Asia Financial/Currency Crisis: 1997 - 1998

•Hot money – capital flight•Vicious circles Debt burdens Bankruptcies Depression

• Asset price collapse• Currency depreciation

•Lender of last resort• Conditionality: Tight money/austerity

•Unorthodox policy• Exchange controls (?)

Financial Crises: East Asia 1997-1998

• Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise.– Banks accumulated losses/net worth declined.

• Uncertainty increased – stock market declines and failure of prominent firms

• Domestic currencies devaluated (1997). • Rise in actual and expected inflation.

Subprime-Triggered Financial Crisis of 2007 - 2009• Financial innovations in mortgage markets:

– Subprime and Alt-A mortgages– Mortgage-backed securities– Collateralized debt obligations (CDOs)

• Housing price bubble forms– World savings glutIncrease in liquidity from cash flows surging to the US

– Subprime mortgage market housing demand and prices up.

• Agency problems arise

– “Originate to distribute” principal (investor) agent (mortgage broker) problem.

– Commercial and investment banks/rating agencies …weak incentives to assess quality of securities

• Information problems surface… A “Minsky Moment”Housing price bubble bursts/Crisis spreads globallyhttp://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

A “Global Saving Glut”

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt DeflationSpiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Unleashed

Financial Crisis of 2007 - 2009 (cont’d)• Banks’ balance sheets deteriorate

– Write downs– Sale of assets and credit restriction

• High-profile firms fail– Bear Stearns (March 2008)– Fannie Mae and Freddie Mac (July 2008)– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and

Washington Mutual (September 2008).

• Fed pumps up bank reserves: TARP/TALF,etc.– Lend and lend freely

• Bailout package enacted– House votes down the $700 billion bailout package (9/29/08) Stock market slumps Bailout passes on October 3. – Congress approves a $787 billion economic stimulus plan on February 13, 2009.

• Recession deepens

ResponsesLender of Last Resort / Spender of Last Resort

• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.

• Emergency Economic Stabilization Act/TARP $700 bil. Government LoansGovernment Equity

• Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

• TARP II

• Stress Tests

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt Deflation

Spiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Reversed? Tackle them all together!

StimulusProgram•Infrastructure Spending•Tax Cuts

Federal AidTo States

RefinanceMortgages

Revive dual banking systemCash for Trash•Recapitalize banks•Revive securitization

G – 20•Coordinated Stimulus

Macroeconomic Linkages and

Feedbacks

Vicious Spirals Unleashed

December, 2008)

8%

10%

12%

13%31%

7%3%

7%

9%

6%

37%

31%10%

16%

http://www2.fdic.gov/sdi/main.asp

Off Balance Sheet Assets/Activities•Structured investment vehicles (SIVs)•Loan sales•Fees for

•Foreign exchange trades for customers•Servicing mortgage backed security•Backup lines of credit/overdraft privileges•Standby lines of credit guaranteeing securities/commercial paper

•Trading activities Principal – agent problem•Bond markets•Foreign exchange markets •Financial derivatives

Shadow Banking System• Financial intermediaries that conduct maturity, credit, and liquidity transformation

without access to central bank liquidity or public sector credit guarantees.– Finance companies– Asset backed commercial paper (ABCP) conduits – Limited purpose finance companies– Structured investment vehicles (SIVs)– Credit hedge funds– Money market mutual funds (MMMFs)– Securities lenders– Government sponsored enterprises (GSEs)

• Interconnections with each other and traditional banking system– ABCP– Asset backed securities– Collateralized debt obligations (CDOs)– Repurchase agreements

• Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks.

http://www.ny.frb.org/research/staff_reports/sr458.pdf

Possible Reforms

• Increase/tighten capital requirements• Trade derivatives only on public exchanges tranparency• “Mark – to – funding” accounting

– Value assets relative to date their funding must be repaid

• Rapid “resolution” of TBTF institutions– Make bankruptcy credible– Put creditors at risk eliminate moral hazard of TBTF

•McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching•Interstate Banking and Branching Efficiency Act (1994) deregulates branching•Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals Glass-Steagall

Regulating Finance: Regulation and Its Discontents

• Lots of bases to coverCover one by regulation or deregulation

Unintended Consequences• Reactions to regulatory policies

frustrate regulator intentRegulate bank balance sheets off-balance sheet activitiesEmplace a safety net bankers become skydivers

• Regulation spreads to cover innovations complexity ineffectivenessWin by gaming the system

Primary Supervisory Responsibility of Bank Regulatory Agencies

• Comptroller of the Currency—national banks chartered by Federal government since 1863

• Federal Reserve and state banking authorities—state banks that are members of the Federal Reserve System

• Fed also regulates bank holding companies• FDIC—insured state banks that are not Fed

members• State banking authorities—state banks without FDIC

insurance

Innovations: Response to Interest Rate Volatility• Adjustable-rate mortgages• Financial DerivativesInnovations: Response to Information Technology• Bank credit and debit cards• Electronic banking

– ATM/Home banking/ABM/Virtual banking• Junk bonds• Commercial paper market … backed by banks• SecuritizationInnovations:Avoiding Regulation/Loophole Mining• Sweep accounts … reserve requirements• Money Market Mutual Funds … Regulation Q

Decline of Traditional BankingDecline in cost advantages in acquiring funds (liabilities)

Rising inflation rise in interest rates and disintermediationLow-cost source of funds, checkable deposits, declined in importance

Decline in income advantages on uses of funds (assets)Information technology less need for banks to finance short-term credit and issue loans IT lower transaction costs for other financial institutions

Bank Responses: •Riskier Lending … Commercial real estate, leveraged buyouts, takeovers•Off balance sheet activities

Size Distribution of Insured Commercial Banks, September 30, 2008 ????

3,0464,039 486 867,640

39.952.9 6.1 1.1

1.3 9.710.079.0

Bank Consolidation

• Benefits of bank consolidationIncreased competition close inefficient banksEfficiencies from economies of scale and scopeLower chance of failure -- diversified portfolios

• CostsFewer community banks less lending to small

businessBanks in new areas increased risks/failures

Skirting branch restrictions•ATMs, Bank Holding Cos.

Interstate Banking and BranchingEfficiency Act, 1994

Pre-Crisis Findings:•Net interest margin up•ROA, ROE up for big banks•Intrastate deregulation more positive for all but big banks•Interstate deregulation helps big banks most•Non-performing loans down for biggest banks but up for smaller banks•State of economy has stronger impact on bank performance than branching deregulation

Geographic deregulation

Skirting branch restrictions•ATMs, Bank Holding Cos.

23

The U.S. regulatory regime: In need of reform?

Sources: Financial Services Roundtable (2007), Milken Institute.

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

• OCC• FDIC

• State bank regulators• FDIC• Fed--state member commerical banks

• OTS• FDIC

• 50 State insurance regulators plus District of Columbia and Puerto Rico

• FINRA• SEC• CFTC• State securities regulators

• Fed• State licensing (if needed)• U.S. Treasury for some products

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Fed is the umbrella or consolidated regulator

Primary/secondaryfunctionalregulator

Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

Justice Department• Assesses effects of mergers and acquisitions on competition

Federal courts• Ultimate decider of banking, securities, and insurance products

Asymmetric Information and Bank RegulationGovernment safety net• Deposit insurance and FDIC

– Short circuits bank failures and contagion effect• Payoff method• Purchase and assumption method

• Fed as lender of last resort: Too BIG to Fail• Financial consolidation Exacerbates Too Big to Fail• Safety net extended to non-bank financial institutions

Safety Net Moral Hazard Problems – Depositors don’t impose discipline of marketplace– Banks have an incentive to take on greater risk

Safety Net Adverse Selection Problems– Risk-lovers find banking attractive– Depositors have little reason to monitor bank

Attempted solutions: Constrain banks from taking too much risk• Promote diversification• Prohibit holdings of common stock• Set capital requirements … Capital as cushion

• Minimum leverage ratio• Basel Accord: risk-based capital requirements

… but there’s regulatory arbitragePrompt corrective action: Close ‘em down when capital inadequate

• Monitor … CAMELS– Capital adequacy– Asset quality– Management– Earnings– Liquidity– Sensitivity to market risk

• Disclosure requirements … mark-to-market issue

• Restrictions on competition … make banking boring

http://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdf

Failed Banks Update

Year Number• 2000 2• 2001 4• 2002 11• 2003 3• 2004 4• 2005/2006 0• 2007 3• 2008 QI+Q2 4• 2008 Q3 10• 2008 Q4 12• 2009 Q1 21• 2009 Q2 24• 2009 Q3 50