from the end of bretton woods to the global financial crisis: 40 years of turbulence

Dr. Hugo BänzigerThe European Association for Banking & Financial History13.06.2014

From the End of Bretton Woods to the Global Financial Crisis: 40 Years of TurbulenceRisk Management Conference

From the End of Bretton Woods to the Global Financial Crisis: 40 Years of Turbulence · Dr. Hugo Bänziger · 13.06.2014 · 2

1. 30 Years of Stability followed by 40 Years of Turmoil

2. The Business Model of Banks after Bretton Woods

3. The Forces which undid Bretton Woods

4. 1973 and its consequences

5. Early Days of Risk Management

6. The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting

7. Latam Debt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Default etc.

8. Risk Management matures …

9. … and fails in the Global Financial Crisis

10. Conclusions

Presentation Outline


30 Years of Stability followed by 40 Years of TurmoilDid Risk Management Make a Difference?








7. Latam Debt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Default



10. Conclusions



March1933, Bank Holiday & Emergency Banking Act• Bank Recapitalisation & Resolution Power

March 1933, Securities Act• Regulation of primary market (underwriting)• Mandatory registration & prospectus,

transparency requirements

June 1933, Glass-Steagall Act • Separation of investment & commercial banks• Federal Deposit Insurance Corporation (FDIC)• Regulation Q & Large Exposure Limits• Regulatory Reporting & Supervision

June 1934, Securities & Exchange Act• Establishment of SEC, Regulation of secondary

trading (stocks, bonds) and Exchanges

June 1935, Banking Act (FED Reform)

The US Financial System after 1933Segregation, Deposit Insurance, Supervision & FED Reforms


Bretton Woods Conference in 1944 with 44 allied signatory countries

3 Pillars of Bretton Wood System• Free Trade (GATT, 1947 in Geneva)• Fixed Exchange Rates & Capital Controls (IMF)• Development & Recovery (IBRD, World Bank)

All currencies pegged to USD USD pegged to gold at $35.-/oz Pegs & capital controls were adjustable Adjustments for France, Germany and UK With international recovery, trade volume

increased faster than gold supply Gold pools after 1961 to defend USD peg US was the world’s central banker

The Bretton Woods SystemStable Exchange Rates, Bail-out Mechanism, USD as Gold substitute

source: Oono K, www.grips.ac.jp


Banks in Europe and AsiaEmerging from the Ashes of World War II

Germany & Japan were bankrupt after WW II. Banks were largely worthless

Inflation was rampant until the currency reform of 1948 and the pegging in 1949

Japan created the Keiretsu system to finance the reconstruction via BoJ

Germany used its Landesbanken Bank lending was the key instrument Cross-shareholdings and -directorship

limited risks of loan portfolio France nationalised banks in 1945 The UK saw a sharp contraction of its

economy after World War II Capital controls across Europe & Asia


The Banking Business Model 1945 to 1973Simple, stable and highly regulated

Banks were national and had few other assets than loans & cross-shareholdings

Deposit rates were regulated No interest or foreign-exchange risk Investment banks were partnerships Limited international capital mobility Sub-due level of IPOs & bond offerings Limited secondary trading – if any Tightly regulated risks on balance sheets Banks organised in branches & regions Every country supervised banks Business & risk management identical

source: Du, L. (2014), C

ambridge Judge B

usiness School

Source: R. W. Goldsmith (1965), National Bureau of Economic Research











10. Conclusions



New Developments in the 1960sReturn of Capitalist Dynamics

President Johnson’s ‘Big Society’ program & Vietnam War root cause of US inflation

EEC and Japan made currency convertible in 1958 and 1964 respectively

1963: Interest Equalisation Tax – large USD amounts build up outside US

1963: Italian Autostrade issues the first USD denominated Eurobond

To lower funding cost, US corporates re-discover Commercial Papers for ST debt

Banks counter by offering convenience accounts and Certificates of Deposits

1959: IBM offers computer service centers NYSE allows members to go public in 1970


The End of Bretton Woods1961 – 1971 From Stable to Floating Currencies 1960s see a negative US balance of payment,

the increase in international trade and the return of large international capital flows

1965: banks begin to establish large international loan-underwriting syndicates

Bretton Woods’ gold pools partially successful 1967: Sterling devaluation after run on £ 1968: US Congress repeals 25% gold covery

ratio for US Dollar 1968: France & other countries start to increase

holding of physical gold 1971: Nixon unilaterally closed the ‘gold window’

– gold convertability ends 1973: Japan & EEC let their currencies float The once stable asset classes of fixed income

(bonds) & foreign exchange become volatile Luckily, most banks still operate domestically











10. Conclusions



1973 and its ConsequencesThe World becomes volatile

Black Scholes Model for valuation of options

Chicago Board of Options Exchange First Mobile Phone Call ATMs rolled out all over the US President Nixon resigns Yom Kippur War Oil Shock – Recessions return IBM S/370 and HP 9800 spread in

the banking industry Glass fibre optic cables invented It becomes possible to handle large

trading volumes


The Oil ShockImpact on Financial Markets

Because US oil production peaked around 1970, OPEC oil embargo lead to sharp re-pricing of oil & energy in 1973

The significantly increased $ proceeds flowed primarily to the interbank market and gave the City of London a boost

The $ liquidity needed to be invested – lending to Less Developed Countries

The flow provided the backbone for the significant growth in syndicate lending

Eurodollar bond market took off (CSFB) US Investment Banks expand to Europe New financial centers around the globe:

Frankfurt, Hong Kong, Singapore


Information Technology and CommunicationChanging the Dynamics of Banking

1981: IBM 5150 Personal Computer WordPerfect, Lotus 1-2-3, PowerPoint,

Access became widely used applications Rapid decline of processing cost 1977: 1st fibre optic cable in California 1986 SOFFEX (EUREX) 1st electronic

options & futures trading platform 1988: 1st trans-atlantic cable All banks invested heavily in technology IT systems followed accounting process;

regional set-up with monthly closing of the bank’s books

IT systems were hardcoded, embedding data in processing instructions

Ln (C

ost p

er m

illio

n in

stru

ctio

ns)

DEC PDP-1:Mini computer

Apple II:Microcomputer

IBM PCCompaq Portable

1950 19601970

1980 1990

source: Morrison, Wilhelm 2004


Institutional InvestorsThe new owners of the bank’s liability side Mid 1950: the Mutual Funds industry

develops in the US (1970: AuM 48bn) Mid 1960: Funds reached Europe Mid 1960: Establishment of US Money

Market Funds (207 AuM 4.0 tr) Demographics in US & Europe force a re-

thinking of government run ‘Pay-As-You-Go’ pension systems

1972: 3-Pillar Retirement System in CH 1974: Employment Retirement Income

Security Act (EIRSA) 1992: UK Pension Scheme Act 2002: Hartz IV reform in Germany Total global deposits of $ 26tr vs. $ 80tr of

professionally managed funds Many of these institutional investors have

statutory return requirements

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

50,000

100,000

150,000

200,000

250,000

300,000

Stock Market Capitalization Public Debt Securities

Private Debt Securities Bank Assets


International ExpansionBanks Become Global Absence of currency controls spurs free flow of

international capital National banks establish branches abroad Citibank has today 9’000 branches in 44 countries Santander makes only 13% of its profits in its home

market in Spain Anchor products are commercial loans and

consumer credit Merger wave begins (Citi, JPM, BofA, BNPP, RBS,

BoS, HSBC, BBVA, UniCredit etc) Rapid consolidation of US investment banks By 2000, ≈ 70 partnerships become 5 large

brokers/dealers: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Sterns

Consolidated: Shearson, Dean Witter, Loeb, Kidder Peabody, Paine Webber, Hutton, White Weld, Salomon Brothers, First Boston


Deregulation – Animal Spirits RestoredThe end of the straight jacket 1958 / 1964: Abolishment of capital controls

in both EEC and Japan 1973: free floating of currencies 1980: Removal of regulation Q – restrictions

on deposit interest rates 1980: Removal of business restrictions for

Savings & Loan Associations 1984: Removal of barriers to interstate

banking 1986: ‘Big Bang’ in City of London 1992: Maastrich Treaty: 4 Liberties (Goods,

Capital, Labour, Services) 1999: Graham-Leach-Billey Act removes

Glass-Steagall separation 2006: European Directive on Services in

Internal Markets











10. Conclusions



Establishment of new credit committees on board level

Joint liability for credit decisions Branch and regions managed by

trusted ex-pats with little credit authority

New HQ units for credit policies for main products (loans)

Matched funding strategies Market & settlement risk hidden

in accrual books 1974: Settlement risk became

visible with Herstatt Bank – not easy to settle across countries

Early Days in Risk ManagementEscalation to the Top

Source: S.Krisiloff 2012


The end of Bretton woods with free flow of capital and floating exchange rates made many central bank governors nervous

1971: a standing BIS committee was set up to assess the macro-economic impact

1975: following the collapse of Herstatt Bank, the BCBS was established, including for the first time bank-supervisors

When 1982 the Latin American Debt Crisis revealed the insufficient capital levels of US Money Center Banks, Congress raised capital standards and tightened supervision

FED Chairman Volcker went to the BCBS in 1983 to ask for equivalent international capital requirements (Japanese banks!)

The result was the Basel Accord on Capital (Basel I) in 1988

It introduced RWAs and min. Tier 1&2 ratios

The Basel Committee for Bank Supervision (BCBS)Central Bank Governors Take Notice











10. Conclusions



Technology advances (PC), revolution in communication (fiber) and deregulation made global trading possible

Arbitrage on a global level provided big revenue opportunities

Derivatives highly profitable in 1990 (20bp for CS, 8bp for IRS)

Both investment and universal banks built large trading operations with thousands of live trades

By the end of the century, all asset classes were traded under FV and VaR

Financial Markets have become truly global. Indonesian bonds were sold to US investors, RMBS to European buyers

Derivatives essential to risk management

The Derivatives Revolution“Eventually, everything will become tradable” – Alan Wheat, CEO CSFB

Derivative financial instruments (notional amounts outstanding in billions of US dollars)

Source: G. Capelle-Blancard

2010


Traders developed VaR and FV simultaneously in order to calculate probability of loss in a portfolio at a given confidence level

VaR was calibrated with historical data or Monte-Carlo simulation

1989: VaR found quickly its way into management reporting (JPMorgan)

1996: the Basel Committee (BCBS) developed capital requirements for market risk based on VaR

1992: JPM began marketing Risk Metrics which was based on VaR for managing risks

1998: EU adopted CRD I which introduced VaR based min. capital requirements for market risk

2007: SEC required all banks to publish their VaR numbers in their annual report

In 2010, EU complemented VaR with SVaR+IDR

Short History of Value-at-Risk (VaR)Performs well for liquid markets but not in cliff events


Started with futures trading mid-1980s to calculate margin requirements

1986: Establishment of SOFFEX, 1st fully electronic exchange

In 1990, few banks (Bankers Trust, CSFP, GS, JPM) used Fair Value to account for their OTC Derivatives

1993: FAS 115 allowed banks to use Fair Value for equity and debt securities in trading books

FV allowed netting of positions (hedge) 1994: when $ yield curve turned, many banks

suffered significant losses These losses accelerated the use of FV 1994: credit default swaps – JPM, CSFP Market liquidity was not a criteria for FV

Short History of Fair Value AccountingThe Law of Unintended Consequences


The Unintended Consequence – Light Capital Treatment Traded Assets and respective Risk Weighted Assets

Trading RWA %Assets

RBS 2007 237bn N/A N/ARBS 2012 173bn 43bn 25%

Citibank 2007 538bn 109bn 20%Citibank 2012 321bn 41bn 13%

Deutsche Bank 2007 596bn 14bn 2%Deutsche Bank 2012 439bn 53bn 12%








7. Latam Debt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Crisis



10. Conclusions



Latin American Debt CrisisThe Lost Decade

Many LatAm countries borrowed huge sums from international banks in 1970s

Cumulative debt growth rate: >20% p.a. Most spent on infrastructure & development 2nd oil shock made balance of payment massively

negative Tightening of monetary policy in US and Europe

increased interest rates sharply 1982: Mexico and Brazil defaulted 16 Latin countries re-scheduled Austerity programs induced recessions USA: banks could delay loss regognition for several

years until 1987 Bready Bonds: ≈1/3 of debt forgiven

source: J.A.Ocampo 2013, data from The World Bank and ECLAC


Japanese Asset Bubble 1986When Japanese Banks Bought the Rockefeller Center

Unrestricted money & credit supply – BoJ cut ST rates from 5% (1986) to 2.5% (1989)

Export boom made corporates cash rich – subdue demand for commercial loans. Stock market boom lowered cost of capital

Deposit rich banks pushed into mortgages & margin lending

Price peaks in 1988/1990 Two lost decades of economic growth Sanyo Sec., Yamaichi Sec., LT Credit Bank &

Nippon Credit Bank rescued by government Wave of mergers created the big banking

conglomerates of today Tax payer’s bill: ¥ 9.3 tr (USD 91bn)


S&L lent their deposits long-term fixed Interest rate increase by FED to curb

inflation caused big banking book losses In 1976, S&L controlled 80% of $ 700bn

mortgage market 1980: deregulation allowed Thrifts to

expand commercial & consumer banking but without adequate oversight

Thrifts grew 56% from 1980 – 1983 by financing speculative malls & property developments

1989: Resolution Trust Corporation RTC resolved 747 S&L to 1995 Losses: USD 160bn (tax payers 120bn)

Savings & Loan Associations 1980 – 19951/3 of 3’240 Thrifts failed


Rapid expansion of lending due to sharp increase of short term debt in banks

Property prices peak in 1991 Bubble bursts in 1991 - 1992 Loan loss provisions 1990 - 1993:

Sweden 4.5%, Finland 3.4%, Denmark 3.0%, Norway 2.7%

1991: Governments had to guarantee all deposits

Nordbanken & Gotabanken nationalized Governments created bad banks which

took over distressed debt for equity GDP dropped by 5% 1990 - 1993 Unemployment rate on new 6% plateau

Scandinavian Financial Crisis 1991-92Well-fare State Re-designed


North American Free Trade Agreement entered in effect January 1, 1994

NAFTA accounts for 21% of world GDP Mexico entered NAFTA with overvalued Peso In anticipation, government and consumer

spending increased rapidly – all debt financed For political reasons, government kept interest

rates low (election year) As investors started to sell Tesobonos, central

bank reserves got depleted December 1994: Peso devaluation USA steps in with a $ 50bn stabilisation

package Three largest Mexican banks went bust and

were sold (Citibank, BBVA, Santander) Mexico recovered quickly due to low debt

levels

The Tequila Crisis 1994NAFTA – To Good to be True


Based on strong economic performance, pegged currencies attracted a significant USD short-term money & portfolio investments

Most was invested long-term in real estate, projects or infra-structure

Crony capitalism syphoned off a large portion of these funds. This mis-allocation of investments was one of the root causes. Investments produced no cash flows for servicing debt

Mid 1997, investors wanted to get out When governments could not defend the peg,

currencies crashed. Cut off from access to finance, GDP dropped. In Thailand & Indonesia banks collapsed.

IMF intervened with package of $ 40bn Korea’s bank had a bad debt problem HK, Singapore & Taiwan were able to defended

their peg

Asian Debt Crisis 1997 - 1998The Curse of Portfolio Investments


Overvalued exchange rate & the large fiscal deficit under Yeltsin at the core of the crisis

In March 1998, the Russian government faced difficulties in placing Ruble denominated debt with Russian banks and investors

Government debt was placed abroad where it was picked up due to high coupon rates

IMF granted a package of $ 22bn to stablize market and swap short-term GKO to long-term Eurobonds

Yeltsin decided to keep the $ peg in July In August, investors started to flee. Stock

market crashed, Ruble plummeted by 75% 17 August, Ruble devaluation & moratorium Inkombank, Oneximbank, Tokobank closed Massive capital outflows, inflation at 85%

Russian Crisis 1998When the Ruble turned to Rubble

Graph source: Morrison, Wilhelm 2004


Low level of $ rates provided start ups with easy access to capital

Investors were looking for higher yielding assets to compensate low yielding treasuries

Internet became available to wider public in 1990. By 2002, almost all US schools had access to internet

Netscape browser 1995: amazon.com, 1998: Google AOL merger with Time Warner Jan 2000 FED increased $ rates 6x in early 2000 10th of March 2000, bubble burst with

NASDAQ at 5’408.60 points 2000 – 2002: $ 5tr in market value destroyed But 48% of dot.com companies survived There was no bank financing

Dot Com BubbleLearning the wrong lesson?











10. Conclusions



Value-at-Risk captured the risk of a portfolio Economic Capital attempted to capture the

risk of the entire enterprise Risk calculated with various comfort levels:

99%, 99.5% or 99.8% Computer runs took easily an entire night Concept developed on trading floors Popularized by JPM’s Risk Metrics 1992 Used to allocate capital in some firms – often

against stiff resistance Key challenge: availability & quality of data

• Loss-Given-Default not retrievable• Probability of Default of banks?• Operational loss data spotty• With a high degree of accuracy, we calculated

garbage

Risk Management MaturesEconomic Capital Concept


Dedicated Risk Managers are first found on the trading floors managing single books

Concept appears first time in GE Capital which is known for its six-sigma concept

With Sarbanes-Oxley it quickly spreads to the manufacturing industry in the US

Mid 1990: James Lam from GE Capital the world’s first CRO?

McKinsey, Oliver Wyman and other consultants advocate for independent risk organisations as early as 1993

Role of Risk Management? First or 2nd line of defence?

Risk systems independent or fully integrated? Centralized or decentralized organisation? Role of Risk in Capital Management?

Risk Management Matures IIRisk Management Divisions

Amy Brinkley, CRO BofA


1997: Core Principles on Supervision (3 Lines of Defence)

1999 – 2004: Basel II Process• 2 Consultation Papers• 2 Impact Studies

Based on Economic Capital concept Advanced Approach based on internal models

and data Let to significant capital savings in Europe FDIC objected; not implemented in the USA National discretions; home – host issues Model x model x model = unknown unknowns

Regulation Becomes GlobalSupervisory Principles and Basel II

RWA = 12.5*K*EAD

K = LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ (-1) × (1 + (M - 2.5) * b (PD))










9. … and fails in the Great Financial Crisis

10. Conclusions


From the End of Bretton Woods to the Global Financial Crisis: 40 Years of Turbulence · Dr. Hugo Bänziger · 13.06.2014 · 413 June 2013

0

20

40

60

80

100

120

140

160

180

200

1st 3-year LTRO loan by ECB

“Whatever it takes” speech by

ECB’s Draghi

Phase 1:Private sector debt bubble implodes

as US housing market collapses

Sources: Bloomberg, DB Research

3m Euribor – 3m Eonia swap rate, in bps (lhs)Itraxx Euro XO generic, 5y spread, in bps (lhs)

VIX implied volatility index S&P 500, % (rhs)

IKB warning

and bailout

Fed rate cuts

Fed approves takeover of Bear Stearns by JPM

Phase 3:Sovereign debt crisis

Phase 2:Unprecedented

intervention transfers risk to public sector

Takeover of AIG & Merrill Lynch, Lehman files for Chapter 11

UK bank capital injections

Hypo Real Estate rescue

Fortisstate support announced

US bank stress-test

results

S&P cuts Greece

rating to junk

Greece reveals budget deficit numbers

EU bank stress-test

results

EU/IMF announce €110 bn bailout for Greece and €750 bn EFSF

Japan earthquake

US downgraded, growth slowdown, EMU crisis focus

shifts to Italy

06/07 12/07 06/08 12/08 06/09 12/09 06/10 12/10 06/11 12/11 06/12 12/12100

200

300

400

500

600

700

800

900

1,000

1,100

1,200

1,300

0

10

20

30

40

50

60

70

80

90

Cyprus bailout deal

PPChart;1;210;Excel84-F5-C8-1D-DF-EF-9D-77-36-BD-9D-E6-2E-38-26-3E

Global Financial CrisisSystemic shocks, high volatility & unprecedented policy interventions


The Epicenter of the Global Financial CrisisUS Mortgage Market

Total size: USD 13.1tr1 Community Reinvestment Act Lending: USD

4.5tr % of prime mortgages in Freddie Mac &

Fannie Mae:• 1990: 80%• 1999: 45%• 2007: 15%

Around USD 2.0tr of aggregated losses during the Global Financial Crisis

Taxpayers paid $ 0.5tr, investors $ 1.5tr

1 Data a/o Q32012 from The US Federal Reserve BankSource: Schiller-Case

00 01 02 03 04 05 06 07 08 99 10 11 120

50

100

150

200

250

Schiller-Case US House Price Index


The Epicenter of the Global Financial CrisisSecondary Triggers

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

US Asset-Backed Securities Issuancein USD mn

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

European Structured Finance Issuancein USD mn

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

2013*0

5001,0001,5002,0002,5003,0003,5004,0004,500

Outstanding Money Market Instrumentsin USD bn


The Epicenter of the Global Financial CrisisLeverage

Evolution of Liabilities of MFIs1998 – 2012, Euro-Area, in EUR bn

Evolution of Assets of MFIs1998 – 2012, Euro-Area, in EUR bn


The Global Financial CrisisShort Narrative Trading & Investment Portfolios key revenue

generators for EU and US banks Collapse of US housing market spilled into

ABS market Any bank with open ABS positions suffered

big losses Liquidity dried up. First LT debt, then Money

Markets, then trading positions Large central bank interventions necessary

as early as July 2007; large expansion of their balance sheets

Bail-outs in 9 & 10/2008 for US & EU banks Quantitative easing as early as 3/2009 Sovereign debt crisis in Europe after 2/2011 EU banks unable to fund in both $ and EUR,

LTR necessary

Source: E

CB

data










9. … and fails in the Great Financial Crisis

10. Conclusions



The Global Financial CrisisCulmination of 40 Years of Instability Key drivers for GFC

• Asset-Liability Mismatch• Large Leverage• Banks became investors• Insufficient transparency• Lack of governance• Total failure of risk management

Regulation not up to date• Basel II focussed on credit risk• Liquidity rules were outdated• Insufficient capital for market risk• Increased leverage not addressed

Crisis Accelerators• Global Interconnectivity of Banks• Fair Value triggered fire sales• Complexity overpowered management• Lack of capital market discipline


The Global Financial CrisisOpen items to address Main losers of GFC were investors

• Insurance, pension plans and mutual funds havel each 1/3 of global USD 80tr AuM. How to protect society’s safety net for rainy days and old age?

Market Structure of the Financial System• The pipes & pipelines to be utilities: payment

systems, clearing & settlement do not need to be part of the private, risk taking sector

• Markets to be accessible for everyone at the same price and liquidity

• Trading to move back to exchanges Proper representation of values

• Capital market discipline requires a high level of transparency – way beyond what bank do today

• Fair Value only for truly liquide instruments approved by supervisory authorities

Simplify Corporate Governance• Checks & Balances; CEO-CFO-CRO one ticket


AppendixLiquidity inFinancialMarkets

Mar-05

Aug-05

Jan-06

Jun-06

Nov-06Apr-

07

Sep-07

Feb-08

Jul-08

Dec-08

May-09Oct-

09

Mar-10

Aug-10

Jan-11

Jun-11

Nov-11Apr-

12

Sep-12

Feb-13

0

0.2

0.4

0.6

0.8

1

1.2

1.4

CHN IDN JPN KOR MYS PHL SGPTHA

%

2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

50

100

150

200

250

300

350

400

450%

NYSE Turnover Asian Bond Turnover

from the end of bretton woods to the global financial crisis: 40 years of turbulence

Documents

r e s t r i c t e d4march1933

end of bretton woods

bretton woods1973

bretton woodsthe forces

banking financial history13

us financial system

russian defaultrisk

banking act fed reform