Abstract
The author in his article gives a brief analysis of the origins of the current financial crisis which has swept across the globe in recent months. He explores the inefficient controls, including regulation and accounting rules, carried out by financial actors which are at the heart of this economic turmoil. Proposals for more efficient financial architecture are then put forward. Mariani concludes that much time, confidence and discipline are needed to surmount the recession and reform the financial system.
Introduction
After the Internet bubble burst in the early 2000s, the world economy experienced a long period of growth and abundant liquidity which led to the current crisis. This situation resulted mainly from the combination of (i) an expansionary bias in US monetary policy as global productivity gains prevented inflationary pressures but failed to prevent asset bubbles, and (ii) emerging economies’ surpluses being reinvested in developed financial markets. The strong liquidity supply is a key explanatory element of the crisis, as it lowered the level of risk awareness in an environment in which intensive financial innovation should have instead come under increased scrutiny.
Despite the massive global imbalances and the bubbles in the real estate and raw materials markets, it was widely believed that the world economy had entered a new era of long-term sustainable growth. This ended with the decision by the US government not to bail out Lehman Brothers, which transformed the growing distrust among financial players into an extreme Knightian uncertainty that has paralysed asset and credit markets, as noted by Caballero [2]. The crisis was then quickly transmitted to the real economy and fuelled a negative spiral, pushing asset prices downward and further limiting the ability of financial institutions to extend new credit in the interbank market and ultimately to the real sector.
The crisis was born in the US with the meltdown of the housing market, as precisely described by Ellis [4]. Unfortunately, prudential regulation failed to prevent this particular reversal from spreading to the global financial markets. The crisis has revealed the flaws in the financial system, which has collapsed under the combined effects of the complexity of financial instruments, underestimation of the liquidity risk and short-term oriented incentive schemes. These have resulted in a global crisis further exacerbated by the pro-cyclical effect of the fair-value accounting mechanism. The current crisis seriously challenges financial sector practices, as general interests and ethics are at stake.
Restoring the stability and the credibility of the financial sector is therefore of the utmost importance to put an end to the current spiral and rebuild trust. There is widespread consensus for a two-stage approach that would be driven mainly by governments and central banks. Banks should be proactive partners but have neither the ability nor the legitimacy to drive the transformation. The first stage, which has already started, should allow the financial sector to continue to perform its core functions by injecting liquidity and capital and organising the disposal of illiquid or toxic assets. The second stage will take more time, as it will require rebuilding regulation principles and bank governance in order to bring the financial sector back to more ethical and, finally, efficient behaviour.
Origins of the current crisis
The large amounts of liquidity available on the market and the inappropriate decision to let Lehman Brothers collapse are key factors to understanding the current crisis. The financial sector should nevertheless acknowledge that most of the reasons for this disaster are endogenous. Inefficient controls over financial institutions, both internally and externally, are crucial explanatory factors but they are not sufficient to understand the current situation. The complexity of financial techniques, combined with greed among stakeholders, is really at the roots of the market collapse.
A tale of greed and the lack of common sense
There is a rule in finance which remains true: risk and return are positively correlated, and financial innovation cannot change anything about this. I believe that some–-not all–-professionals had forgotten this reality and, in some cases, consciously decided to ignore it when the risk was transferred to other players. They forgot the basic disciplines of the banking business.
This is, for instance, the case with the US real estate brokers who originated subprime or near-subprime loans and sold them to banks, which then got rid of them through securi-tisation. All of them knew perfectly well that the only way for the portfolios to maintain their quality was for real estate prices to keep rising, as many of the borrowers were far from having sufficient financial guaranties. The original, sane lending behaviour was completely distorted by the distribution of risk.
The competition among financial institutions to create ever-larger corporations contributed to weakening the system, as external acquisitions were often financed by leveraged buyouts (LBO). The resulting large companies had huge balance sheets comprised of very different activities. But they often had a limited capital base partly due to the hybrid capital solutions developed in the last years. The relatively low tier-one ratio required by the regulators also allowed the capital weakening process.
Bank shareholders also have some responsibility for the crisis, as the rates of return they demanded were incompatible with the level of risk they were willing to take. Given the growth rates of developed economies and the added value of the financial sector, rates of return well above the cost of capital are simply impossible to reach in global banking without taking significant risks.
It was widely noted that the incentive schemes for traders and bank managers were based on short-term results, pushing them to take too many risks, while the punishment in case of failure (departure with a large compensation) was not proportionate.
Inefficient controls on financial actors
Inefficient regulation and accounting rules
As described above, the highly liquid environment combined with dynamic financial innovation and, ultimately, inappropriate political decisions, explain the mechanisms which triggered the crisis. However, regulators should have been able to cope with these factors in order to avoid letting the financial system drift away from sound practices.
The main mistake was certainly to have left unregulated many of the key new financial players and the most widely used financial instruments. This was the case with the US real estate loan brokers, who initiated the real estate bubble, the hedge funds and the structured investment vehicles (SIV), but also with financial instruments such as collateralised debt obligations (CDO), credit default swaps (CDS) and other derivatives.
The second main weakness was that a significant part of the regulation work was somehow delegated to the rating agencies. This would not be a problem per se, if agencies were themselves tightly regulated and required to enforce strict principles. But this was not the case. Moreover, rating agencies faced conflicting interests, as they were paid by the companies they rated rather than by the investors.
Innovation combined with financial globalisation ended up with toxic assets spread all around the world on the balance sheets of all kinds of investors. This was, in particular, very harmful to local public bodies which often did not have the financial expertise to assess the risk embedded in the financial products they were offered. The lack of coordination between the main regulators ended up allowing all financial products originating in developed countries to be freely traded almost worldwide once they had been rated by a recognised agency.
Finally, the high liquidity environment let regulators neglect the liquidity risk and mainly focus on credit risk and solvency issues. Risk-weighted assets and tier-one capital have proved to be only partial measures of the banks’ strength. The financial sector collapsed when distrust spread through the markets and banks, with maturity mismatches on their balance sheets, became highly distressed sellers. Some regulators, such as the French Commission Bancaire, have taken a more proactive stance on liquidity issues and have enforced liquidity ratios. However, these actions turned out to be insufficient to avoid liquidity stresses among the domestic banks.
In this context, the International Financial Reporting Standards (IFRS) accounting rules, initially aimed at better reflecting the banks’ financial health by taking the market value of assets into account, have had a strong pro-cyclical impact. Basel II rules put additional pressure on banks when the economic cycle began to deteriorate, because the downward migration of ratings resulted in expanded capital requirements. As asset depreciations have translated into capital needs for banks and automatically reduced their solvency, it increased uncertainty and further reinforced illiquidity. This was certainly not a cause of the crisis, but it did serve as a catalyst to deepen it.
Inefficient internal control rules
The main responsibility for the crisis belongs not to the regulators but first and foremost to the banks. They have, as part of their main mission, to protect deposits and to efficiently allocate savings by using appropriate risk analysis. They partly failed in fulfilling these obligations.
The recent scandals have shown that risk management and internal control departments had often lost part of their internal compelling power against front office teams. This should not be a surprise, as it reflects what Keynes named the ‘wild animal spirits’. Nevertheless, the risk/return ratios proposed for some investments were simply unrealistic and some investment decisions should have been blocked, since banking institutions are expected to have procedures to resist pro-cyclical investment behaviour. Compliance departments also failed to ensure that all due diligence procedures were implemented before investment decisions were taken.
The end of blind faith in financial models
Over the last decade, the financial industry developed increasingly complex models and instruments aimed at disentangling risks, providing the impression that almost perfect hedging was possible. Derivatives such as CDSs and securitisation practices were developed based on that hypothesis. This belief may partly explain how systemic risk could rise over the last years without being detected.
Many models were built on probabilistic risk distributions with thin tales. However, as noted by Spence [8], risk distribution tails may be thicker than commonly thought when systemic risk rises, as endogenous dynamics cause the correlation between the various risks to increase over time. The recent events may thus weaken the Gaussian vision of the financial markets and rehabilitate Mandelbrot's view that risks may not always cancel out.
Proposals for a more efficient financial architecture
Getting out of the crisis requires a two-stage approach: an emergency response to stop the negative spiral of the financial markets from causing the collapse of the real economy, and an adequate regulatory response to reduce the probability that a similar crisis will occur in the future and to bring the financial sector back to more ethical practices. Governments and central banks appear to be the only actors able to lead these processes, as they require both an outsider approach and a long-term commitment.
Immediate and massive public intervention to stabilise financial markets
As underlined by the IMF in the January 2009 update of its Global Financial Stability Report (IMF 2009), restoring financial sector functionality and confidence are necessary elements for an economic recovery. Restoring confidence in the financial markets by providing liquidity and injecting capital were urgent measures rightly taken by the public authorities. They were successful, as they have avoided a complete collapse of the financial sector. However, the situation is far from being fully satisfactory, as a significant share of liquidity in circulation is still ensured by central banks.
The IMF estimates the upcoming write-downs in European and US banks in 2009-2010 will be half a trillion US dollars, which will imply a necessary new recapitalisation effort. If recapitalising and deleveraging banks is a rational individual solution, it seems to be suboptimal at the aggregate level, as it reinforces panic-driven fire sales and further exacerbates uncertainty and the capital needs of banks, as noted by Caballero [3]. Nevertheless, I am afraid that no best solution can be achieved in this matter, since running a financial system without capital until panic subsides does not seem to be a realistic solution. As explained by Caballero, this would require developing a comprehensive public insurance system, which is, I believe, a solution too difficult to implement in globalised financial markets.
The current issue is to determine the best way to quickly restore confidence and market liquidity to their pre-crisis levels. Next to liquidity and capital provision, it is urgent to organise the orderly disposal of problematic assets in order for the financial sector to be able to fulfil its core mission of efficiently irrigating the economy with credit. This is a monumental task: Goldman Sachs recently estimated the amount of troubled assets on the balance sheets of US banks at 3-4 trillion dollars. Setser [7] nicely summarised the three main options faced by governments: nationalising banks, creating bad banks or providing private investors with credit to buy the distressed assets. I believe that nationalising banks should be considered as a solution of last resort, as it may frighten the markets and cause much inefficiency in the medium term.
The second solution would consist in transferring toxic assets into a bad bank managed by the public sector. The governments are the only ones able to safely refinance existing portfolios until asset markets normalise. As they would not need to dispose of the assets in a fire sale, this would also greatly contribute to normalising asset markets and would therefore lighten the pressure on the banks’ capitalisation needs. The main issue with this solution is the difficulty in determining the price of the assets to be transferred, as their markets have often dislocated.
Handing the toxic assets over to private investors while providing them with credit to buy the assets is the solution recently chosen by the US administration. It relies on the assumption that most of the assets are still of good quality but that the liquidity stress prevents the market from functioning normally. This solution would allow the banks, once their illiquid assets were cleaned up, to start extending new credit to the real economy. This would solve the issue of the price-setting mechanism, as it would result from market forces.
However, the troubled banks are likely to be reluctant to sell their assets at distressed prices as long as they can keep liquidity support from the authorities. This solution would therefore require coordination between central banks and governments to ensure that the right incentives are put in place to make the sales possible.
Necessary rethinking of the prudential regulation framework
In parallel to implementing emergency measures, there is a need for developing a medium-term view of the financial sector which would allow supporting global economic growth while limiting the risk of a major disruption. The recommendations recently made by the Group of 30 constitute a solid basis to reform the system.
Strengthening the financial sector regulation framework is a necessity. This should deal with a broad range of financial players such as hedge funds or real estate brokers in the US, and financial products, as shown by the systemic risks involved in credit securitisation or credit default swaps. Given the importance of rating agencies, an in-depth analysis of their role and incentive schemes should be conducted. There is no doubt that they are of crucial importance, but large financial institutions should also rely on their own analysis to ensure a pluralism of views and to avoid mimetic investment behaviour.
Financial globalisation makes international coordination between regulators an absolute necessity. This is particularly true for multinational financial groups using complex leverage mechanisms which may generate large systemic risks. This raises the issue of the need for a supranational agency, which could be the Bank for International Settlements (BIS), and to which national regulators would report. Coordination seems to be a more efficient system as it allows national bodies to adapt the rules to the specific constraints of local markets. But if the main international stakeholders prove difficult to coordinate, I believe that a central coordinator will be needed. This is of the utmost importance, as financial protectionism could damage modern economies as much as trade protectionism did in the 1930s.
Tighter regulation and supervision are only credible if they are strictly enforced. Some of the main regulators already impose sanctions on banks guilty of improper behaviour. However, a worldwide alignment of the practices would improve the effectiveness of the regulatory frameworks.
Finally, the proposal to implement counter-cyclical regulatory rules, which could adapt to the state of the economy like monetary policy does, is appealing from a theoretical point of view. Dynamic mechanisms could get out of control when extreme situations occur. Therefore, in-depth research should be conducted before such ideas are seriously envisaged. A detailed analysis of the risk-provisioning rules implemented in Spain could constitute an interesting starting point. As a first step, more differentiated rules for the risk weighting of assets could be adopted, as proprietary trading, for instance, involves a much larger systemic risk than financial intermediation activities.
Towards more transparency and adapted accounting rules
The crisis has shown that the lack of transparency in financial communication has critically reinforced the impact of the bank failures on the markets. Better communication is crucial for financial institutions. The liquidity crunch could have been significantly less severe if, when the crisis erupted, they had been able to quickly provide a precise description of their liquidity situation as well as of their balance sheet and off-balance-sheet commitments.
The market for structured products should be carefully rethought, as the complexity of the mechanisms they involve was one of the causes for the recent financial panic. Enhancing disclosure standards is crucial for markets to disentangle financial products with very different risk profiles. Covered bonds, for example, which exhibit a very low risk profile, have suffered in the financial crisis in the same proportion as much riskier assets such as residential mortgage-backed securities (RMBS), which would not have been the case in a perfect information environment.
Asset valuation at market value has also played a very significant negative role in the crisis due to the pro-cyclical nature of the mechanism. More realistic guidelines to value illiquid or distressed assets should be implemented. In particular, financial institutions should be allowed to switch to mark-to-model methods when markets collapse. This policy adjustment should be completed by harmonisation and communication efforts on mark-to-model practices in order to increase transparency and comparability.
A need for improved governance and more ethical behaviours
The crisis has shown the need for strengthening governance principles for financial institutions. The proposal by Blankfein [1] to empower risk departments is interesting, as it could contribute to counterbalancing the usually rising influence of commercial teams in good times. Another interesting suggestion is to make it impossible for a bank to distribute a product without booking a significant share on its own balance sheet. But, I believe that most of the improvement will lie in finding ways of modifying the incentive schemes. Proposals to lengthen the period of reference for bonuses, in order to take the long-term performance of the investments into account, lead in the right direction. This would contribute to reinstating the longer view in the decision processes.
The second part of a new incentive structure would concern shareholders’ requirements in terms of capital return. These returns should come back to more reasonable figures, thereby allowing banks to limit their strategies to reasonable levels of risk. In the United States, financial-services industry profits reached 40%, as a share of total corporate profits, on the eve of the crisis. It is difficult to believe that the sector should represent that proportion of the value created by an economy.
But the main issue is the necessity for the banks to understand their responsibility in recommending to their customers products which fit their financial and risk profiles. In the current crisis, the damage to the real economy could have been reduced if the banks had restricted their activity to selling financial products adapted to their clients’ needs.
This new behaviour and new set of incentives could contribute to bringing the industry back to more ethical practices. Individual stakeholders should realise that they are part of a global system, which has some public-good features. Therefore, this requires them to limit the risks that they can make their institution take.
Conclusion
It will take some time to recover from the current crisis, because we are experiencing a full-scale market disruption and the end of an era of multiple and unsustainable imbalances. From this point of view, although short-term stimulus combined with an accommodating monetary policy surely makes sense to avoid a panic-driven slump, we must keep in mind the necessity of discipline in the long run. Basic disciplines should apply to all actors: governments, companies and financial institutions. In any case, a deep and violent financial crisis combined with the burst of a widespread real estate bubble always costs a lot of money and time: we should not expect a V-shaped exit from the crisis, even with better coordination of macro-economic policies all around the world. We should also remember that new and old debts–-public and private–-will have to be paid in the future.
No confidence, no credit. The main issue in the short term is to rebuild confidence in the financial system, and this cannot be taken for granted in the current environment. Absurd bonuses and compensation packages paid to managers of companies that were bailed out have created social trouble and anger. It would, therefore, be a tragedy for corporate standards if governance bodies showed themselves unable to regulate these excesses. More broadly, what we really need to put at the top of the agenda is the implementation of mechanisms to reduce both the probability of a new crisis and the real cost of financial market disruptions, as they cannot–-and never will–-be totally avoided. Tougher and more tightly enforced regulation would constitute the basis for new practices, as the arbitrage between financial stability and economic growth is the responsibility of governments and should not be left to the market alone. In other words, the invisible hand should have real fingers. In these conditions, it is also time for financial institutions to become more disciplined in order to regain the trust of their clients, shareholders and employees. It is crucial that they implement more realistic internal incentives and reward policies to reduce the systemic risks, and that they ensure that they will be able to protect deposits and efficiently allocate capital throughout the economy in the long term. ‘Back to basics’ should be the motto of the financial system's reform.
As the taxpayers will have to pay for the return to financial stability, it is crucial to align the interests of all stakeholders. Governments now pouring money into troubled financial institutions to avoid a systemic failure should have a reasonable incentive to do so; that is, they must be able to have a share in the future profits. Government intervention should converge with the interests of the management, the employees and the shareholders. As always, there is no panacea. I do not think punitive nationalisations on a large scale would offer the best value for money, but maybe a mix of common equity, warrants and preferred stocks should be considered on an ad hoc basis. It would certainly deflect the anticipated political uproar over the distribution of risks and rewards when we get out of the crisis. Choosing this road does not lead to socialism. On the contrary, this is precisely what Warren Buffett did when he decided to support Goldman Sachs in October 2008.
Footnotes