What went wrong

Longitude (Italian foreign policy journal)

May 1, 2013

In his recent book, Howard Davies has set out a survey of 38 distinct causes of the global financial crisis beginning in the summer of 2007. The reality is that the crisis spawned from a confluence of both macro- and microeconomic factors.

Preceding the crisis was a remarkably benign macroeconomic environment characterized by strong global growth, stable prices and low interest rates. In the US in particular, this environment encouraged strong credit growth, weakened risk assessments and also contributed to domestic imbalances, which most notably manifested in a major asset price bubble in the housing market. Contributing to these phenomena were protracted balance of payments disequilibria on the global scale, connected in part to managed exchange rate regimes and excess savings in a number of developing countries which led capital to flow to the US to finance consumer spending and large US current account deficits. The proximate cause of the crisis was, however, a domestic one: the rupture of the US housing bubble.

The International Monetary Fund (IMF) has affirmed that the vulnerabilities in the US eventually exposed by the collapse of the sub-prime mortgage market were driven by credit and housing price booms, as well as the weaknesses in financial regulation resulting in system-wide overleveraging and mispricing of risk. Financial regulation is invocative of the microeconomic factors at play. It has traditionally meant regulation of individual institutions or market actors and their transactions. Oft-cited necessary antecedents to the crisis at the micro-level include, inter alia: weaknesses in oversight of both mortgage origination and distribution; reliance on credit rating agencies in assessing risk; regulatory arbitrage and excessive leveraging through special purpose subsidiaries and other special vehicles; a lack of transparency in a number of complex financial instruments (contracts); the procyclical behavior inherent in mark-to-market accounting; and general undercapitalization of financial institutions. Yet the resulting international contagion and systemic nature of the crisis brought to the fore the weaknesses of traditional “micro-prudential” regulation. Macro-prudential regulation – a word first used in the Tietmeyer report establishing the Financial Stability Forum (FSF) after the Asian Financial Crisis – is now being heralded as the new international regulatory paradigm.

A useful method of distilling the regulatory failings in a crisis produced by what Willem Buiter has called a “perfect storm” of pathologies is with reference to the priority areas of the international regulatory agenda identified by the Financial Stability Board (FSB) – the body charged with coordinating that agenda. Under direction from the G20, the FSB Plenary determines regulatory priorities that will undergo more intensive monitoring. The latter include, but are not limited to, the Basel framework, over-the-counter (OTC) derivatives, policy measures for global systemically important financial institutions (G-SIFIs), and shadow banking. In what follows we review why policymakers, with post-crisis hindsight, identified these regulatory areas as having failed in promoting financial stability. During a period of crisis, banks will be faced with two choices: either recapitalize or reduce assets. Banks are reluctant to raise capital during a period of financial distress and so often their only real alternative is to reduce assets. This leads to credit-crunch conditions and fire sales – in short, pro-cyclicality –with a high social cost to the financial system and economy. Capital requirements for banks are governed by the standards set out by the Basel Committee on Banking Supervision (BCBS).

At the most general level, the first Basel Agreement (1998) dictated that banks hold 8percent of capital, subdivided into Tier I and Tier II capital. The former consists mostly of shareholder’s equity while the latter includes subordinated debt and a number of other instruments. Shortly after Basel I, the BCBS began developing a new accord, but according to Davies, the Committee spent “little time on determining the overall quantum of capital…[and] they also devoted little attention to the quality of capital.” Furthermore, sophisticated institutions were permitted to use their own risk models to determine their own capital requirements, subject to regulatory validation. In any event, Basel II had not been implemented in the US at the onset of crisis. (This last point should serve as a prescient reminder that agreeing and implementing are two different things).

The criticisms levied on the basis of capital standards can be organized into two main streams. The first is that firms were simply overleveraged and holding too little capital and poor quality of capital. During the crisis, Philipp Hildebrand argued that high leverage was, both historically and in the instant case of 2007, the main cause of financial fragility, noting that “on average, listed non-financial firms have capital-to asset ratios of 30percent to 40 percent. In stark contrast, before the onset of the current crisis, all of the world’s top 50 banking institutions held, on average, only 4percentof capital. None of them held more than 8percent.” In addition to already arguably low quantity and quality capital requirements, banks were further able to move certain deals off their books as a way of circumventing the Basel rules. The use of certain “shadow banking” entities like structured investment vehicles (SIVs) or conduits was one such means that allowed banks to increase their leverage.

The second and related criticism is that the rules encouraged pro-cyclicality: individual banks would hold too little capital in prosperous times to increase their assets, but reduce lending and hoard capital during crisis times. This line of criticism was explicitly accepted by the G20 in the April 2009 London Summit.

The Basel III framework agreed to by the BCBS in September 2010 and announced by the G20 at the November 2010 Seoul summit has been “the most prominent international regulatory reform” in the aftermath of the crisis, in the words of Eric Helleiner. Basel III was negotiated at a record pace and includes not only an increase in the required standards respecting quantity and quality of capital and liquidity, but also, in its endorsement of leverage ratios and counter-cyclical buffers, incorporates macro- prudential principles.

The Basel Committee has been actively monitoring the implementation of Basel III. As of December 2012, 11 jurisdictions have transposed the Basel III requirements into domestic regulations. Seven other jurisdictions – including the US and the European Union – have tabled draft regulations. A large number of jurisdictions – including, arguably, the two most important ones – therefore did not meet the January 1, 2013 date for which national legislation and regulation w ere to be amended.

All in all, Eric Helleiner seems skeptical that the framework will be implemented and notes that in order to appease various interests, “the regulators agreed that the new standards would need to be fully in place until 2019.” Masters and Brathwaite write that the financial industry is “preparing a full-on assault” on Basel III, noting a much-popularized clash between JP Morgan Chase chief executive Jamie Dimon and Mark Carney, the FSB chair.

As of December 2009, “approximately 89percent of derivatives contracts were transacted over-the-counter”; that is, between two contracting parties without any intermediary. OTC derivatives are viewed as perhaps the primary culprits in the financial crisis. Prior to the crisis, OTC derivatives were “often left to private ordering, most often led by the International Swaps and Derivatives Association.” In the US, a proposal by the Commodities Futures Trading Commission (CFTC) for increased oversight over credit derivatives was famously rejected. One staunch opponent of the proposal, Alan Greenspan, argued that “the fact that OTC markets function quite effectively without the benefits of CFTC regulation provides a strong argument for development of a less burdensome regime…” It is generally accepted that the opacity of OTC credit derivatives exacerbated financial instability, loss of confidence and the rapid fall in market liquidity during the crisis by obscuring the locus of risk and preventing efficient information dissemination. The lack of regulative jurisdiction over these products prevented national authorities from identifying the developing vulnerabilities.

Among the most criticized OTC derivatives have been the so-called “naked” credit default swaps (CDS) that were made into legally enforceable contracts by legislative intervention in 1984 in the UK and 2000-2001 in the US. As Lynn Stout has pointed out, prior to this intervention, “private ordering” of derivatives markets would have led parties to create centralized exchanges; legal enforceability detracted from this exchange-establishing incentive.

In response, the FSB has convened a working group led by the Committee on Payment and Settlement Systems (CPSS), IOSCO and the European Commission in April 2010 to make recommendations on the G20 derivatives reform. In October 2010 the group issued its initial report containing 21 recommendations. Working from the premise that the opacity of the OTC derivatives market exacerbated instability during the crisis, the recommendations focused on implementation issues surrounding the following key reform areas: i) standardization (more of the market should be standardized to allow for central clearing); ii) central clearing (including the regulation of central counterparties (CCPs) iii) trading on exchanges or electronic platforms and iv) trade repositories (TRs) (so that authorities can have a “comprehensive” data on the OTC market). At the June 2010 Toronto Summit, the G20 reaffirmed their “commitment to trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through CCPs by end-2012 at the latest.”

The FSB has since issued five progress reports on OTC reform implementation, the latest of which were published in October 2012 and April 2013 respectively. Generally, the October 2012 report is positive, citing “encouraging progress” with respect to the four key issue areas, noting that the most important derivatives markets – the EU, Japan and the US – are the “most advanced in structuring their legislative and regulatory frameworks.” The latest report is less positive, noting that less than half of the FSB member jurisdictions “have legislative and regulatory frameworks in place to implement the G20 commitment,” and at present only three have “requirements adopted and in force for OTC derivatives to be traded on organized platforms.”

Before the crisis, and under the micro-prudential paradigm, the failure of a financial institution was generally considered as an independent event with limited consequences for direct and indirect partners and counterparties. During the crisis, the distress of SIFIs led to uncertainty and a reassessment of risk across the entire financial system. In theory, when a bank fails, the “shareholders should lose everything and the depositors nothing,” but in practice, this proved “hard to engineer,” in the words of Howard Davies. Across jurisdictions, there was no clear mechanism for the resolution of a large financial institution. Moreover, it has often been argued that the implicit promise that “if a large institution failed, it would be saved” negated the market discipline taming institutions’ risk appetites – that is, the moral hazard argument.

The lack of a mechanism to deal with failed gargantuas was arguably compounded by the repeal of Glass-Steagall in 1999, which had previously prevented commercial banks from underwriting securities. Already large commercial banks could now merge with already large investment banks, and in the US, benefit from the Federal Reserve’s safety net.

In October 2010 the FSB released a general policy framework for reducing moral hazard risk posed by GSIFIs along with implementation time lines. The report recommendations centered around three pillars of the G-SIFIs framework: increased intensity and effectiveness of supervision of SIFIs, higher loss absorbency, and effective resolution of failing G-SIFIs.

The latest FSB progress report on supervision, published in November 2012, is direct in its finding that “weak risk controls at financial institutions are still being witnessed…FSAPs continue to identify problems in the fundamental requirements for effective supervision, such as the core principles for official and dates, resources and independence [among the aforementioned ten].”

The BCBS was charged with examining the additional loss absorbency capacity that G-SIFIs should have and by what instruments such capacity could be achieved. A prerequisite to this is identification of which institutions should be characterized as systemically important. In November 2011, the BCBS finalized a methodology for identifying globally systemically important banks (G-SIBs) based on the effect of the failure of an institution on the financial system and real economy as influenced by five indicators: size, interconnectedness, lack of available substitutes or infrastructure for the services they provide, global (cross-jurisdictional) activity, and complexity. Based on the ranking produced by the indicators, G-SIBs are allocated into “buckets” with varying levels of (additional) loss absorbency capital requirements (as a percentage of risk-weighted assets) corresponding to their importance. G-SIBs must meet their additional loss absorbency requirement with Common Equity Tier 1 only. As of the November 2012 update of the FSB’s GSIBs list, Citigroup, Deutsche Bank, HSBC and JPMorgan Chase are subject to the highest additional loss absorbency requirement at 2.5 percent. The additional requirements are scheduled to be phased in starting in 2016. To address the issue that while an institution may not meet G-SIB criteria, but may still be vital domestically, the BCBS has been working on extending the framework to domestic systematically important banks.

The BCBS seems to have responded to the problem of externalities emanating from G-SIFIs in what is, in a sense, the standard (Pigouvian) tax remedy recommended by theory. The largest firms are being asked to pay for their externality by holding better and higher quality capital. The challenge for regulators is, however, to maintain the levies at an efficient level.

The shadow banking system, according to the FSB, “can be broadly described as credit intermediation involving entities and activities outside the regular banking system.” This includes instruments such as repurchase (“repo”)markets for short-term financing of securities, asset-backed commercial or other paper, money market funds, structured investment vehicles and other finance companies like special-purpose vehicles. From 2002 to 2007, the size of this “Other Financial Intermediaries” sector grew from $26 trillion to $62 trillion. Prior to the crisis, many of the system’s short term liabilities were seen as nearly risk-free, but the sector quickly contracted once crisis struck along with its provision of financing to the regular banking system. For example, in September 2008, in response to Lehman’s collapse, there was an industry-wide run on prime money-market funds, “amounting to roughly 40percentof their funds over a two-week period.” The US Treasury was forced to take the ad hoc measure of guaranteeing all money-market funds. To the extent that the shadow banking system can undertake “bank like” activity, and be a source of finance to the banks, it can serve as a source of systemic risk. Moreover, because shadow bank entities were not subject to the oversight of regular banks, the shadow sector can also be a hub for regulatory arbitrage. For example, prior to the crisis “banks substituted asset backed commercial paper (ABCP) financing for regular bank lending because the capital requirements for ABCP back-up lines were lower under” the Basel requirements.” The general lack of oversight prevented regulators from seeing the build-up of vulnerabilities in the shadow sector. After an annual symposium in Jackson Hole, Wyoming in August 2007, one attendee remarked that “it is stunning how little many policymakers know about the workings of ABCP and collateralized debt obligations.”

The FSB released its initial consultative recommendations to enhance the oversight and regulation of shadow banking in October 2011and has developed various recommendations for regulatory change in cooperation with BCBS.

Despite these initiatives, in 2011 the size of the shadow banking sector surpassed pre-crisis levels. The FSB’s latest global monitoring report on shadow banking was made public in November 2012. The pervasiveness of shadow banking continues to be country-specific: the Netherlands, the UK and the US fall into the group of countries with the highest share of “other financial institutions” – the FSB proxy for shadow banking. The US shadow banking system continues to be the largest, but its share in US credit intermediation is shrinking, though this has been offset on a global scale by increases in Europe and the UK. The 2011 “slow-motion” run on US money-market funds in response to concerns about their European sovereign debt exposure provides an example of the continued systemic importance of the shadow sector and its linkages. Darrell Duffie writes that despite the attempted overhaul of US “financial plumbing,” many systemically important borrowers continue to depend on short-term financing through such funds. Overall, there is “considerable divergence in jurisdictions” of the share of shadow banking in the overall financial system, its size as a proportion to GDP and recent growth trends as measured by FSB proxies.

A general economic impulse is that if the shadow sector behaves and fulfills the same functions as the regular banking sector, and its firms are subject to the same market failures, then it ought to be regulated in similar fashion. This might entail improved capital and liquidity requirements or regulated haircut rules to counter pro-cyclicality (in repo markets for example). Indeed, as Duffie points out, in the US money market fund quality and liquidity requirements were significantly tightened following the crisis. As with other areas, then, while the international agenda continues to promulgate best standards, it appears as if it is ultimately up to the “hard law” of national and sub-national regulatory authorities to enforce and implement the changes.

DomenicoLombardi  is the Director of the Global Economy Program at The Centre for International Governance Innovation (CIGI), Canada.

John Zelenbaba is a Research Intern at the Global Economy Program at The Centre for International Governance Innovation.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

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