Professional Documents
Culture Documents
North Asia
In association with
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
Lambs to the slaughter: Real causes of the financial crisis Peter J. Wallison
Integrating China’s economy into global capital markets Terry Tse & Gene Guill
In Financial Risk Management,
Experience Counts For Everything.
In Asia Pacific, We’ve Got Plenty Of It.
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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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ISSN No: 2071-5455
Journal of Regulation and Risk – North Asia
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Tel (852) 2982 0297
Email: christopher.rogers@irrna.org
Website: www.jrrna.org
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.
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
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.
Christopher Rogers
Publisher & Editor-in-Chief
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.
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.
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.
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
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.
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.
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
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
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
Subscribe
Risk managem
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Of ‘Black
Swans’, stre
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risk manag ts &
Com pliance ement
Legal & Standard &
outlines the Poor’s
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s pap er, Tham t, examines the unlikely or
unpr by apparently s, and; apply
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In thi tan ecede to these
in Asia.
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– for exam
nts
Piper Ho ious effects of the Howe ver, solving the adjusted pricin
rman ce analysis ple,
fying the risk problem of and risk-
pernic cies that give
concentrati
ons and depen
identi- into
account.
g that takes
stress test result
which rise to worst den- s
many of
panies – legis-
vital if the
indus
-case outco
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
gations by
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
’s anti-
north asia
ide mon
ey or
offer or prov ials (“foreign”mea or
anything
n-
igorat ed stress testin
man- busin
g and or
ess growth
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
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
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.
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
www.edit24.com
Asia, Australia, Africa
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
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).
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
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.
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
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).
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
10
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.
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
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
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
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
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
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
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
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
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
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
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
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
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
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.
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
15
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).
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.
Notes: Inflation is available for all the countries listed above for the full sample covering the Great
Depression through 2010.
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.
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.
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.
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
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.
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
15
10
–5
March 2008 July 2008 November 2008 March 2009 July 2009 November 2009 March 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
80
60
40
20
0
<1.5 1.5–2.0 2.0–2.5 >2.5
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.
115
110
105
100
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
120
110
100
90
Japan (Q3 1993)
United Kingdom (Q3 1991)
United Kingdom (Q3 2009)
80
–8 –4 0 4 8 12 16
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.
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.
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
Reprint Service
ulation & risk
north asia
Issues in resolving
systemically important
impacts
financial institutions
l change
Resecuritisation Dr Eric S. Rosengren
in banking: major
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
the United that
a huge mentione ical perso s
financial d, resulting in by as
Alan Ewins and Angus
regarded e we (phys ut the bank Ross
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
involveme ents. regulator former banki g and they implic
specia itly demonstrate
ly revolves mobile paym crime. As one lising in ‘white
ng cal failure
s of regula three criti-
ing large mers, los-
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
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
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
Issues in resolving
systemically important
impacts
financial institutions
change
Resecuritisation Dr Eric S. Rosengren
in banking: major
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
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
Cube
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
ng
essarily represe commentary does not cipline.” Instead private sector “mark
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
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
Reprint Service
lation & risk
north asia
Issues in resolving
systemically important
impacts
financial institutions
change
Resecuritisation Dr Eric S. Rosengren
in banking: major
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
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
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
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Asia, Australia, Africa
Hong Kong: +852 9144 5549 Australia: +61 (41) 271 8715 South Africa: +27 (82) 449 6333
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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.
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
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Asia, Australia, Africa
Hong Kong: +852 9144 5549 Australia: +61 (41) 271 8715 South Africa: +27 (82) 449 6333
email: ian@edit24.com email: fiona@edit24.com email: remo@edit24.com
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
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
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).
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).
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.
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.