate safety net.
world as a tip to protect shareholders’interest It should not be the intent of the legis-
from fraud and personal greed. In the midst lative or judicial branch to mandate how
of urgency, politics and publicity behind publicly traded global companies should
implementing the SOX Regulation Act, its conduct their business. However, due to

240 Journal of Regulation & Risk North Asia


disastrous financial market accounting disputes and SOX allegation issues. Imple-
scandals, the SOX regulation has placed top menting strong corporate compliance and
executives under intense scrutiny. CEOs and ethics training programmes will encourage
financial managers are held directly respon- transparency and accountability at all levels.
sible for their companies’ full compliance This global corporate compliance and ethics
with the laws. Indeed, they are required by framework will certainly connect the con-
law to certify the accuracy of financial state- glomerate structure and provide the needed
ments and disclosures. awareness. Also, the corporate compliance
governance and organisation management
Costly compliance systems structure must support the core strategy.
The burden put on the corporate executives The corporate chief compliance officer
during the past seven years has forced them and general counsel must take an active roles
to implement state-of-the-art costly inter- in handling SOX complaints. Treating the
nal compliance and ethics systems. Keeping whistleblower not as an enemy or nuisance
compliance and ethics as the core govern- to its operations but as a loyal employee will
ance strategy has improved confidence in, certainly uplift morale as well as manage-
and credibility of, the financial market to a ment trustworthiness.
certain degree. On the other hand corporate manage-
Despite the costly hotline systems in ment does not have the bandwidth to spot
place, the corporate conglomerate views or investigate every fraudulent activity under
SWPA as a “nuisance” to its operations. The its wings. Having trustworthy employee and
rational behind this view is a contribution transparency in the management will con-
from defending a vague SWPA statute and tribute towards maximising the shareholder
unnecessary negative publicity. The recent value.
legal trend shows that employers are being
forced into binding arbitration agreements Meritless claims
in the form of contracts with their employees Employees also have a major part in shap-
to prevent SOX allegations. ing SOX credibility by eliminating meritless
claims and providing stronger, specific evi-
Office disputes dence of SEC violation in order to support
Binding arbitration agreement in turn only their claims. In an employment law context
protects the corporate interest in SOX alle- there are several provisions available for
gations. Even though courts have upheld an employee to seek justice for corporate
such binding agreements, it is questionable retaliatory action. However it is essential
to force an employee to comply beforehand to recognise that SWPA or any employ-
with a SOX arbitration agreement as a con- ment retaliation claim is not an outlet for
dition for employment. It is also corporate mere office disputes. Insubordination and
responsibility to train all its human resource disagreement with corporate officials on any
functionality to identify and differentiate given dispute have no grounds for claiming
the fundamental difference between office retaliation or discrimination charges under

Journal of Regulation & Risk North Asia 241


SWPA. As presented in the case of Hagman See: Rollins v.American Airlines, Inc,ARB No. 04-140
v. Washington Mutual Bank Inc, quality and – April 3, 2007 SSRN http://www.oalj.DoL.gov/pub-
evidentiary case support does show a clear lic/ARB/decisions/ARB_decisions/air/04_140.air.htm
intent of the employee in presenting a merit See: Welch v. Cardinal Bankshares Corp., ARB No.
worthy claims. 05-064 – May 31, 2007 SSRN http://www.oalj.
DoL.gov/public/ARB/decisions/ARB_decisions/
Human character sox/05_064.soxp.htm
When it comes to fraud and greedy activities, See: Roger Fredrickson v. The Home Deport USA,
a whistleblower’s moral conciseness should Inc, Case No. 2007-SOX-13–July 10, 2007 SSRN
dictate his or her actions to fight for what http://www.oalj.DoL.gov/Decisions/ALJ/SOX/2007/
they believe is right for the company and fredrickson_roger_v_the_home_depot_
its shareholders. Finally, the shareholders inc_2007SOX00013_(jul_10_2007)_092740_
should never be victims of corporate finan- cadec_sd.pdfId14
cial misconduct. In a capitalistic world, sheer See: Mark Livingston v.Wyeth, Inc., cited as 520 F.3d
fraud and greed will prevail irrespective of 344
strong corporate governance and ethical See: Robert Schmidt v. Levi Strauss, Cited as : 2008
regulatory rules. WL 859705
The rule of law applies only to the con- See: Chapter 4 Corporation and other Business
sequence of ill human character; however, Organisations by Melvin A. Eisenberg (page 220)
character remains the origin of the problems. See: O’Mahony v. Accenture Ltd, Cited as: 2008 WL
A whistleblower solution can be an asset 344710
and not a nuisance if the legislative, judicial See: Guyden v.Aetha, Inc., Cited as: 544 F.3d 376
and corporate officials view the importance See: Occupational Safety & Health Adminstration,
they bring in maximising shareholder value. SN-1980.109: Procedures for the Handling of
Ultimately, whistleblowers are not left dan- Discrimination Complaints Under Section 806,
gling in the capitalistic world. • SSRN http://www.osha.gov/pls/oshaweb/owadisp.
show_document?p_table=standards&p_id=12967.
References See:Theresa Hagman v.Washington Mutual Bank, Inc.,
See: United States Department of Labor – Office Case No. 2005-SOX-00073 – Dec. 19, 2006 SSRN
of Administrative Law Judges, DoL Whistleblower http://www.oalj.DoL.gov/Decisions/ALJ/SOX/2005/
Statutes, SSRN http://www.oalj.DoL.gov/public/ Hagman_Theresa_v_Washington_Mutual_
whistleblower/references/statutes/whistleblower_ BA_2005SOX00073_(Dec_19_2006)_174914_
statutes.htm#sox cadec_sd.pdf. Id 2
See: The Wall Street Journal, WSJ.com, See: Time.com – 25 People to Blame for
Sept10,2008,SSRN http://online.wsj.com/article/ the Financial Crisis, SSRN http://www.
SB122101918024118495.html time.com/time/specials/packages/arti-
See: Whistleblower Litigation: Dealing With SOX cle/0,28804,1877351_1877350_1877320,00.html
Allegations in the Current Economic Climate – See: CNN.com – February 5, 2009 SSRN http://
December 17, 2008, SSRN http://www.mayer- www.cnn.com/2009/CRIME/02/05/madoff.whistle-
brown.com/events/archive.asp blower/index.html

242 Journal of Regulation & Risk North Asia


Capital markets

Integrating China’s economy


into global capital markets
Deutsche Bank’s Terry Tse and Gene Guill
have some practical ideas to help China’s
financial sector access the global economy.

The emergence of China’s economic to manage the development of capital mar-


might over the past 30 years ranks as one kets in this transition. Under the guidance of
of the most significant events in modern Deng Xiaopeng and his successors, Chinese
economic history. As the country’s econ- leaders have adopted a pragmatic approach
omy grows in size and sophistication, it to shift the economic model gradually, first
will increasingly rely on markets to allo- through Special Economic Zones such as
cate capital among alternative means. Shenzhen and the open reception to for-
eign direct investment, then through gradual
The integration of Chinese capital markets development of a market infrastructure. This
into global markets is urgently needed; how- gradual shift has helped to maintain social
ever, the development of capital markets in and economic stability while lifting millions
China has been slow compared to other sec- of Chinese citizens out of poverty.
tors of the economy for a variety of reasons
– among them the relatively slow pace of Legacy issues
change in the institutional and legal systems This gradualist, pragmatist approach
that underpin the Chinese economy. This did not seek to overhaul China’s most fun-
essay summarises the challenges of capital damental institutions. Indeed, some would
markets development in China and pro- argue that is precisely its greatest merit. It is
poses some practical ideas to confront them. in this context that we would like to discuss
China is presently facing a huge the obstacles to capital markets development
dilemma, namely, how to overcome three in China. The obstacles were not put in place
major obstacles preventing its financial ser- per se to thwart the growth of capital markets.
vices sector from becoming a global force They exist as a legacy to the gradualist, prag-
to be reckoned with. Unfortunately for matist approach to transitioning the Chinese
the Chinese, no manual exists to describe economy away from a Soviet-style planned
the transition of a planned economy into economy. In this sense, it is almost inevitable
a market economy, much less one on how that these obstacles exist because they reflect

Journal of Regulation & Risk North Asia 243


the reality of China’s economy. The first great risks in seemingly familiar instruments.
obstacle standing in the way of China’s inte- For example, in the 2005 to 2007 securiti-
gration into global capital markets is capital sation pilots, securitisations had to be set
controls. The value of the renminbi (RMB) is up as trust structures as these structures
a politically contentious topic, but a lot of the are closest to fulfilling that function under
political grandstanding often overlooks the Chinese law. The bankruptcy remoteness of
larger and perhaps more significant fact that these structures is somewhat uncertain, and
it is not a freely convertible currency. Foreign hence investors would hesitate to regard
investors cannot easily invest large sums in them as securitised transactions from the
Chinese financial instruments without spe- perspective of international law.
cial approvals and foreign companies, until
recently, could not borrow large quanti- Complex bankruptcy rules
ties of capital in RMB. Conversely, Chinese And nowhere is this difficulty more evident
investors, with the exception of the sover- than in the area of bankruptcy. In China,
eign fund, cannot readily invest their wealth bankruptcy often involves complex adminis-
in assets denominated in foreign currency trative procedures with local authorities, not
without special approvals. just the courts. It is vastly different from the
Without the free flow of capital, capi- court-driven legal processes in most devel-
tal markets cannot develop rapidly since oped countries.The nature of this bankruptcy
domestic markets will be virtually divorced process poses challenges in differentiating
from international markets and unable to debt into senior and subordinated classes.
respond to the price signals thereof. On the Without a legal system which investors
other hand, capital controls provide much can easily understand, complex capital mar-
needed stability for the exchange rate and kets instruments will be difficult to value and
the economy overall. It protects domestic execute. On the other hand, evolution of the
markets from the risks of massive capi- legal system can only progress slowly as the
tal flights and the disorderly inflow of hot legislative and judicial functions of govern-
money which can wreak havoc on a fledg- ment as well as society at large must keep
ling financial system. pace. Also, the bankruptcy procedures in
China play an important role in maintaining
Antiquated legal structure social and economic order, particularly for
The second great obstacle preventing large state-owned enterprises which employ
China’s full participation in international a significant number of workers.
capital markets is the country’s antiquated The third major obstacle preventing
legal structure. At their most basic level, China’s full entry into international capital
financial instruments are legal agreements. markets is the lack of a broad domestic inves-
Differences in the Chinese legal system tor base. A vibrant financial system requires
and legal systems of most other devel- a large number of investors with sufficiently
oped countries have far reaching repercus- diverse risk-return objectives. Only then can
sions, as investors struggle to evaluate legal capital markets distribute risks across the

244 Journal of Regulation & Risk North Asia


economy. Such a broad investor base does which has fuelled its economic reforms
not yet exist in China. since the late 1970s, mostly in the form
The problem is particularly acute in of foreign direct investment. The logic is
fixed income, where corporate bonds often straightforward. As an underdeveloped
trade within the confines of the inter-bank economy, total social wealth is not sufficient
market. And with capital controls, for- to fund capital intensive industries and
eign investors cannot easily participate. infrastructure. But without capital intensive
Without a broad investor base, liquid- industries and infrastructure, an economy
ity is stunted. Few investors, other than can not develop. It was foreign capital, in
banks, can absorb large quantities of risk, the form of foreign direct investment, that
especially credit risk. Hence the banking broke the vicious cycle.
system ends up shouldering most of the
credit risk of the Chinese economy. Redistribution of risks
Mainland banks routinely suffer from The same logic applies to the development
highly concentrated credit portfolios. Even if of capital markets. But the nature of capital
regulators were to allow a variety of hedg- markets makes the argument all the more
ing instruments overnight, there are hardly powerful because capital markets can pro-
any investors capable and willing to take vide leverage and redistribute risks, thus
this risk. On the other hand, a broad inves- leading to a more efficient allocation of
tor base will emerge only gradually, as the capital for the entire economy. Most impor-
total social wealth of China accumulates to tantly, capital markets can alleviate the overly
a critical mass and becomes organised into concentrated credit portfolios of Chinese
various structures such as pension funds, banking system. The history of capital mar-
endowment funds, foundations, etc. kets development in the United States is
instructional here, especially the case of rail-
Stupendous wealth way bonds. In some respects, the Chinese
These funds, in turn, will hire professional economy today resembles the US economy
asset managers to invest on their behalf and in the late 19th century. The United States
fulfill different risk-return objectives. Whilst had already developed basic industries and
China exhibits the perception of stupendous enjoyed bountiful natural resources.
wealth, particularly in the form of immense However, as an emerging economy, it
foreign reserves, GDP per capita still trails lacked capital to further develop critical mas-
advanced economies, and the total social sive infrastructure such as the continental
wealth of China has not yet reached the level railroad. Attention was turned abroad. As
to support a broad investor base. economic historian, Mira Wilkins, noted:
Unfortunately, even if these three great “There was not a prominent American rail-
obstacles exist for the right reasons in road leader who did not desire and expect
China, they do not exonerate the urgency foreign monies.” (The History of Foreign
to integrate into international capital mar- Investment in the United States to 1914 p.
kets. China is no stranger to foreign capital, 190, chapter 6.) Britain was the undisputed

Journal of Regulation & Risk North Asia 245


economic and political leader of world at Most importantly, Hong Kong is Chinese
that time. Thus, it was no surprise that the sovereign soil. Hong Kong’s unique position
British dominated the group of European enables China to retain a degree of control
railroad investors willing to pump much while interfacing with international capi-
necessary funds into the country’s nascent tal markets, thus resolving the three great
railroad infrastructure. obstacles cited above. Since Hong Kong is
With foreign capital, the railroad system in Chinese sovereign soil, authorities (both
the United States expanded rapidly between mainland and local Hong Kong) have com-
1875 and 1914. Today, most economic histo- plete control of the flow of capital between
rians would agree that the American railroad mainland China and Hong Kong.
system could not have been built as swiftly
and vastly without foreign direct investment. Flexible capital controls
The important historical lesson here is not Most importantly, it is a flexible form of con-
just the amount of foreign capital, but also its trol. Authorities can approve different sizes,
sophistication. structures and direction of capital flows as
Foreign capital was mostly invested in the needed, while maintaining stability afforded
form of bonds, many of which were traded by capital controls in the mainland. This
in London, then the undisputed global regulatory structure resolves the dilemma of
financial centre. The world’s most sophisti- capital controls.
cated banking houses, from the Rothschilds Most international investors are comfort-
to the Morgans, conducted business there, able with Hong Kong laws and regulations,
as did the world’s elite lawyers. London not which enable the structuring and execution
only provided capital, but also the financial of a large variety of transactions – including
expertise to structure it. securitisations and most forms of derivative
contracts – according to international stand-
China’s dilemma ards. China can also tap into the wealth
If China is confounded by the dilemma of of international financial expertise there.
quickly integrating into international capi- International familiarity with Hong Kong
tal markets while preserving the stability laws and regulations resolves the dilemma
afforded by broader capital controls, giv- of the mainland Chinese legal system.
ing adequate time for the legal system to Once in Hong Kong, capital flows freely
evolve and allowing the growth of total between there and the rest of the world. The
social wealth to take its natural course, the global investor community, which operates
country is also blessed with a world class in Hong Kong, becomes available to China
financial centre at its disposal. As a former with all their sophistication and diverse risk-
British colony, Hong Kong is endowed with return objectives.
an English-based legal system. It oper- Some will chase riskier equity-like
ates with well developed regulatory and returns while others will seek different
accounting frameworks which are based on kinds of fixed-income opportunities. Hong
international standards. Kong’s presence in the international investor

246 Journal of Regulation & Risk North Asia


community resolves the dilemma of the lack GE Capital is a well-known example. Hong
of a wide investor base in mainland China. Kong incorporated subsidiaries have the
Calls to leverage the Hong Kong plat- obvious advantage of being governed by
form are not new to China. In recent years, Hong Kong bankruptcy laws. Hence they
for example, Chinese authorities have can issue bonds palatable to international
worked closely and proactively with Hong investors in RMB as well as other currencies.
Kong authorities to facilitate RMB settle- Chinese authorities can encourage large,
ment in Hong Kong as part of Beijing’s effort sophisticated Chinese companies with good
to internationalise the country’s currency. credit standing to establish such subsidiaries
Our two suggestions will focus on capital in Hong Kong as financing vehicles.
market initiatives, particularly in the con-
text of alleviating Chinese banks from their Acceptable credit curves
overly concentrated credit portfolios. In the short term, these firms can repay their
The first suggestion is offshore secu- bank loans with bonds and reduce their reli-
ritisation. Many large international banks ance on bank financing. In the medium to
regularly use asset securitisation to manage long term, as the bonds are more actively
the concentration risk of their credit port- traded, market pricing of credit risk slowly
folios. The issuance of securities backed by surfaces, creating internationally recognised
loans, commonly known as collateralised credit curves for Chinese corporates. Single
loan obligations (CLOs), requires complex name CDS on these corporates will emerge
legal structures which are difficult to set as a natural consequence. Such develop-
up in China in a way that is comfortable to ments will enable banks to price and hedge
international investors. credit risks, thus safeguarding their credit
portfolios from concentration risk perils.
Deal-by-deal basis The development of capital markets is
Hong Kong’s legal system resolves this dif- a lengthy and potentially bumpy process.
ficulty. Chinese authorities could consider While the need for sophisticated capital
allowing Chinese banks to transfer loans markets solutions has become more urgent
to Hong Kong on a deal-by-deal basis for for China in order to fund its growing
the purpose of securitising them and sell- industrial might and relieve Chinese banks
ing CLO tranches to international inves- from concentration risks, the country is also
tors. Securitisation not only enables Chinese blessed to have Hong Kong as a platform to
banks to reduce concentration risks, but international capital markets.
could also generate funding (in the case of Leveraging this platform would allow
true sale CLOs) without issuing more equity. Chinese authorities flexible control to over-
The second suggestion is the develop- come the three great obstacles to their capi-
ment of Hong Kong incorporated financing tal markets development. And more efficient
vehicles for large Chinese corporates. Large capital allocation powered by capital markets
multinational corporations often use spe- will launch the next phase of the Chinese
cialised subsidiaries as financing vehicles. economic miracle. •

Journal of Regulation & Risk North Asia 247

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