The subprime series, part 1 Financial crises are not going away Stephen G. Cecchetti Bank for Internationa/ Settlements and CEPr 26 November 2007 This is the first in a series of four essays exploring the lessons from the subprime turmoil. It sets the stage for the series, arguing that financial crises are intrinsic to the modern economy, but both individuals and governments should make adjustments to reduce the frequency of financial crises and their impact on the broader economy. While the crisis may not be over, we can still pause and take stock. What lessons should we take away from the turmoil that began in early August 2007? Most of what I will discuss is not new. But recent events have brought some important issues into better focus. Reflecting on the central causes of the problems we cur- rently face leads me to conclude: there will always be a next crisis. Its centrality to industrial economic activity, combined with a potential for abuse, has made the financial system one of the most heavily regulated parts of our economy. Through a variety of regulators and supervisors with overlapping responsibilities, governments make voluminous rules and then set out to enforce them. The idea of a laissez-faire financial system makes no sense even to most ardent champions of the free market Even with intense oversight by the governmental authorities-in the United States we have the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve, as well as state banking authori- ties- crises continue to come. One reason for this is the natural tendency of officials to fight the last battle, looking for systemic weaknesses revealed by the most recent crisis. So, when complex automated trading schemes were thought to have contributed to the October 1987 stockmarket crash, circuit breakers were put in place that shut down computer-based order systems when indices move by more than a certain amount. In the aftermath of the asian crisis, the imf create new lending facilities in an attempt to address issues of contagion -in essence, to deal with countries that were innocent victims of problems created elsewhere And when LTCM collapsed there was a flurry of activity to understand the poten- tial impact of what were called highly leveraged institutions. As necessary as each of these reforms may have been, we are not going to stop omorrow's crises by looking backwards. Financial innovators will always seek out the weakest point in the system Innovations will both exploit flaws in the regu latory and supervisory apparatus and manipulate the inherent limitations of the
26 November 2007 This is the first in a series of four essays exploring the lessons from the subprime turmoil. It sets the stage for the series, arguing that financial crises are intrinsic to the modern economy, but both individuals and governments should make adjustments to reduce the frequency of financial crises and their impact on the broader economy. While the crisis may not be over, we can still pause and take stock. What lessons should we take away from the turmoil that began in early August 2007? Most of what I will discuss is not new. But recent events have brought some important issues into better focus. Reflecting on the central causes of the problems we currently face leads me to conclude: there will always be a next crisis. Its centrality to industrial economic activity, combined with a potential for abuse, has made the financial system one of the most heavily regulated parts of our economy. Through a variety of regulators and supervisors with overlapping responsibilities, governments make voluminous rules and then set out to enforce them. The idea of a laissez-faire financial system makes no sense even to most ardent champions of the free market. Even with intense oversight by the governmental authorities – in the United States we have the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve, as well as state banking authorities – crises continue to come. One reason for this is the natural tendency of officials to fight the last battle, looking for systemic weaknesses revealed by the most recent crisis. So, when complex automated trading schemes were thought to have contributed to the October 1987 stockmarket crash, circuit breakers were put in place that shut down computer-based order systems when indices move by more than a certain amount. In the aftermath of the Asian crisis, the IMF created new lending facilities in an attempt to address issues of contagion – in essence, to deal with countries that were innocent victims of problems created elsewhere. And when LTCM collapsed there was a flurry of activity to understand the potential impact of what were called highly leveraged institutions. As necessary as each of these reforms may have been, we are not going to stop tomorrow’s crises by looking backwards. Financial innovators will always seek out the weakest point in the system. Innovations will both exploit flaws in the regulatory and supervisory apparatus and manipulate the inherent limitations of the The subprime series, part 1: Financial crises are not going away Stephen G. Cecchetti Bank for International Settlements and CEPR 21
22 The First Global Financia/ Crisis of the 2 1st Century relationship between asset managers and their investor clients. The 2007 crisis provides examples of both of these. Let us look at each in turn Innovations exploited flaws in the regulatory and supervisory apparatus Financial institutions have been allowed to reduce the capital that they hold by shifting assets to various legal entities that they do not own, what we now refer to as conduits and SIVs. (Every financial crisis seems to come with a new vocabulary. Instead of owning the assets, which would have attracted a capital charge, the banks issued various guarantees to the SIVs, guarantees that did not require the banks to hold capital The purpose of a financial institutions capital is to act as insurance against drops in the value of its assets. The idea is that even if some portion of a banks loan portfolio goes bad, there will still be sufficient resources to pay off depositors. Since capital is expensive, bank owners and managers are always on the lookout for ways to reduce the amount they have to hold. It is important to keep in mind that under any system of rules, clever(and very highly paid) bankers will always develop strategies for holding the risks that they want as cheaply as they can thereby minimizing their capital Manipulation of the asset manager-client relationship But this is not the only problem. Financial innovators will also seek ways in which to exploit the relationship between the ultimate investor(the principal) and the managers of the investor's assets(the agent). The problem is that the agent acts primarily in his or her personal interest, which may or may not be the same as the nterest of the principal. The principal-agent problem is impossible to escape. Think about the manager of a pension fund who is looking for a place to put some cash Rules, both governmental and institutional, restrict the choices to high-rated fixed-income securities. The manager finds some AAA-rated bond that has a slightly higher yield than the rest. Because of differences in liquidity risk, for example, one bond might have a yield that is 20 or 30 basis points(0.20 or 0.30 percentage points) higher. Looking at this higher-yielding option, the pension-fund manager notices that there is a very slightly higher probability of a loss. But, on closer examination, he sees that this higher-yielding bond will only start experiencing difficulties if there is a system-wide catastrophe. Knowing that in the event of crisis, he will have bigger problems than just this one bond, the manager buys it, thereby beating the benchmark against which his performance is measured. I submit that there is no way to stop this. Managers of financial institutions will always search for the boundaries defined by the regulatory apparatus, and they will find them. After all, detailed regulations are a guide for how to legally avoid the spirit of the law. And the more detailed the rules, the more ingenious the avoidance. This brand of ingenuity is very highly rewarded, so I am sure these strategies will
relationship between asset managers and their investor clients. The 2007 crisis provides examples of both of these. Let us look at each in turn. Innovations exploited flaws in the regulatory and supervisory apparatus Financial institutions have been allowed to reduce the capital that they hold by shifting assets to various legal entities that they do not own, what we now refer to as conduits and SIVs. (Every financial crisis seems to come with a new vocabulary.) Instead of owning the assets, which would have attracted a capital charge, the banks issued various guarantees to the SIVs, guarantees that did not require the banks to hold capital. The purpose of a financial institution’s capital is to act as insurance against drops in the value of its assets. The idea is that even if some portion of a bank’s loan portfolio goes bad, there will still be sufficient resources to pay off depositors. Since capital is expensive, bank owners and managers are always on the lookout for ways to reduce the amount they have to hold. It is important to keep in mind that under any system of rules, clever (and very highly paid) bankers will always develop strategies for holding the risks that they want as cheaply as they can, thereby minimizing their capital. Manipulation of the asset manager–client relationship But this is not the only problem. Financial innovators will also seek ways in which to exploit the relationship between the ultimate investor (the principal) and the managers of the investor’s assets (the agent). The problem is that the agent acts primarily in his or her personal interest, which may or may not be the same as the interest of the principal. The principal–agent problem is impossible to escape. Think about the manager of a pension fund who is looking for a place to put some cash. Rules, both governmental and institutional, restrict the choices to high-rated fixed-income securities. The manager finds some AAA-rated bond that has a slightly higher yield than the rest. Because of differences in liquidity risk, for example, one bond might have a yield that is 20 or 30 basis points (0.20 or 0.30 percentage points) higher. Looking at this higher-yielding option, the pension-fund manager notices that there is a very slightly higher probability of a loss. But, on closer examination, he sees that this higher-yielding bond will only start experiencing difficulties if there is a system-wide catastrophe. Knowing that in the event of crisis, he will have bigger problems than just this one bond, the manager buys it, thereby beating the benchmark against which his performance is measured. I submit that there is no way to stop this. Managers of financial institutions will always search for the boundaries defined by the regulatory apparatus, and they will find them. After all, detailed regulations are a guide for how to legally avoid the spirit of the law. And the more detailed the rules, the more ingenious the avoidance. This brand of ingenuity is very highly rewarded, so I am sure these strategies will continue. 22 The First Global Financial Crisis of the 21st Century
The subprime series, part 1: Financial crises are not going away 23 Conclusions what to do? Both individuals and government officials need to make adjust ments. Individual investors need to demand more information and they need to get it in a digestible form. As individuals we should adhere to the same principle that President Ronald Reagan followed in agreements over nuclear weapons with the Soviet Union: trust, but verify. We should insist that asset managers and underwriters start by disclosing the detailed characteristics of what they are sell ing together with their costs and fees. This will allow us to know what we buy, as well as understand the incentives that our bankers face As for government officials, most of the lessons point to clarifying the relative riskiness associated with various parts of the financial system. Elsewhere I have suggested that at least some of the problems revealed by the current crisis can be ameliorated by increasing the standardization of securities and encouraging trad ing to migrate to organized exchanges. Next articles In the next essays in this series I will continue along this theme. Part 2 discusses the lesson I have taken away from the Bank of Englands recent experience: that a lender of last resort is no substitute for deposit insurance. In part 3, I address whether central banks should have a direct role in financial supervision, conclud ing that they should. And finally, in part 4, I examine whether central banks' actions have created moral hazard, encouraging asset managers to take on more risk than is in society's interest. My answer is no otes: Deposit insurance has a dramatic impact on the amount of capital a bank holds. with deposit insuranc olders(the depositors) there is a natural tendency to increase the risk that they take. The banks owners an agers de if the higher-risk loans and investments yield high retums, while the deposit insurer faces onside if the risky assets fail to pay off. The response to this is to regulate banks and force them to hold capital. The argument that follows is due to Joshua D. Coval, Jakub W. Jurek and Erik Stafford (2007),'Economic e Bonds, Harvard Business School Working Paper 07-102, ( une). ets Financial Times. 4 October 2007 and provide more details in"Preparing for the Next Financial Crisis published initially at www.eurointelligence.comon5November2007,andreprintedatwww.voxeu.comon18Nowember2007
Conclusions So, what to do? Both individuals and government officials need to make adjustments. Individual investors need to demand more information and they need to get it in a digestible form. As individuals we should adhere to the same principle that President Ronald Reagan followed in agreements over nuclear weapons with the Soviet Union: trust, but verify. We should insist that asset managers and underwriters start by disclosing the detailed characteristics of what they are selling together with their costs and fees. This will allow us to know what we buy, as well as understand the incentives that our bankers face. As for government officials, most of the lessons point to clarifying the relative riskiness associated with various parts of the financial system. Elsewhere I have suggested that at least some of the problems revealed by the current crisis can be ameliorated by increasing the standardization of securities and encouraging trading to migrate to organized exchanges. Next articles In the next essays in this series I will continue along this theme. Part 2 discusses the lesson I have taken away from the Bank of England’s recent experience: that a lender of last resort is no substitute for deposit insurance. In part 3, I address whether central banks should have a direct role in financial supervision, concluding that they should. And finally, in part 4, I examine whether central banks’ actions have created moral hazard, encouraging asset managers to take on more risk than is in society’s interest. My answer is no. Notes: Deposit insurance has a dramatic impact on the amount of capital a bank holds. With deposit insurance, depositors do not care about the assets on their bank’s balance sheet. And without supervision from their liability holders (the depositors) there is a natural tendency to increase the risk that they take. The bank’s owners and managers get the upside if the higher-risk loans and investments yield high returns, while the deposit insurer faces the downside if the risky assets fail to pay off. The response to this is to regulate banks and force them to hold capital. The argument that follows is due to Joshua D. Coval, Jakub W. Jurek and Erik Stafford (2007), ‘Economic Catastrophe Bonds’, Harvard Business School Working Paper 07-102, (June). I made this proposal initially in ‘A Better Way to Organize Securities Markets’, Financial Times, 4 October 2007, and provide more details in ‘Preparing for the Next Financial Crisis’ published initially at www.eurointelligence.com on 5 November 2007, and reprinted at www.voxeu.com on 18 November 2007. The subprime series, part 1: Financial crises are not going away 23
The subprime series, part 2: Deposit insurance and the lender of last resort Stephen G. Cecchetti Bank for Internationa/ Settlements and CEPr 28 November 2007 he second essay in this 4-Part series discusses the lesson from the Bank of England's recent experience, arguing that a lender of last resort is no substitute for a well-designed deposit insurance mechanism For decades a debate has been simmering over the advisability of deposit insur ance. One side produces evidence that insuring deposits makes financial crises more likely. These critics of deposit insurance as the first line of defence against bank panics go on to argue that that the central bank, in its role as lender of last resort, can stem bank panics. Countering this is the view that, as a set of hard nd fast rules, deposit insurance is more robust than discretionary central bank lending. In my view, the September 2007 bank run experienced by the British mortgage lender Northern Rock settles this debate once and for all-deposit insur- ance is essential to financial stability. To understand this conclusion, we need to look carefully at experiences with entral bank extensions of credit-discount lending - and at the varying experi ence with deposit insurance. Let's start with the lender of last resort Lender of last resort In 1873 Walter Bagehot suggested that, in order to prevent the failure of solvent but illiquid financial institutions, the central bank should lend freely on good collateral at a penalty rate. 2 By lending freely, he meant providing liquidity on demand to any bank that asked Good collateral would ensure that the borrowing bank was in fact solvent, and a high interest rate would penalize the bank for failing to manage its assets sufficiently cautiously. While such a system could worl to stem financial contagion, it has a critical flaw. For Bagehot-style lending work, central bank officials who approve the loan applications must be able to dis tinguish an illiquid from an insolvent institution. But since there are no operat- This is the condlusion reached by Asli D c-Kunt and Edward Kane in their search on this issue. See their paper, " Deposit Insurance around the Globe: Where does it Work?', Journal of Economic Perspectives 16(2)(Spring 2002), Pp. 175-95 2 The original source is Walter Bagehot(1873), Lombard Street: A Description of the Money Market, London:
28 November 2007 The second essay in this 4-part series discusses the lesson from the Bank of England’s recent experience, arguing that a lender of last resort is no substitute for a well-designed deposit insurance mechanism. For decades a debate has been simmering over the advisability of deposit insurance. One side produces evidence that insuring deposits makes financial crises more likely.1 These critics of deposit insurance as the first line of defence against bank panics go on to argue that that the central bank, in its role as lender of last resort, can stem bank panics. Countering this is the view that, as a set of hard and fast rules, deposit insurance is more robust than discretionary central bank lending. In my view, the September 2007 bank run experienced by the British mortgage lender Northern Rock settles this debate once and for all – deposit insurance is essential to financial stability. To understand this conclusion, we need to look carefully at experiences with central bank extensions of credit – discount lending – and at the varying experience with deposit insurance. Let’s start with the lender of last resort. Lender of last resort In 1873 Walter Bagehot suggested that, in order to prevent the failure of solvent but illiquid financial institutions, the central bank should lend freely on good collateral at a penalty rate.2 By lending freely, he meant providing liquidity on demand to any bank that asked. Good collateral would ensure that the borrowing bank was in fact solvent, and a high interest rate would penalize the bank for failing to manage its assets sufficiently cautiously. While such a system could work to stem financial contagion, it has a critical flaw. For Bagehot-style lending to work, central bank officials who approve the loan applications must be able to distinguish an illiquid from an insolvent institution. But since there are no operatThe subprime series, part 2: Deposit insurance and the lender of last resort Stephen G. Cecchetti Bank for International Settlements and CEPR 25 1 This is the conclusion reached by Asli Demirgüç-Kunt and Edward Kane in their summary of international research on this issue. See their paper, ‘Deposit Insurance around the Globe: Where does it Work?’, Journal of Economic Perspectives 16 (2) (Spring 2002), pp. 175–95. 2 The original source is Walter Bagehot (1873), Lombard Street: A Description of the Money Market, London: Henry S. Kin & Co