the financial crisis: who’s to blame?
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The Financial Crisis: Who’s to blame?
Howard Davies
Director, LSE
Confederation of Indian Industry
New Delhi, 9 April 2010
Rolling Stone described Goldman Sachs as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”
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0 10 20 30 40 50 60 70 80 90 100
Economic policies of your country
Economic policies of the US
Economic policies of China
Consumers in your country taking on moredebt than they should
Bankers in your country taking excessiverisks
International bankers taking excessiverisks
India UK
Who is to blame for the current financial crisis?
% of respondents answering “a lot” to the given statement: “For each one please tell me if you think it has contributed a lot, some, or not at all to the downturn”
Source: WorldPublicOpinion.org. Public Opinion on the Global Economic Crisis, 21 July 2009.
•economists - “if anything needs fixing, it’s the sociology of the profession” – Dani Rodrik (Harvard)
• business schools – the Guardian
•testosterone – Scientific American: “risk-taking in an investment game with potential for real monetary pay-offs correlates positively with salivary testosterone levels and facial masculinity”
•video games – Professor Susan Greenfield of Oxford
• human greed – Rowan Williams
•Jews
Some suspects
Who blames “the Jews” for the financial crisis?
Source: N Malhotra, Y Margalit: State of the Nation. Boston Review, May/ June 2009.
% blaming
49 US banks
29 Investment banks
29 Credit Rating Agencies
28 US regulators
25 Hedge funds
23 EU banks
6 EU regulators
……and the answer?
Views of Members
of the European Parliament
…66% recommend deeper political union in Europe, as a key response
to the crisis
“ Bank failures are caused by depositors who don’t deposit enough money to cover the losses due to mismanagement”.
Dan Quayle
Act One: Subprime
Act Two: Liquidity
Act Three: Unravelling
Act Four: Meltdown
Act Five: Pumping
The Credit Crisis: A Five-Act Shakespearian Tragedy
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-1
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1
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2007 2008 2009 2010 2011 2012 2013 2014
France
Germany
Japan
UK
US
The IMF forecast a modest recovery next year
Source: IMF World Economic Outlook Database, October 2009.
Gross domestic product forecast (% change), constant prices, 2007-2014
But global unemployment is likely to continue to rise
Unemployment (Million) and unemployment rate (%), 1999 - 2009
Source: ILO, Trends Econometric Models, December 2008.
•global imbalances
•loose monetary policy, leading to•mispricing of risk•credit bubble
•‘excess’ leverage, facilitated by procyclical regulation, and regulatory arbitrage
•‘excess’ unmanaged growth of the financial sector, which magnified risks, rather than diversifying them
What are the underlying causes?
Global current account imbalances grew rapidly from 2003
Estimates of account balances for selected countries ($ Billion), 1993-2007
Source: Datastream, FSA Calculations.
Source: Bank of England, Speech of Charles Bean at the Annual Conference of the European Economic Association, 25th Aug 2009.
Monetary policy was loose, especially in the US
Deviation of policy rates from Taylor rule (%), 2000-2009
Household debt as % of GDP, 1987-2007
Source: FSA, ONS, Federal Reserve, Eurodata, Datastream
Household debt rose sharply
Case-Shiller Home Price Index (2000 Q1 = 100), Jan 1987 - 2005
Source: Silverlake, Case-Shiller Price Index.
US house prices doubled in five years
Source: ECB, National Statistical Offices, IMF, EMF, Italian Ministry of Infrastructure, Morgan Stanley Research.
House prices rose rapidly in much of Europe also
Real house price changes over the last ten years (%), 1996-2006
Bank Balance Sheets expanded
Source: Silverlake, Capital IQ.
Large-cap banks’ aggregate assets rose to 43x tangible book equity
UK banks leverage grew sharply from 2003 onwards
Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.
Major UK banks’ leverage ratio, %, 1998 - 2008
Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.
Source: The Turner Review, March 2009.
ABS – volumes outstanding, $ Billion, 1996 - 2007
As did the securitised credit market
Resecuritisation magnified credit creation
BBB
A
AA
AAA
Residual/Equity
SUPER SENIOR
AAA
AAA
AA
A
BBB
Equity
Capital Structure Containing Subprime Loans
Subprime Mezzanine CDO Containing BBB Subprime Bonds
100%
28%
20%
11%
7%
0%
11%7%
11%
8.6%
7%
100%
40%
0%
CUMULATIVE LOSSES
Source: Morgan Stanley.
Private Equity Leverage Multiples grew
Source: Silverlake, Morgan Stanley, Capital IQ.
44.6 4.8
5.3 5.4
6.2
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2002 2003 2004 2005 2006 2007
Debt/EBITDA, 2002 - 2007
X
Growth in Hedge Fund Assets & Leverage accelerated
Source: Silverlake, Through Q308 – HFR industry report; Q408 projections based on CS analysis.
This points to the need for monetary policy to focus more on
- credit growth- financial intermediation, and- asset prices
…with a stronger emphasis on the risk of financial instability
Weak regulation may not have been the main cause of the crisis, but it is important to reform it
• trust in markets, and in regulation, has been affected, which damages investment and economic growth
•the global system does not meet the needs of global markets
The crisis revealed problems with the existing regulatory architecture:
• Hopelessly complex global structure
• Lacking a central authority to drive co-operation and make changes happen
• US system balkanised and ineffective
• European system a fudge – neither truly European nor truly national
• No two national systems the same
Global Committee Structure - A Regulator’s View
G-20(Gov’ts)
Financial Stability Board
WTOOECD
(Gov’ts)
FATF (Money Laundering) IASB
(Accounting IASC
Bank for International Settlements
(Central Banks)
G-10(Central Banks)
CGFS CPSS
Basel Committee(Banking)
IOSCO(Securities)
Joint Forum
IAIS
(Insurance)
Monitoring Group
IAASB(Audit)
PIOB
IMFWorld Bank
(Gov’ts)
IFIAR(Audit)
Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007.
National Regulatory Structures
Tripartite Dual 'Twin Peaks' Unified regulator
Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications.
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35
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28
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Other bank regulators
Central banks as banking regulator
Central bank as one pillar
No Central Bank interest
Non-Central Bank
Central Bank
And there were a number of regulatory failures
US Financial markets regulation was uncoordinated and overlapping
- Promoted regulatory “competition”
European Regulation also at fault: complex mix of European and national rules
In the UK, weak FSA regulation of Northern Rock, and the Bank of England too distant from financial markets
More regulatory failures
Key markets were unregulated– Non-bank private mortgage industry– Credit Default Swaps
• No exchange, central clearing or capital requirements
Insurance industry in the US was lightly regulated– No federal regulator– Missed “one-sided” credit insurance & CDS risks taken on by
AIG and others
Basel II capital requirements were flawed– Allowed too much leverage, over-reliance on credit ratings, and
didn’t encompass liquidity– Pro-cyclical: as asset prices rose, banks seemed to need less
capital
G20 Summits
“Reshaping the global financial and regulatorySystem”
• Enhance corporate governance and risk management
• Strengthen prudential regulation, but with a ‘managed transition’ to avoid exacerbating the downturn
• Regulate financial activities according to their economic substance and ensure regulation is consistent in all jurisdictions
“Reshaping the global financial and regulatory system”
• Financial Stability Board with standing committees• Membership of FSB, Basel etc extended to BRICs and
others• Expanded coverage of regulation to include systemic
hedge funds• Tighter controls on offshore centres• Tighter regulation of credit rating agencies• More and better quality capital in the banking system• Macro-prudential mechanism to respond to asset price
bubbles• Regulatory controls on bank remuneration
G20 Summits
What about the bankers themselves?
• Poor risk management– excessive reliance on Value at Risk Models– herding behaviour– inadequate hedging
• Flawed capital allocation mechanisms– trading strategies under-capitalised
• Incentive structures which reward short-term risk-taking
• Weak corporate governance: boards ignorant of the risks management were taking on
Failures in the financial firms themselves may have been even more important
Much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst”
Prof. Paul Krugman, Princeton
“The unfortunate uselessness of most ‘state of the art’ academic monetary economics”
Prof. Willem Buiter, LSE
“The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year”
Alan Greenspan
And, finally, there are major problems with Economics – and efficient markets
• Macro imbalances, loose monetary policy and financial innovation
• Rapid credit growth, asset price bubbles, overborrowing
• Global finance without global government
• Flawed assumptions about market efficiency and investor rationality
Such a complex failure has many parents
The Financial Crisis: Who’s to blame?
Howard Davies
Director, LSE
Confederation of Indian Industry
New Delhi, 9 April 2010
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