1 lessons from the sub-prime crisis kevin davis commonwealth bank chair of finance, university of...

1

Lessons from the sub-prime crisis

Kevin Davis

Commonwealth Bank Chair of Finance, University of Melbourne

Director, The Melbourne Centre for Financial Studies

www.melbournecentre.com.au

kevin.davis@melbournecentre.com.au

November 2008

2

Outline

• Origins of the Crisis• Features of the Crisis• Regulatory Responses• Future Regulatory Responses

3

Origins of the Crisis

• Financial engineering and financial products• Liquidity creation and leverage• “Shadow banking” & risk sharing and

spreading• Inadequate public information

4

An Increasingly Complex Financial System

CentralBank

Banks & ADIs

InvestmentBanks

ManagedFunds

HedgeFunds

Pension Funds

FinanceCos.

InsuranceCos.

PrivateEquity

CashCash

CDO’sCDO’s

RMBSRMBS

CFDsCFDs

FuturesFutures

SwapsSwapsOptions

Options

Warrants

Warrants

ABCPABCP

Conduits

ConduitsSIV’sSIV’s

Debentures

Debentures

IndexedIndexedFundsFunds

Margin

MarginLoans

Loans

ShortShortSellingSelling

SecuritiesSecuritiesLendingLending Reverse

ReverseReposRepos

ReposReposDepositsDeposits

FXFX

BondsBonds

SharesShares

LoansLoans

5

Origins of the Crisis

• Financial engineering and financial products• Liquidity creation and leverage• “Shadow banking” & risk sharing and

spreading• Inadequate public information

6

7

Easy Credit – An ExampleLarge Business Credit Spreads - Australia

0

0.5

1

1.5

2

2.5

3

Sep-98

Sep-99

Sep-00

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Quarter

%

Spread over 30 day bank bill rate

Source: RBA

8

Origins of the Crisis

• Financial engineering and financial products• Liquidity creation and leverage• “Shadow banking” & risk sharing and

spreading• Inadequate public information

9

An Interdependent Financial System

CentralBank

Banks & ADIs

InvestmentBanks

ManagedFunds

HedgeFunds

Pension Funds

FinanceCos.

InsuranceCos.

PrivateEquity

CashCash

CDO’sCDO’s

RMBSRMBS

CFDsCFDs

FuturesFutures

SwapsSwapsOptions

Options

Warrants

Warrants

ABCPABCP

Conduits

ConduitsSIV’sSIV’s

Debentures

Debentures

IndexedIndexedFundsFunds

Margin

MarginLoans

Loans

ShortShortSellingSelling

SecuritiesSecuritiesLendingLending Reverse

ReverseReposRepos

ReposReposDepositsDeposits

FXFX

BondsBonds

SharesShares

LoansLoans

10

Origins of the Crisis

• Financial engineering and financial products• Liquidity creation and leverage• “Shadow banking” & risk sharing and

spreading• Inadequate public information

11

Public Information

12

A simple explanation

Ian Ramsay April 1, 2008 http://business.theage.com.au/opes-prime-who-understood/20080331-22qf.html

Illustration: Michael Leunig

13

Features of the Crisis

• Consumer sophistication• Incentive structures• Outsourcing due diligence• Regulatory avoidance• Inadequate risk management systems• Excessive liquidity creation

14

Features of the Crisis

• “Shadow banking sector” importance• Deposit insurance inadequacy• “Freezing” of funding and asset liquidity• Liquidity support facility arrangements• Inadequacy of risk based capital• Globalization issues• “Flight to quality” issues

15

Regulatory Responses

• Protection of national banking systems• Liquidity Creation/restoration• Bail Outs• Temporary regulations

16

Regulatory Responses

• Protection of national banking systems• Liquidity Creation/restoration• Bail Outs• Temporary regulations

17

The Flight to Quality Effect

CentralBank

Banks & ADIs

InvestmentBanks

ManagedFunds

HedgeFunds

Pension Funds

FinanceCos.

InsuranceCos.

PrivateEquity

CashCash

CDO’sCDO’s

RMBSRMBS

CFDsCFDs

FuturesFutures

SwapsSwapsOptions

Options

Warrants

Warrants

ABCPABCP

Conduits

ConduitsSIV’sSIV’s

Debentures

Debentures

IndexedIndexedFundsFunds

Margin

MarginLoans

Loans

ShortShortSellingSelling

SecuritiesSecuritiesLendingLending Reverse

ReverseReposRepos

ReposReposDepositsDeposits

FXFX

BondsBonds

SharesShares

LoansLoans

18

Regulatory Responses

• Protection of national banking systems• Liquidity Creation/restoration• Bail Outs• Temporary regulations

19

Socializing the losses

20

Regulatory Responses

• Protection of national banking systems• Liquidity Creation/restoration• Bail Outs• Temporary regulations

21

22

23

24

A Fragile Financial System?

CentralBank

Banks & ADIs

InvestmentBanks

ManagedFunds

HedgeFunds

Pension Funds

FinanceCos.

InsuranceCos.

PrivateEquity

CashCash

CDO’sCDO’s

RMBSRMBS

CFDsCFDs

FuturesFutures

SwapsSwapsOptions

Options

Warrants

Warrants

ABCPABCP

Conduits

ConduitsSIV’sSIV’s

Debentures

Debentures

IndexedIndexedFundsFunds

Margin

MarginLoans

Loans

ShortShortSellingSelling

SecuritiesSecuritiesLendingLending Reverse

ReverseReposRepos

ReposReposDepositsDeposits

FXFX

BondsBonds

SharesShares

LoansLoans

25

Banking Crises: 1980-96

26

Financial Crises since 1996

• Asian crisis 1997• Russian crisis 1998 (& Long Term Capital

Management)• Brazil 1999• DotCom Bubble 2000• Argentina 2001• “since the collapse of Argentina in 2001, the international financial

system has been an oasis of stability. Some believe this is merely good luck, and that the bad old days will return. They are wrong.” Andrew K. Rose 31 May 2007 CEPR Policy Insight No. 1, June 2007

• http://www.voxeu.org/index.php?q=node/199• Subprime Crisis – June 2007 - ??

27

Future Regulatory Issues

• Central Bank targets• Macro-prudential policy• Mark-to-market accounting• Deposit Insurance• “Too big/important to fail”• Automatic recapitalization stabilizers

28

Future Regulatory Issues

• Basel II• Domain of Prudential Regulation• Reporting and Information Requirements• Promoting organized exchanges• Transactions taxes and volatility

29

Future Regulatory Issues

• Governance and agency problems• Financial consumer protection• Securitization structures• Financial sector concentration

30

Conclusion

• Was it inevitable – probably!• Who’s to blame – enough for all to share!

31

32

Conclusion

• Was it inevitable – probably!• Who’s to blame – enough for all to share!• Will a depression result – probably not!• Will similar financial crises recur – probably!• Will the financial system be restructured

– Needs to be, but vested interests are strong!