Reform of the Financial System

Franklin AllenFranklin AllenWharton School

University of Pennsylvania

Presentation to the G-20 CommitteeSeoul KoreaSeoul, Korea

February 2, 2010

What caused the crisis?• The conventional wisdom used to be that the basic

cause of the crisis was bad incentives in the mortgage g gindustry

But now it seems much more is going on…g g• The large global impact of the crisis suggests that the

problems with subprime mortgages were a symptomth th thrather than the cause

• The main problem is that there was a bubble in property prices in the U S Spain Ireland andproperty prices in the U.S., Spain, Ireland and elsewhere, and we are now suffering the fallout from the collapse of that

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Current Crisis:Case-Shiller 10 Cities Composite

3Source=S&P

What caused the bubble?What caused the bubble?

• The monetary policies of central banks particularlyThe monetary policies of central banks particularly the US Federal Reserve were too loose – they focused too much on consumer price inflation and ignored asset price inflation

• Global imbalances – the Asian crisis of 1997 and the policies of the IMF led to a desire among Asian governments to save funds

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Reserves: A ComparisonReserves: A Comparison

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The Financial CrisisThe Financial Crisis

• The collapse in property prices in the US has led toThe collapse in property prices in the US has led to enormous disruption in the global financial system

Th fi t bl ith b i t• The first problem was with subprime mortgages

• Then the problem became a general problem of credit p g prisk because of the uncertainty about long term prospects

• The financial system has stabilized and the real economy is starting to recover

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economy is starting to recover6

To summarize:To summarize:

• The first aspect of the problem was the developmentThe first aspect of the problem was the development and bursting of the property bubble

• The second aspect was that this problem was considerably exacerbated by the poor functioning of h fi i l i h i ithe financial system in the crisis

• How much of the disruption to the real economy is• How much of the disruption to the real economy is due to the bursting of the bubble and how much is due to the financial crisis?

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due to the financial crisis?

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Spainp• One of the largest property bubbles occurred in Spain

• The bursting of this bubble has devastated the real economy – unemployment has doubled to a level of l 20% d GDP h f llalmost 20% and GDP has fallen

• BUT the financial system, and in particular the banks such as Santander and BBVA have come through the crisis very well

• This suggests that the bursting of the bubble can cause tremendous damage to the real economy even if the financial s stem remains strong

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the financial system remains strong

USUS

• The US also had a property bubble that burstThe US also had a property bubble that burst

• The example of Spain illustrates that this collapse canThe example of Spain illustrates that this collapse can badly affect the real economy even without problems in the financial system

• How many of the problems in the US were due to the collapse of the property bubble and how many to the poor performance of the financial system?

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Why has the financial system performed so poorly?

• Why didn’t regulation help?

• Banking regulation is different from other kinds of regulation in that there is no wide agreement on the market failures it is designed to correct

• It is backward looking in the sense that it was put in place to prevent the recurrence of past types of crises

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RegulationRegulation

• What are the benefits and costs of regulation?What are the benefits and costs of regulation?

• What exactly are the market failures?• What exactly are the market failures?

• The Basel agreements illustrate the lack of a widely• The Basel agreements illustrate the lack of a widely agreed theoretical framework

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The market failuresThe market failuresThe most important are:

1. Multiple equilibria and bank runs

2. Contagion

3. Inefficient liquidity provision

4. Mispricing due to limits to arbitrage

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Going forwardGoing forward

• Central banks and governments need to be muchCentral banks and governments need to be much more focused on preventing bubbles and global imbalances than in the past – this is the real cause of the crisis

• Banking regulation needs to focus on correcting market failures rather than being imposed ad hoc as has been done historically

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The G20 AgendaThe G20 Agenda

1. Capital regulations1. Capital regulations

2. Systematically important financial institutions

3. Principles for sound compensation practices

4. Risk management

5 M d ti l l ti d i i5. Macroprudential regulations and supervision

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1 Capital regulations1. Capital regulations• Main tool for regulation in recent yearsg y• What is the market failure this regulation is solving?• Basel agreements are silent on this issueg• Traditional argument

– Capital regulation needed to offset moral hazard from d i ideposit insurance

• But why is there deposit insurance?– Supposed to prevents runs due to multiple equilibria– Supposed to prevents runs due to multiple equilibria– But the insurance is only for deposits it does not cover

wholesale funding so it does not solve the problem

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1 Capital regulations (cont )1. Capital regulations (cont.)

• May be better to use other methods such as lender ofMay be better to use other methods such as lender of last resort to solve the multiple equilibria bank runs problem

• Prevention of contagion is another rationale for gcapital regulation– In this case the capital provides buffers to prevent the

spread of contagion

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1 Capital regulations (cont )1. Capital regulations (cont.)

Key issues:Key issues:

• How large should capital buffers be?

• Why aren’t market based of measures of capital used in addition to or instead of accounting based add t o to o stead o accou t g basedmeasures (e.g. Wachovia)?

Wh t i th t f it l b ff i h i it• What is the cost of capital buffers – i.e. why is equity more costly than other forms of finance?

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1 Capital regulations (cont )1. Capital regulations (cont.)• Most plausible explanation of the high cost of equity p p g q y

finance is that there is a tax subsidy to debt in the form of interest deductibility

• If this is the case then the best policy is to remove the interest deductibility of debt so that large capital b ff b h i l d i ll i l i ibuffers are both privately and socially optimal – it is not clear there is any good justification for the tax deductibility of interestdeductibility of interest

• Cocos – Contingent Convertible debt may be superior to debt but it is not superior to equity

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to debt but it is not superior to equity

1 Capital regulations (cont )1. Capital regulations (cont.)

• Closely related to the issue of capital regulation isClosely related to the issue of capital regulation is limitations on leverage

• Current crisis characterized by build up of very high leverage and then rapid deleveraging as the crisis g p g gstruck – this considerably exacerbated the crisis

• Restrictions on leverage are likely to be helpful in reducing this leveraging/deleveraging cycle

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2. Systemically important financial institutions

• Many central bank interventions to save financial yinstitutions are justified using the rationale they are systemically important

• The market failure that is pointed to is contagion – if the institution was allowed to fail there would be a

l d i h fi i lmeltdown in the financial system

• The problem with this argument is that it is not p gnecessary to bail out an institution to prevent contagion

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2. Systemically important financial institutions (cont.)

• “Too big to fail” is not “Too big to liquidate”g g q

• The government needs to guarantee the short term commitments of failing banks to prevent contagioncommitments of failing banks to prevent contagion

• When a bank fails or is close to failure the government should step in take it over and resolve itgovernment should step in, take it over and resolve it – the top 5 executives should be removed immediately– all employee pension claims should be eliminatedp y p– over the next few years the bank should be liquidated– no guarantees for long term debt holders

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2. Systemically important financial institutions (cont.)

• One of the biggest difficulties with this type ofOne of the biggest difficulties with this type of scheme is the resolution of large, complex, cross-border financial institutions– Difficulty is that assets and liabilities within each country

are not necessarily matchedO f h bi i f i l i h d l i h– One of the big issues facing regulators is how to deal with this issue

– Eliminate cross-border branches and only allowEliminate cross border branches and only allow subsidiaries?

– Require banks to post collateral (e.g. foreign securities) for i b l ?

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any imbalance?

3. Principles for sound compensation practices

• Government bail outs and subsidies have led to a significant moral hazard problem – Executives know that if they take risks they will earn large

bon ses hen things go ell and ill be bailed o t b thebonuses when things go well and will be bailed out by the government when they do not

• Restrictions on bankers’ compensation potentially p p yprovides a brake on this behavior– Limit cash bonuses

P id t i ti th h t k t th t t b– Provide most incentives through stock grants that cannot be sold for several years

– Build in claw-back provisions that allow the stock grants

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to be reversed if long run performance turns out to be bad

3. Principles for sound compensation practices (cont.)

• The resolution mechanism described above in 2, ,should also help provide the necessary incentives

In partic lar the remo al of pension rights for all• In particular, the removal of pension rights for all employees should the financial institution enter the resolution process is an important component of

ti ticompensation practices

• Why does the governance of financial institutions by• Why does the governance of financial institutions by shareholders appear to have broken down – has the process been captured by employees?

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3. Principles for sound compensation practices (cont.)

• Real issue is how banks are able to make so muchReal issue is how banks are able to make so much money that they can pay such high compensation

• What is really needed is a full competition reviewthat establishes how they make so much moneyy y– Market structures that are anticompetitive?– Front running in the bond market?– Swapping privileged information about takeovers and so

forth with other institutions to make high profits on their proprietary trading?

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proprietary trading?

4 Risk Management4. Risk Management• There appear to have been significant failures in risk pp g

management by banks

• One aspect of this is the failure to correctly assess theOne aspect of this is the failure to correctly assess the probability of a fall in property prices despite the fact that simple rental-purchase price models showed h b bblthere was a bubble

• The other problem was the exclusive use of U.S. data pin the U.S. and very little understanding of property bubbles in Asia and elsewhere

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4 Risk Management (cont )4. Risk Management (cont.)

• Far too much reliance on market efficiency in theFar too much reliance on market efficiency in the public and private sectors

• Central banks need to provide estimates of whether there are any bubbles in asset pricesy p

• Does credit risk transfer share risk or concentrate it?oes c ed s s e s e s o co ce e ?

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5. Macroprudential Regulations and Supervision

• Current regulatory approaches assume that byCurrent regulatory approaches assume that by regulating individual institutions it is possible to control overall risk

• This ignores systemic risk, which provides the justification for macroprudential regulationsjustification for macroprudential regulations

• What drives systemic risk?– Common risk factors such as real estate prices – Domino contagion

C l i i h ldi28

– Correlations in asset holdings

5. Macroprudential Regulations and Supervision (cont.)

• Collapses in real estate prices are probably the most p p p yimportant factor for systemic risk – macroprudential regulations should be contingent on the chance of a collapse in propert pricescollapse in property prices

• Domino contagion and correlations in asset holdings ll d d b h i iare not well understood yet because the incentives to

form links are not usually modeled

• It will be difficult to design macroprudential regulations until domino contagion and asset holding correlations are fully understood

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correlations are fully understood

What the G20 agenda missesWhat the G20 agenda misses• Preventing bubbles

• Reform of central banks to allow checks and balances

• Elimination of global imbalances• Elimination of global imbalances

• Policies to ensure liquidity is provided efficiently

• Policies to counter limits to arbitrage and mispricing of assets

• Separation of commercial banks and risky activities

• Is there a role for public banks?

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Is there a role for public banks?

Preventing bubblesPreventing bubbles

• One of the main focuses of policy should be toOne of the main focuses of policy should be to prevent asset price bubbles because as Reinhart and Rogoff (2009) document this is the main cause of financial crises

• Frequent causes of asset price bubbles are – Loose monetary policy– Excessive availability of credit

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Reform of central banksReform of central banks• Central bank independence works well for combating

inflation but not for financial stabilityinflation but not for financial stability

• The private sector is being criticized for taking soThe private sector is being criticized for taking so much risk but it is really the Federal Reserve and other central banks that took the risks, e.g. low interest rates in 2003 and currently quantitative easing

Th d t b h k d b l• There needs to be some check and balance mechanism such as a Financial Stability Board that helps to control public sector risk taking

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helps to control public sector risk taking32

Solving the global imbalance problem

• Self-insurance by Asian and other countries throughSelf insurance by Asian and other countries through the accumulation of reserves is optimal for them, e.g. South Korea

• However, it is a very inefficient mechanism from a global perspectiveglobal perspective

• Reform of the IMF? Global currency?

• Regional risk sharing

• Rmb as a reserve currency33

Rmb as a reserve currency33

The provision of liquidityThe provision of liquidity

• Market incentives to provide liquidity appear to beMarket incentives to provide liquidity appear to be inadequate and this has led to frantic intervention by central banks

• Markets are incomplete in the sense that it is not possible ex ante to ensure the desired provision of liquidity state by state – instead liquidity is obtained by selling assets

• The provision of incentives to hold liquidity requires fire sale prices ex post as otherwise the opportunity

t f h ldi li idit ill t b d34

cost of holding liquidity will not be recouped

Limits to arbitrage and the mispricing of assets

• Many people believe that prices of securitized y p p pproducts broke free from fundamentals and this is why prices fell so low

• TARP and many other plans were designed to restore prices to their proper level more effective policiesprices to their proper level – more effective policies need to be developed to ensure asset prices reflect fundamentals

• Mark-to-market versus historic cost accounting

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Separation of commercial banks and risky activities

• Suggested by President Obama Mervyn King and• Suggested by President Obama, Mervyn King and many others

• Details are different from Glass-Steagall but spirit is the samethe same

• This would not have helped prevent the current crisisThis would not have helped prevent the current crisis but it may help prevent future crises

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Public sector banksPublic sector banks

• Many central banks have vastly expanded theirMany central banks have vastly expanded their balance sheets and have directly lent to firms and banks

• Most central banks are ill equipped to assess credit riskrisk

• A better solution may be to have public sector banks that can act as a firewall in a crisis and ensure lendingthat can act as a firewall in a crisis and ensure lending to firms continues– E.g. Chile’s Banco Estado

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E.g. Chile s Banco Estado