by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets

TO BE NOTED: From Vox:

"Punter of last resort

Debate: Financial rescue and regulation, a Global Crisis Debate Posted by: Christopher D. Carroll (Department of Economics, Johns Hopkins University), 18 March 2009

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The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) ‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the ‘puzzle’ does not seem to have weakened participants’ belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’).¹

Some economists, of course, view narrative history in the deLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the ‘risk-free’ rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.² Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk.³

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,⁴ shows that over the “Taylor Rule” era of systematic monetary policy (roughly since 1984), the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.⁵ The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences. ( NB DON )

As the Economist magazine might put it, the problem is that the ‘punters’ (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.

Christopher D. Carroll

Department of Economics, Johns Hopkins University

References

Barbera, Robert J., and Charles L. Weise (2008): “Minsky Meets Wicksell: Using the Wicksellian Model to Understand the 21st Century Business Cycle,” Manuscript, Gettysburg College, Available at http://www.gettysburg.edu/dotAsset/2104335.pdf.

DeLong, J. Bradford (2008): “Republic of the Central Banker,” The American Prospect, Available at http://www.prospect.org/cs/articles?article=republic_of_the_central_banker.

Holland, A. Steven, and Mark Toma (1991): “The Role of the Federal Reserve as “Lender of Last Resort” and the Seasonal Fluctuation of Interest Rates,” Journal of Money, Credit and Banking, 23(4), 659–676, Stable: http://www.jstor.org/stable/1992702.

Kindleberger, Charles P. (2005): Manias, Panics, and Crashes: A History of Financial Crises. Wiley, 5th Edition.

Macaulay, Frederick R. (1938): The Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1856. National Bureau of Economic Research, New York.

Mehra, Rajnish, and Edward C. Prescott (1985): “The Equity Premium: A Puzzle,” Journal of Monetary Economics, 15, 145–61, Available at http://ideas.repec.org/a/eee/moneco/v15y1985i2p145-161.html.

Weise, Charles L., and David Krisch (2009): “The Monetary Response to Changes in Credit Spreads,” Paper Presented at the Eastern Economic Meetings, March 1 2009, Corresponding Author: Charles Weise, weise@gettysburg.edu."

Overall, Sweden’s financial crisis containment and resolution strategy largely avoided mistakes that would skew uninsured investors’ incentives going

TO BE NOTED: From Vox:

"Sweden as a useful model of successful financial crisis resolution

Kent Cherny Emre Ergungor 19 March 2009

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The way Sweden handled its 1990s banking crisis has been offered as a useful case study in resolving systemic banking crises. This column discusses the merits of the Swedish experience relative to ideal resolution strategies.

Governments of the world’s rich nations are clearly in need of positive examples of how to fix broken banking sectors. While we have many such examples from the last century (Caprio, Hunter, Kaufman, and Leipziger 1998), one of the most recent is the Swedish crisis.

In the early 1990s, Sweden’s economy was nearly toppled by a banking sector swollen with bad loans from the preceding decade’s credit bubble. The Swedish government seized ownership of the largest financial institutions and publicly-capitalised asset managers were put in charge of managing the poorly performing banking assets and returning what could be salvaged back into private hands. In this column, we compare the Swedish government’s intervention to four identified principles of effective crisis resolution:

• Transparency of asset losses up-front, and honest communication about the extent of public intervention
• Politically and financially independent receivership
• Maintenance of market discipline
• Restoration of credit flows
• Four principles of effective crisis resolution

A paper published by the Federal Reserve Bank of Cleveland, based on the analysis of evidence from financial crises across the globe, identified four practices common to successful financial crisis resolutions.

Transparency

The most important attribute of successful crisis resolutions has been the transparency of the entire process. Triage and full public disclosure of associated losses clear the uncertainty surrounding financial institutions and make it possible for viable institutions to raise new funds from private investors or from the government if private sources are not available. Failing to acknowledge the true value of assets or the condition of troubled banks early on makes it easy for them to live on as propped-up “zombies” (as happened in Japan during the 1990s or with savings and loans in the US in the 1980s) – healthy on paper but economically insolvent.

Politically and financially independent receivership

Crisis resolutions have been most successful when they were handled by a politically and financially independent agency. Granting independence to those responsible for containing the crisis and restructuring shields decision makers from political pressures, which mount as institutions are closed and assets are liquidated. The decision to close a financial institution or a business must be economic, not political. Financial independence is necessary to give credibility to political independence – if a government agency holds the purse strings, it can dictate policy. Incidentally, a transparent process is essential to the success of the independent agency. Without transparency, investors and taxpayers cannot verify independence.

Maintenance of market discipline

A successful resolution strategy must maintain market discipline, lest it simply set the stage for future crises. Investors who assumed greater risks must be credibly exposed to loss and suffer the consequences of having ignored or failed to detect signs of trouble. Blanket guarantees of uninsured depositors and investors are an example of a policy manoeuvre that might lessen the pain of a crisis in the short run but also distort market discipline going forward.

Restoration of credit flows

Finally, a full crisis resolution must begin to restore credit flows within the economy. For that to happen, the creditworthiness of borrowers must be restored throughout the economy – a difficult task, given that the economic fallout from a crisis (such as rising unemployment) actually erodes credit quality further.

How did these principles work in Sweden?

Sweden’s crisis

Sweden’s crisis followed a massive surge in speculative real estate and consumer debt. In 1991, two of Sweden’s largest banks, Föreningsbanken and Nordbanken, fell below their required capital levels amid rising loan defaults. Afraid of a meltdown, the government guaranteed all of Nordbanken’s liabilities and took ownership of the bank, while arranging a guarantee for Förenings. When a third large bank, Gota, was taken over shortly thereafter, policymakers acted quickly to separate the good from the bad.

Government-held assets that were deemed viable were merged under one name, Nordbanken, and permitted to continue operating. Bad assets were transferred to two asset management companies – Securum for Nordbanken’s assets and Retrieva for Gota’s.

The asset management companies were charged with managing and liquidating the bad assets of these banks and taking on the assets of non-bank companies that were in default. Swedish legislators made sure that the companies were adequately capitalised and granted exemptions from regulatory rules that would have rushed their actions or limited their effectiveness, including a rule that required seized collateral to be liquidated within three years.

Often, the asset management companies became managers of otherwise private, failed companies, performing such tasks as hiring and firing, managing property, and changing operational strategies until their assets could be favourably sold. Their flexibility and financial resources shortened their own existence from an expected duration of 15 years to a few years. Liquidations were completed in 1997, and the companies’ remaining funds (less than half of their original capitalisation, in real dollars) were returned to the Swedish treasury.

Lessons learned

Sweden emerged from its credit market turmoil without the zombie banks and dismal growth that characterised Japan’s “lost decade”. This achievement is at least partly due to Sweden’s crisis containment and resolution strategies.

First, Sweden’s approach was remarkably transparent. The magnitude of losses was established by a Bank Support Authority, which was independent of the Ministry of Finance and the central bank. Good assets were separated from bad assets, and the full extent of the government’s involvement was clearly outlined. Transparency about losses from the outset likely avoided the “zombie” effect and what Douglas Diamond has called “evergreening,” a process whereby undercapitalised banks choose not to address problem loans because doing so would force asset write-downs, possibly prompting technical insolvency.

Sweden also extended considerable political and financial independence to the asset management companies, which allowed them to carry out their task with adequate resources. Doing so served as a public signal that their operations would not be subject to changing political winds. Similarly, Swedish officials’ relaxation of collateral liquidation requirements implied that the dispensation of assets would take place over an extended period of time. Arguments can be made either way about the best time to sell assets – selling early returns assets to private use and avoids investor anxiety about debt overhang, while selling gradually sidesteps a distressed-pricing feedback loop. In any case, asset managers were given flexibility to make their own decisions about the trade-off.

To restore credit flows, Sweden moved quickly to provide incentives to bank owners to inject additional capital into their banks or to inject government capital into banks directly, when necessary. Asset management companies played a key role in restoring the financial health of the non-bank companies they were operating. Some viable corporations were allowed to survive through capital injections, though in return the government acquired a majority of their shares so that taxpayers could profit from any upside. Recapitalised institutions could return to ordinary operation, gradually rebuilding the creditworthiness of the overall economy.

Sweden’s success at maintaining market discipline was perhaps more limited. Ideally, discipline is sustained by not saving undisciplined investors through issuing blanket guarantees and unlimited liquidity. In Sweden’s case, policymakers avoided the liquidity pitfall but ended up guaranteeing bank liabilities before the banks themselves were taken over. Edward Kane and Daniela Klingebiel have suggested an alternative to such incentive-skewing guarantees. They have argued that the optimal response to a systemic banking crisis is to call a bank holiday long enough for examiners to determine which banks are viable, while still giving insured depositors access to their funds. Doing so would insure business as usual for insured depositors without permitting uninsured investors to cash out before they’ve taken their share of unrecoverable losses.

Most of the criticisms that can be levelled at the Swedish crisis resolution are easy to make in hindsight. Overall, Sweden’s financial crisis containment and resolution strategy largely avoided mistakes that would skew uninsured investors’ incentives going forward. Its policies were enacted transparently, insured political independence, and attempted to restore credit flows in the broader economy. The Swedish case illustrates the trade-offs and considerations of market discipline that crisis managers must address if they are to minimise taxpayer losses and speed the return to a rebalanced, growing economy.

Recommended reading

Caprio, Gerard, William Hunter, George Kaufman, and Danny Leipziger, 1998, “Preventing Bank Crises: Lessons from Recent Global Bank Failures”, Federal Reserve Bank of Chicago and the EDI of The World Bank, Washington, D.C.

Diamond, Douglas W. “Should Banks Be Recapitalized?” 2001. Federal Reserve Bank of Richmond, Economic Quarterly, vol. 87, 71–96.

Ergungor, O. Emre. “On the Resolution of Financial Crises: The Swedish Experience,” 2007. Federal Reserve Bank of Cleveland, Policy Discussion Papers, no 21.

Ergungor, O. Emre and James B. Thomson. “Systemic Banking Crises,” 2006. In Research in Finance, edited by Andrew H. Chen. Elsevier.

Kane, Edward J. and Daniela Klingebiel. “Alternatives to Blanket Guarantees for Containing a Systemic Crisis,” 2004. Journal of Financial Stability, September, 31–63"

banks load up on exposures when measured risks are low, only to shed them as fast as they can when risks materialise

TO BE NOTED: From Vox:

"Securitisation and financial stability

Hyun Song Shin 18 March 2009

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Did securitisation disperse risks? This column argues that it undermined financial stability by concentrating risk. Securitisation allowed banks to leverage up in tranquil times while concentrating risks in the banking system by inducing banks and other financial intermediaries to buy each other’s securities with borrowed money.

Financial booms and busts are as old as finance itself, but the current global financial crisis has the distinction of being the first post-securitisation crisis. Securitisation refers to banks’ practice of parcelling and selling loans to other investors. Securitisation was meant to disperse risks associated with bank lending so that deep-pocketed investors who were better able to absorb losses would share the risks.

But in reality, securitisation worked to concentrate risks in the banking sector. In a paper published this week (Shin 2009)), I argue that there was a simple reason for this. Banks wanted to increase their leverage ( NB DON ) – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself.

Against received wisdom

To understand the true role played by securitisation in the current financial crisis, we need to dispose of two pieces of received wisdom concerning securitisation - one old, one new. The old view, now discredited, emphasised the positive role played by securitisation in dispersing credit risk, thereby enhancing the resilience of the financial system to defaults by borrowers.

But having disposed of this old conventional wisdom, the fashion now is to replace it with a new one that emphasises the chain of unscrupulous operators who passed on bad loans to the greater fool next in the chain. We could dub this new fashionable view the “hot potato” hypothesis. The idea is attractively simple and blames a convenient villain, so it has appeared in countless speeches given by central bankers and politicians on the causes of the subprime crisis.

But the new conventional wisdom is just as flawed as the old one. Not only does it fall foul of the fact that securitisation worked well for thirty years before the subprime crisis( NB DON ), it fails to distinguish between selling a bad loan down the chain and issuing liabilities backed by bad loans. By selling a bad loan, you get rid of the bad loan from your balance sheet. In this sense, the hot potato is passed down the chain to the greater fool next in the chain. However, issuing liabilities against bad loans does not get rid of the bad loan. The hot potato is sitting on your balance sheet or on the books of the special purpose vehicles that you are sponsoring. Thus, far from passing the hot potato down the chain to the greater fool next in the chain, you end up keeping the hot potato. In effect, the large financial intermediaries are the last in the chain. They are the greatest fool. While the investors who buy your securities will end up losing money, the financial intermediaries that have issued the securities are in danger of larger losses. Since the intermediaries are leveraged, they are in danger of having their equity wiped out, as many have painfully learned.

Figure 1. Total subprime mortgage exposure

Source: Greenlaw, Hatzius, Kashyap and Shin (2008)

Indeed, Greenlaw, Hatzius, Kashyap and Shin (2008) report that, of the approximately $1.4 trillion total exposure to subprime mortgages, around half of the potential losses were borne by US leveraged( NB DON ) financial institutions, such as commercial banks, securities firms, and hedge funds (see Figure 1). When foreign leveraged institutions are included, the total exposure of leveraged financial institutions rises to two-thirds. So, far from passing on the bad loan to the greater fool next in the chain, the most sophisticated financial institutions amassed the largest holdings of the bad assets – they were the greatest fools.

It’s all about leverage ( NB DON )

Securitisation should be viewed in the larger context of balance sheet management by banks. Financial intermediaries manage their balance sheets actively in response to shifts in measured risks. In the name of modernity and price-sensitive risk management, banks load up on exposures when measured risks are low, only to shed them as fast as they can when risks materialise. The supply of credit is the outcome of such decisions and depends sensitively on key attributes of intermediaries' balance sheets. Three attributes merit special mention – equity, leverage, and funding source. The equity of a financial intermediary is its risk capital that can absorb potential losses. Leverage is the ratio of total assets to equity and reflects the constraints placed on the financial intermediary by its creditors on the level of exposure for each dollar of its equity. Finally, the funding source matters for the total credit supplied by the financial intermediary sector as a whole to the ultimate borrowers.

At the aggregate sector level (i.e. once the claims and obligations between leveraged entities have been netted out), the lending to ultimate borrowers must be funded either from the equity of the intermediary sector or by borrowing from creditors outside the intermediary sector. Aggregate lending to end-user borrowers by the banking system must be financed either by the equity in the banking system or by borrowing from creditors outside the banking system. For any fixed profile of equity and leverage across individual banks, the total supply of credit to ultimate borrowers is larger when the banks borrow more from creditors outside the banking system.

In a traditional banking system that intermediates between retail depositors and ultimate borrowers, the total quantity of deposits represents the obligation of the banking system to creditors outside the banking system. However, securitisation opens up potentially new sources of funding for the banking system by tapping new creditors. The new creditors who buy the securitised claims include pension funds, mutual funds, and insurance companies, as well as foreign investors such as foreign central banks. Foreign central banks have been a particularly important funding source for residential mortgage lending in the US.

As balance sheets expand, new borrowers must be found. When all prime borrowers have a mortgage, but balance sheets still need to expand, banks have to lower their lending standards in order to lend to subprime borrowers. The seeds of the subsequent downturn in the credit cycle are thus sown.

When the downturn arrives, the bad loans are either sitting on the balance sheets of the large financial intermediaries, or they are in special purpose vehicles that are sponsored by them. This is so since the bad loans were taken on precisely in order to utilise the slack on their balance sheets. Although final investors such as pension funds and insurance companies will suffer losses, too, the large financial intermediaries are more exposed in the sense that they face the danger of seeing their capital wiped out. The “hot potato” was sitting inside the financial system, carried by the largest and most sophisticated financial intermediaries. The severity of the current financial crisis attests to this feature.

References

Greenlaw, David, Jan Hatzius, Anil Kashyap and Hyun Song Shin (2008) “Leveraged Losses: Lessons from the Mortgage Market Meltdown” US Monetary Policy Forum Report No. 2.

Shin, Hyun Song (2009) “Securitisation and Financial Stability” paper presented as the Economic Journal Lecture at the Royal Economic Society meeting, Warwick, March 2008."

Policy must be carried out swiftly and openly, aiming at saving banks, not their owners or managers.

TO BE NOTED: From Vox:

"The Swedish model for resolving the banking crisis of 1991-93: Is it useful today?

Lars Jonung 14 March 2009

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Sweden's fix of its banks in the early 1990s is considered a model for today’s policymakers. This column reviews the main features of the Swedish approach and discusses its applicability to today’s banking problems. Policy must be carried out swiftly and openly, aiming at saving banks, not their owners or managers.

The Swedish banking crisis was part of a major financial crisis that hit the Swedish economy in 1991-93. Its origin should be traced to financial liberalisation in the mid-1980s that triggered a rapid lending boom. The pegged exchange rate for the krona prevented monetary policy from mitigating the boom by means of interest rate increases. The boom turned into bust and crisis around 1990, threatening a meltdown of the banking sector. The response of policymakers developed into the Swedish model for bank resolution. It comprises the following seven key features.

The Swedish model for bank resolution

Political unity

A central feature was the political unity across party lines which underlay the bank resolution policy from the very start. The Centre-Right government and the political opposition - the Social Democrats - joined forces and avoided making the banking crisis into a partisan political issue. This unity, initially forged by the determination of the major political parties to defend the pegged exchange rate of the krona, lasted throughout the crisis. Political unity guaranteed the passage through the Swedish parliament, the Riksdag, of measures to support the financial system. It also created policy trust amongst voters.

Blanket guarantee of bank deposits and liabilities

The Swedish government, in cooperation with the opposition, announced in a press release on 24 September 1992 – a critical month when currency pegs in several European countries were successfully attacked – that depositors and other counterparties of Swedish commercial banks were to be fully protected from any future losses on their claims. The guarantee was successful in the sense that foreign confidence in the solvency of the Swedish commercial banks remained intact.

In addition, this measure proved highly beneficial, as it expanded the options for the Riksbank to support commercial banks regardless of their financial position. The government guarantee of bank liabilities gave the Riksbank the option to lend to any commercial bank operating in Sweden, even to those that were on the brink of insolvency.

Swift policy action

Once it was fully understood that a serious financial crisis was in the making, the government, the Riksdag, and the Riksbank responded by taking decisive steps to support the financial system, in particular to help banks in distress. In this way, the confidence of depositors and counterparties in the financial system was strengthened at an early stage of the financial crisis by swift and determined action. Throughout the resolution of the crisis, confidence could then be maintained at a relatively low political cost.

An adequate legal framework based on open-ended funding

In December 1992, the Riksdag, passed legislation by an overwhelming majority to establish a Bank Support Authority, Bankstödsnämnd, as envisaged in the press release of 24 September 1992. The parliament approved open-ended funding for the Bankstödsnämnd, rather than settling for a predetermined fixed budget. This was a deliberate choice in order to avoid the risk that the Bankstödsnämnd would be forced to go back to the Riksdag to ask for additional funding at a later stage. The open-ended funding underpinned the credibility of the bank resolution policy.

The Bankstödsnämnd was set up as an independent agency at arm's length distance from the government, the Riksbank, and the Finansinspektion (the financial supervisory authority) to underline its independence. This construction fostered credibility and trust in its operations. The opposition was given full insight into its activities. The agency was staffed by professionals, and it began operation in the spring of 1993, shortly after being established.

Full information disclosure

Banks that turned to the Bankstödsnämnd with requests for support were obliged to give disclosure of all their financial positions, opening their books completely to scrutiny. This requirement facilitated the resolution policy and made it acceptable in the eyes of the public.

Differentiated resolution policy to maintain the banking system and prevent moral hazard

Banks that turned to the Bankstödsnämnd were dealt with in a way that minimised moral hazard. The policy priority was to save the banks, not the owners of banks or the bank managers. Banks in trouble were first asked to obtain capital from their shareholders. If they were not able to do so, present owners would have to surrender control and ownership before public support was given. Faced with this threat, private banks in Sweden made great efforts to raise capital from their owners. One bank, the SEB, decided to withdraw its request for government support. Banks that were in temporary difficulties could ask for government guarantees.

Out of six major banks, two were not expected to be profitable in the long run. They were taken over by the government with the aim of being re-privatised. Their assets were split into a good bank and a bad bank, the “toxic” assets of the latter being dealt with by asset-management companies set up by the Bankstödsnämnd, which focused solely on the task of disposing of them. When transferring assets from the banks to the asset-management companies, the government applied cautious market values, thus putting a floor under the valuation of such assets, mostly real estate. This restored demand and liquidity, and thus put a break on falling asset prices. The "good" assets of the two failed banks were transferred to a new bank that eventually emerged as Nordea, now one of the major Nordic banks.

The role of macroeconomic policies in ending the crisis

The bank resolution was facilitated by monetary and fiscal policy. The fall of the pegged exchange rate of the krona on November 19, 1992, following heavy speculative attacks, was an important move towards recovery. Once the krona was floating, it depreciated sharply, encouraging a rapid growth in exports. The ensuing fall in interest rates eased the pressure on the banking system. In July 1996, the crisis legislation and the blanket guarantee were abolished. The government allowed huge budget deficits to build up during the crisis, mainly as a result of the workings of automatic stabilisers, peaking at around 12% of GDP in 1993.

A successful bank resolution

The Swedish bank resolution was successful. Sweden's banking system remained intact. It continued to function with no bank runs and hardly any signs of a credit crunch. It remained largely privately owned and became profitable shortly after the crisis.

In the long run, the net fiscal cost - the 'cost to the taxpayer' - turned out to be very low, close to zero. Figure 1, displaying the net fiscal costs for 39 systemic banking crises in 1970-2007, demonstrates Sweden's favourable ranking with a net fiscal cost of almost zero. The gross fiscal cost for the bank support policy amounted to around 4% of GDP initially.

Figure 1. Net fiscal costs from systemic banking crises, 1970-2007, per cent of GDP.

Source: Jonung (2009).

Can the Swedish model be exported?

Answering this question requires comparing the Swedish crisis of the early 1990s with the present global crisis. On a very general level, the similarities are striking. The two crises are both financial crises driven by identical forces – a boom fuelled by lax monetary policy and negligent financial oversight, later turning into a bust.

On the other hand, there are considerable differences. The Swedish crisis of the early 1990s was primarily a local phenomenon, or – more accurately - a Nordic one, as Finland and Norway also went into crisis at roughly the same time as Sweden. Being a small open economy, Sweden was able to abandon its pegged rate and obtain a significant and lasting depreciation of its currency that contributed to strong recovery. This option is hardly open to an individual country today because the present crisis is global.

The small size of the Swedish financial system in the 1990s facilitated the bank resolution policy. Policy-makers dealt with a limited number of banks - only six major banks - in an overall environment of trust in the banking system. This is in sharp contrast to the current situation in the US, for example, with thousands of banks of different types and many non-bank financial actors, and where public trust in the financial system and its actors (“Wall Street”) is extremely low.

The Swedish bank resolution policy was faced with a financial system that was much less sophisticated and much less globalised than the financial systems of today. There were no structured products, no sophisticated derivatives, hardly any hedge funds, less securitisation, and so on. Indeed, the ongoing crisis has been difficult for the authorities to manage, in part, because some traditional central banking tools – especially in the UK and the US – are not well suited, either legally or architecturally, to provide liquidity for the institutions most in need, including investment banks and insurance companies.

In addition, Sweden has a tradition of substantial public confidence in its domestic institutions, political system, and elected representatives. Such social capital made it easy for the government and opposition to reach swift and stable agreements on policy actions.

Lessons for today

In spite of the differences between Sweden in the early 1990s and the world today, the Swedish experience holds lessons. A policy to support the financial system benefits from political unity and from being carried out swiftly and openly. The aim should be to save banks in distress, not their owners or managers. This minimizes moral hazard. The resolution policy should be implemented within a consistent and all-encompassing strategy, having a legal framework in which the administration of the support is left to experts acting at arm's length from the government, the central bank, and the financial supervisory authority. The support benefits from being financially open-ended to ensure the solvency of the financial system. The support should also be designed in a way that the public perceives as fair and just.

The Swedish case illustrates that the task of government during a financial crisis, or - in popular terms - the task of the taxpayer, is to serve as the capitalist or investor of last resort by recapitalising the financial system, thus dampening the effects of the financial breakdown on the real economy.

The Swedish formula cannot be fully imported by other countries due to institutional differences. Still, its guiding principles are applicable outside Sweden today, most prominently in four areas. First, the Swedish experience demonstrates that the threat of public receivership or nationalisation should be a real one as it forces the private sector to find private solutions. Second, the Swedish record suggests that banks in distress, nationalised as well as in private hands, should be split into a good and a bad bank, in order to get the financial system swiftly working again – more precisely, bad assets should be taken off the balance sheets of banks to prevent them from becoming "zombie" banks. Third, the bank resolution policy credibility is significantly enhanced by an open-ended financial commitment by the government. Fourth and finally, policy action should be swift and decisive to arrest the negative feedback loops arising during a financial crisis.

To sum up, the Swedish model of bank resolution should be used as a general template for countries facing financial crisis, but these countries will need to adapt the details of the implementation to their own circumstances.

Editors’ Note: The views expressed here are those of the author.

References

Jonung, L., (2009) "The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful." European Economy, Economic papers 360, European Commission, February 2009, Brussels.

---

The idea of a good-bad bank solution was actually inspired by the US experience of bank resolution.

The Swedish record looks attractive compared to that of Japan, where the banking system remained in distress for a much longer period than in Sweden."

However, there is no way to prevent bubbles and crises from emerging.

From Vox:

"Edward J. Kane
3 March 2009

This column introduces Edward J. Kane’s new Policy Insight on the incentive roots of the securitisation crisis

The disastrous meltdown of structured securitisation represents a dual failure of market discipline and government supervision. At every stage of the securitisation process, incentive conflicts tempted private and government supervisors to short-cut and outsource duties of due diligence that they owed not only to one another, but to customers, investors, and taxpayers.

When commissions and other fees for service are paid upfront, managers and line employees of firms that originate, securitise, rate, or insure loans fear that they are passing up short-run income whenever they nix a questionable deal. At the same time, accountants, appraisers, and even government supervisors know that they can win business from competing enterprises in the short run by establishing a reputation for not challenging a troubled client’s dodgy representations about asset values or assessing its efforts to transfer risks off balance sheet as conscientiously as a third party might suppose.

For government supervisors, incentive conflicts trace principally to short horizons, clientele influence, and pressure to support the expansion of homeownership for low-income households. As credit spreads increased in 2007-08, these incentive conflicts led authorities to temporise by adopting policies that risked allowing the depth and duration of the crisis to increase. Ignoring the lessons of the Savings and Loan (S&L) Mess, Federal Reserve press releases (e.g., that of March 16, 2009) and speeches by Chairman Bernanke and New York Federal Reserve President Geithner repeatedly misframed the difficulties that highly leveraged and short-funded institutions faced in rolling over their debt as evidencing a shortfall in aggregate market liquidity rather than volatile and widespread concerns about the individual solvency of troubled institutions.

CEPR Policy Insight No. 32 attributes the ongoing financial crisis instead to economic and political difficulties of monitoring and controlling the production and distribution of safety-net subsidies. Crisis pressures will not relent until access to safety-net subsidies has been capped and managers and authorities acting together find a way to quell doubts about the future viability of institutions known to be struggling with outsized losses. This can be done in the short run by temporarily nationalising zombie firms and by producing and publicising convincing forensic evidence that their insolvency has been repaired.

Structured securitisations may be visualised as manufacturing risk exposures in a series of work stations located alongside a conveyor belt. The different stations produce contracts that create, disguise, assess, reassign, or insure the risk exposures that move steadily along the belt. Society’s problem is that, during the bubble, Product-Quality Inspectors located at each station (i.e., supervisors) were using their computer scanners to entertain themselves rather than to inspect the quality of the work passing by.

More supervision is not the solution

Although it is dishonest, it is natural for supervisors to blame the poor quality of the final product on weaknesses either in their lines of sight or in the supervisory equipment they had to work with. But giving supervisors more and better scanners or relocating their work stations will not cure the root problem.

The root problem is the de facto corruption of supervisory incentives that poorly monitored safety-net subsidies create and sustain. TARP recipients paid out $76.7 million on lobbying and $37 million on federal campaign contributions in 2008 and (through Feb 2, 2009) received access to $295.2 billion in TARP funds. The ratio of lobbying expense to TARP receipts suggests that, during the initial stages of the crisis, financial institutions have reaped extraordinary benefits from investing in efforts to scare federal officials and to tell them how “best” to dispel crisis pressures. Following this self-interested advice has been ineffective partly because the return from expanding large firms’ investments in lobbying activity has dwarfed the return they could expect to earn from diligently attending to their ordinary business of intermediating the nation’s flow of savings and investment.

A medley of potentially effective reforms

Numerous complementary actions could improve the odds of getting less-destructive bubbles and better crisis management in the future. To be effective, a program of reform will have to rework in both the private and public sectors the way in which supervisory activities are performed and compensated. More importantly, it will have to make sure that compensation schemes and the division of labour mesh across private and governmental elements of the financial-engineering transaction chain.

It is convenient to consider first some purely private-sector reforms. This will occur if and only if the reform is seen to improve the competitive positions of firms that adopt it. The first reform is to incorporate explicit and effective contractual clawbacks for subsequent interruptions in securitised cash flows into the contracts of employees and firms at all stages of securitisation. It is unwise to allow employees and firms that can make, securitise, or over-rate bad loans to collect compensation in advance without bonding their work by accepting liability for future defaults. Second, much like the bottom lines of corporate income and balance-sheet statements, the evolving value of the pools of assets backing various securitised claims needs to be tracked and reported explicitly at regular intervals (say, monthly). This would make it easier for investors and supervisors to identify securitisation chains in which the performance of due diligence is subpar. Third, credit-rating organisations must change the way they rate asset-backed securities and take explicit responsibility for errors they make in rating them.

To improve incentives in government requires reworking the employment contracts of top officials in ways that would define their missions more sharply and make them personally accountable for outsized safety-net expenses. Building on the information used to construct bankruptcy plans at regulated firms, I would require regulators to establish, publicise, and test regularly a benchmark market-mimicking scheme for crisis management. To help them to put crisis-management plans into operation more promptly, I would also require regulators to collect and analyse estimates of safety-net subsidies from every regulated institution and consolidate these estimates in ways that would track over time the aggregate value of safety-net subsidies for the firms they supervise.

Because these reforms would make the jobs of top regulators more difficult, I would also raise the salaries of these officials. However, to lengthen the horizons of safety-net managers, I would fund this raise as deferred compensation that would have to be forfeited if a crisis occurred within three or five years of their leaving office. This would have the further benefit of making new appointees more cognizant of unresolved problems that his or her predecessor might be leaving behind. To discourage elected officials from trying to win special breaks for firms that contribute money to their campaigns, I would require that regulatory personnel report fully on interactions with elected officials that occur outside the public eye.

A third approach to sharpening monitoring and loss-control responsibilities would be to establish schemes in which private and governmental monitors could hold one another responsible for the quality of their work. For example, it has been widely proposed that safety-net managers be required to move trading in over-the-counter derivative and other securities to clearinghouses or exchanges when and as their volume becomes large enough to pose material safety-net consequences.

However, there is no way to prevent bubbles and crises from emerging.

References

Timothy Geithner, The Current Financial Challenges: Policy and Regulatory Implications, Remarks at the Council on Foreign Relations Corporate Conference 2008, New York City, Mar. 6"

Me:

Lobbying And Implicit Guarantes

On March 3rd, 2009 Don the liberta... says:

"Although it is dishonest, it is natural for supervisors to blame the poor quality of the final product on weaknesses either in their lines of sight or in the supervisory equipment they had to work with. But giving supervisors more and better scanners or relocating their work stations will not cure the root problem.

The root problem is the de facto corruption of supervisory incentives that poorly monitored safety-net subsidies create and sustain. TARP recipients paid out $76.7 million on lobbying and $37 million on federal campaign contributions in 2008 and (through Feb 2, 2009) received access to $295.2 billion in TARP funds. The ratio of lobbying expense to TARP receipts suggests that, during the initial stages of the crisis, financial institutions have reaped extraordinary benefits from investing in efforts to scare federal officials and to tell them how “best” to dispel crisis pressures. Following this self-interested advice has been ineffective partly because the return from expanding large firms’ investments in lobbying activity has dwarfed the return they could expect to earn from diligently attending to their ordinary business of intermediating the nation’s flow of savings and investment."

This is why insurance won't work. The large banks already have it through lobbying.

"For government supervisors, incentive conflicts trace principally to short horizons, clientele influence, and pressure to support the expansion of homeownership for low-income households. As credit spreads increased in 2007-08, these incentive conflicts led authorities to temporise by adopting policies that risked allowing the depth and duration of the crisis to increase. Ignoring the lessons of the Savings and Loan (S&L) Mess, Federal Reserve press releases (e.g., that of March 16, 2009) and speeches by Chairman Bernanke and New York Federal Reserve President Geithner repeatedly misframed the difficulties that highly leveraged and short-funded institutions faced in rolling over their debt as evidencing a shortfall in aggregate market liquidity rather than volatile and widespread concerns about the individual solvency of troubled institutions."

They also failed to notify everyone that these major banks and financial concerns had an implicit government guarantee to intervene in a crisis, because allowing them to fail would not be a viable option under current realities.

However, I believe that a return to narrow banking could help keep this from happening again, at least to this extent. But who the hell really knows?

This column presents an opinionated synthesis of the key issues and proposals with the aim of focusing and stimulating the debate.

From Vox:

Thomas Philippon
15 February 2009

Proposals for financial regulatory reform are everywhere. This column presents an opinionated synthesis of the key issues and proposals with the aim of focusing and stimulating the debate.

The global crisis has scared the public, captivated policy makers, and fascinated the academic community. A consensus has emerged that the financial system is broken and must be fixed. This column puts forth an opinionated overview of the various reports and proposals for new financial regulations in an attempt to stimulate and focus discussion.

I do not describe the crisis itself since much has already been written about it. Brunnermeier (2008) and Hellwig (2008) provide excellent analysis of the early part of the crisis, the Policy Recommendations from NYU Stern (2009) has a complete coverage, and Blanchard (2008) offers a clear and concise macroeconomic perspective.

Three key reports

I will mostly focus on three reports:

· The “Geneva Report” (Brunnermeier, Crocket, Goodhart, Persaud, and Shin;

· The “G30 Report” by the Group of Thirty, chaired by Paul Volcker; and

· The “NYU-Stern Report” by a group of professors from NYU’s Stern School of which I am one.

These three reports cover most, if not all, areas of financial regulation. I also discuss the capital insurance proposals of Kashyap, Rajan and Stein (2008), and the proposals of Zingales (2008, 2009).

SECTION 1: The failures of current regulations

There is much agreement regarding the shortcomings of current regulations. Let me focus on five specific areas.

Systemic risk. All reports agree that the financial regulatory frameworks around the world pay too little attention to “systemic risk”. For instance, Acharya, Pedersen, Philippon and Richardson (2009) argue that “Current financial regulations seek to limit each institution’s risk seen in isolation; they are not sufficiently focused on systemic risk. As a result, while individual risks are properly dealt with in normal times, the system itself remains, or is induced to be, fragile and vulnerable to large macroeconomic shocks.” Or, as the Geneva Report puts it: “regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. … a fallacy of composition.”

Pro-cyclical risk taking. All reports agree that current financial regulations tend to encourage pro-cyclical risking taking which increases the likelihood of financial crises, and their severity when they occur. Under current regulations, prolonged periods of low volatility reduce statistical measures of risk and thus encourage excessive risk taking. In bad times, the pendulum swings back producing excessive risk aversion.

Large Complex Financial Institutions (LCFIs). All reports agree that current regulations do not deal adequately with LCFIs, defining LCFIs as “financial intermediaries engaged in some combination of commercial banking, investment banking, asset management and insurance, whose failure poses a systemic risk or `externality’ to the financial system as a whole.” (Saunders, Smith and Walter 2009). All reports also insist on the danger induced by implicit Too-Big-To-Fail guarantees.

Capital requirements. All of the reports struggle with a paradox of financial regulation; capital held to meet minimum requirements cannot be used as a buffer against unexpected losses. As such, fixed capital requirements can only ensure that losses do not immediately make banks insolvent. They might give regulators enough time to intervene, but they are ineffective against systemic risk. The real buffer can only come from equity in excess of the requirements.

Liquidity and maturity mismatch. The traditional view of systemic risk focuses on sequences of bank failures, for example a domino-like spread of counterparty failures. Today’s financial system, where many banks finance their investments in credit markets, faces a different type of systemic risk. As the Geneva Report points out, “a key avenue through which systemic risk flows today is via funding liquidity combined with adverse asset price movements due to low market liquidity.” Acharya and Schnabl (2009) also explain why regulators should take liquidity into consideration when assessing capital adequacy ratios, and Hellwig (2008) insists on the maturity mismatch in vehicles that relied on short term market financing to fund long term assets (real estate assets in particular).

SECTION 2: Propositions for regulatory reforms

The various reports agree broadly on the principles that new regulations should follow – they should be based on rules rather than discretion, and they should address well-identified externalities (see Hart and Zingales, 2008). When it comes to concrete proposals, however, there are fewer practical ideas, and less agreement.

My goal here is not to be exhaustive, focusing rather on the issues that I view as most essential, and on the proposals that are sufficiently spelled out to be evaluated.

Systemic risk. The first step towards regulating systemic risk is to measure it. But how should we do that? In particular, how do we define how much a particular firm contributes to systemic risk? How can we improve Value at Risk (VaR) measures?

There is some good news on the VaR front. There are currently two proposals to incorporate systemic risk into the standard measures. The Geneva report argues for CoVaR, based on the work of Adrian and Brunnermeier (2008), where CoVaR is the VaR of financial institutions conditional on other institutions being in distress. The NYU-Stern report proposes a systemic capital requirement based on the individual firm’s contribution to aggregate tail risk. These two measures have much in common, and are specifically tailored to deal with systemic as opposed to individual risks.

My view is that a combination of systemic and liquidity risk measures proposed by the NYU-Stern and Geneva Reports can considerably improve risk management practices inside financial firms, and, just as importantly, create the basis for a constructive dialogue between these firms and their regulator. At this stage, we need more empirical work to show that the proposed measures can indeed be used to identify institutions that pose systemic risk before a crisis hits.

As far as institutions are concerned, all reports also agree that Central Banks should be explicitly in charge of what the NYU-Stern Report calls “systemic regulations” and the Geneva Report calls “macro-prudential regulation”.

LCFIs, Moral Hazard and the Scope of Regulation. A key problem in improving LCFI regulation is that we do not have a good definition of LCFIs. The Geneva report argues that the best measures are leverage, maturity mismatch, and asset growth. These measures are certainly useful, but it is difficult to argue that they differentiate systemic from individual risks: a firm with high leverage and maturity mismatch would already be classified as individually risky. Saunders, Smith and Walter (2009) argue that LCFIs should be identified based on measures of size in combination with measures of complexity or interconnectedness. The difficulty is that we do not have readily available measures of complexity and interconnectedness.

LCFIs are particularly problematic because they are too-big-to-fail. This is in part because we do not have the procedures to deal with their failures. Altman and Philippon (2009) “advocate the creation of specific Bankruptcy procedures to deal with LCFIs.” Zingales (2008, 2009) argues that we need a “new piece of legislation introducing a new form of bankruptcy for banks, where derivative contracts are kept in place and the long-term debt is swapped into equity.” The G30 report argues that “legislation should establish a process for managing the resolution of failed non depository financial intuitions comparable to the process for depository institutions.” Thus, there is broad agreement on what is needed, but, as far as I am aware, there are few concrete proposals about how to deal with the mind-boggling complexity of the issue. Chapter 11 was deemed too risky for the standard (if large-scale) bankruptcy of General Motors. How far are we, then, from a procedure that we could use to deal with the failure of financial Godzillas such as AIG or Citigroup?

Hedge funds and similar. The reports do not present a consensus on the critical issue of what to do with the largely unregulated sector of hedge funds and private equity. Should we impose systemic regulations to a “group of institutions” if they are interconnected and can collectively pose systemic risks even though they appear individually small? My view is that we should, but I would not know how to start.

Capital requirements and cyclical risk taking. The reports suggest that capital adequacy requirements should incorporate liquidity risk, and that they should be tightened in good times – when systemic risk is building up but has not yet been realized – and should be loosened in bad times when banks need a breathing space to weather the crisis.

I see mostly good news on the liquidity front. The G30 Report proposes “norms for maintaining a sizeable diversified mix of long term funding and an available cushion of highly liquid unencumbered assets.” The NYU-Stern report argues that, in order to limit regulatory arbitrage, “regulation should not be narrowly focused on a single ratio of bank balance-sheet,” and should take into account “liquidity to assets ratio” (measured only through stress-time liquidity). The Geneva report has a well-articulated proposal for regulating liquidity and maturity mismatch (their Chapter 5 is a must-read in my opinion).

Unfortunately, I have not seen as much progress on the issue of cyclical risk taking. As Blanchard (2008) explains, “pro-cyclical capital ratios, in which capital ratios increase either in response to activity or to some index of systemic risk, sound like an attractive automatic stabilizer. […] The challenge is clearly in the details of the design, the choice of an index, the degree of pro-cyclicality.” The Geneva report argues that “macro-prudential regulation should be countercyclical and lean against bubbles,” but does not propose an index against which the cycle should be measured.

The Group of Thirty report is even vaguer, since it simply advocates tighter benchmarks when “markets are exuberant and tendencies for underestimating risk are great.” This hardly sounds like the starting point of a useful regulatory debate. The NYU-Stern report argues that stress tests for systemic risk capital can be used to construct a-cyclical risk measures. This is a more precise and practical idea, but it is not clear that this will be enough to create pro-cyclical regulations.

I very much doubt that we can agree on a set of objective measures of ‘excessive’ credit expansion (let alone bubbles). I think that the best we can expect is a powerful regulator running systemic stress tests based partly on historical data and partly on subjective forward looking scenarios. The critical issue in my view does not lay in the construction of an appropriate cyclical index, but rather in making sure that the regulator is powerful enough to enforce tighter prudential regulations based in part on subjective and debatable interpretations of economic data. The financial industry will not like it, and it has a strong track record of capturing its regulators, so this will not be easy.

Recapitalization during crises. This is probably the most controversial and most interesting topic. In times of crisis, asset values decline, and banks tend to curtail lending and liquidate assets in order to control their leverage. These actions increase systemic risk. It would be more efficient to recapitalize the banks automatically at the first sign of crisis.

An interesting idea is to create recapitalization requirements, in addition to capital requirements. One way to do so is to force levered financial institutions to issue securities that provide automatic recapitalization if the firm’s value decreases. Wall (1989) proposed subordinated debentures with an embedded put option. Doherty and Harrington (1997) and Flannery (2005) proposed reverse convertible debentures. These securities limit financial distress costs ex-post without distorting bank managers’ ex-ante incentives.

In a thought-provoking paper, Kashyap, Rajan and Stein (2008) argue that the idea of automatic recapitalization can be applied to systemic risk. They propose a capital insurance scheme based on systemic risk. Each bank would buy capital insurance policies that would pay off when the overall banking sector is in bad shape. The insurer would be a pension fund or a sovereign wealth fund that would essentially provide fully funded `banking-industry catastrophe insurance’. Kashyap, Rajan and Stein explain that “a bank with $500 billion in risk-weighted assets could be given the following option by regulators: it could either accept a capital requirement that is 2% higher, meaning that the bank would have to raise $10 billion in new equity. Or it could acquire an insurance policy that pays off $10 billion upon the occurrence of a systemic event.”

The issue with this proposal is that it does not provide a link between a firm’s own contribution to aggregate losses and the insurance it must get. The policy pays off $10 billion regardless of the health of the bank at that point. The financial institution still has the incentive to lever up, take concentrated bets, and build illiquid positions which may improve the risk/return profile of the firm but nevertheless increase the systemic risk in the system. The crisis has shown that this is a first order concern. Another limitation of this sort of proposal is that if the crisis is large enough, no amount of private money will ever be enough, and the Fed is always going to be the lender of last resort. The mere existence of a LOLR creates moral hazard unless LOLR services are properly priced ex-ante.

The NYU-Stern report proposes solutions to these problems (Acharya, Pedersen, Philippon and Richardson 2009). One is to make the size of the required insurance policy proportional to the estimated systemic risk capital charge defined above in the section on systemic risk. Another is to specify that the insurance must cover the short fall from a pre-specified target: the bank would have to buy an insurance contract such that its equity is at least $50 billion upon the occurrence of a systemic event. If the bank had only $30 billion, the policy would pay off $20 billion, but if the bank had $55 billion, the policy would pay nothing. The bank would have an incentive to limit its systemic exposure in order to decrease its insurance premium.

The Geneva Report is sceptical: “We doubt whether additional private insurance can then help much on occasions when market and funding liquidity vanishes; the examples of the mono-lines and of AIG confirm our doubts.” The NYU-Stern Report argues that the scheme could be implemented with a mixture of private capital (if only for price discovery) and public capital.

Another important caveat is that capital insurance dominates capital requirements only to the extent that it is expensive to keep equity on banks’ balance. This is indeed the core motivation of Kashyap, Rajan and Stein (2008). But one can take the opposite view, in which case higher equity ratios would be a much simpler solution. Hellwig (2008) puts it eloquently: “At this point, the institutions concerned will protest that equity capital is expensive. I have yet to see a convincing argument showing that this protest is referring to social costs, rather than just the private costs to the bank manager of having to go to outside financiers and having to explain to them what he is doing and why his activities should merit their entrusting him with their money.”

My view is that having some insurance and, perhaps more importantly, some price discovery for the costs of systemic risk would be invaluable. It is therefore worth implementing such a system even if its scale is somewhat limited. I would also argue that an imperfect system is still preferable to ad-hoc LOLR interventions that create incentives for reckless risk taking ex-ante, and leave large liabilities for tax-payers ex-post.

SECTION 3: Conclusion

Let me offer two concluding thoughts.

1. Regarding financial regulations, the devil is in the details – and the successive failures of TARP versions 1.0, 2.0, etc. prove this point more than ever. We have enough agreement on the broad principles of financial regulations, and we need to get down to specifics. I would therefore consider any future report that does not include tables, figures, numbers, equations, and specific proposals to be useless rhetoric.

2. We need to be ready to take a tough stand on future regulations for institutions that are too-big-to-fail.

This issue reminds me of the paradox of free trade. The benefits of free trade are widespread and difficult to grasp, while its costs are concentrated and easily publicized. Public support for free trade is therefore structurally weak. Moral hazard created by implicit guarantees is also widespread and difficult to grasp. It shows up in spreads lowered by a few basis points here and there, in slight distortions of comparative advantages, and in overall weaker governance. But the costs of LCFI failures are large and concentrated. It is therefore tempting for regulators to focus too much on bailouts, and too little on incentives. But this is clearly the wrong policy for the long run. Incentives and accountability must be improved, even if it means fighting a regulatory battle with the industry.

Sir Winston Churchill famously remarked that “Britain and France had to choose between war and dishonour. They chose dishonour. They will have war.” If in the hope of ending the crisis quickly, we choose to bail out the banks without making their managers, shareholders and creditors accountable, then we choose dishonour, and we will have more devastating crises."

Me:

Causes Of This Crisis

On February 16th, 2009 Don the liberta... says:

"Moral hazard created by implicit guarantees is also widespread and difficult to grasp."

It's not that hard to grasp. Through lobbying, the large banks have purchased an insurance policy that implicitly guarantees that they will be bailed out in a financial crisis. Does anyone doubt that now? It is the main cause of this crisis, in that it allowed large and systemically important banks to forgo prudence and take ludicrous risks. The insurance premiums for systemic risk would either be huge or ineffective. The government has to guarantee certain banks to avoid Calling Runs and Bank Runs. Perhaps a Narrow/Limited Banking sector could be put in place that is guaranteed, to be complemented by other financial concerns which are not guaranteed, but cannot cause either Calling or Banks Runs.

You also don't mention Fraud, Mismanagement, Negligence, and Collusion, the second most important cause of this crisis. Do you really believe that subprime loans being handed out at the height of the housing bubble, when prices were at their peak, was completely honest and aboveboard? Please.

This is not an ordinary recession that differs from other recent episodes simply by being somewhat more severe. It differs in kind.

From Vox:

Axel Leijonhufvud
13 February 2009

This recession is different. Balance sheets of consumers, firms, and banks are under strain. The private sector is bent on reducing debt and this offsets Keynesian stimulus more than standard flow calculations would suggest. Bank deleveraging is by far the most dangerous. Fiscal stimulus will not have much effect as long as the financial system is deleveraging.

This is not an ordinary recession that differs from other recent episodes simply by being somewhat more severe. It differs in kind.

Past recessions and the reallocation of employment

The end of the Cold War brought a decline in military spending and a recession which impinged most heavily on the states, like California, where the military-industrial complex was an important part of the local economy. The nationwide unemployment rate rose from 5.25% in 1989 to 7.5% in 1992. It then fell every year reaching just under 4% in 2000. The “free market” took care of the recession of the early 1990’s. Resources moved from the defence industries, trickling into other uses through innumerable channels. The federal government did not need to take a hand. Beginning in 1993, the federal deficit in fact shrank every year turning into a modest surplus in 1998. That was a very ordinary recession.

If the current situation were at all similar we would expect a recession in residential construction with unemployment among construction workers and mortgage brokers. Naturally, recent boom areas would be hard hit but we would expect resources gradually to trickle into alternative employment. Instead, we are threatened by a veritable disaster.

Balance sheet recessions

What is the difference? It resides in the state of balance sheets. The financial crisis has put much of the banking system on the edge – or beyond -- of insolvency. Large segments of the business sector are saddled with much short-term debt that is difficult or impossible to roll over in the current market. After years of near zero saving, American households are heavily indebted.

The holes that have opened up in the balance sheets of the private sector are very large and still growing. A recent estimate by Jan Hatzius and Andrew Tilton of Goldman Sachs totes up capital losses of $2.1 trillion; Nouriel Roubini thinks the total is likely to be $3 trillion. About half of these losses belong to financial institutions which means that more banks are insolvent – or nearly so – than has been publicly recognised so far.

So the private sector as a whole is bent on reducing debt. Businesses will use depreciation charges and sell off inventories to do so. Households are trying once more to save. Less investment and more saving spell declining incomes. The cash flows supporting the servicing of debts are dwindling. This is a destabilising process but one that works relatively slowly. The efforts by financial firms to deleverage are the more dangerous because they can trigger a rapid avalanche of defaults (Leijonhufvud 2009).

The Japanese example

Richard Koo (2003) coined the term “balance sheet recession” to characterise the endless travail of Japan following the collapse of its real estate and stock market bubbles in 1990. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. At the same time it supported the real sector by repeated large doses of Keynesian deficit spending. It took a decade and a half for these policies to bring the Japanese economy back to reasonable health.

The Great Depression counterexample

The US Great Depression saw no consistent policy of deficit spending on adequate scale in the 1930’s. War spending not only brought the economy back to full resource utilisation but also crowded out private consumption to a degree (Barro 2009).¹ The deficits run during the war meant that:

1. At war’s end, the federal government’s balance sheet showed a debt of a size never before seen, but also
2. The balance sheets of the private sector were finally back in good shape.

At the time, a majority of forecasts predicted that the economy would slip back into depression once defence expenditures were terminated and the armed forces demobilised. The forecasts were wrong. This famous postwar “forecasting debacle” demonstrated how simple income-expenditure reasoning, ignoring the state of balance sheets, can lead one completely astray.

Lessons from the two cases: Fill the financial sinkholes first

The lesson to be drawn from these two cases is that deficit spending will be absorbed into the financial sinkholes in private sector balance sheets and will not become effective until those holes have been filled. During the years that national income fails to respond, tax receipts will be lower so that the national debt is likely to end up larger than if the banking sector’s losses had been “nationalised” at the outset.

Sweden’s successful policy mix: Don’t forget the mega devaluation

The Swedish policy following the 1992 crisis has been often referred to in recent months. Sweden acted quickly and decisively to close insolvent banks, and to quarantine their bad assets into a special fund.² Eventually, all the assets, good and bad, ended up in the private banking sector again. The stockholders in the failed banks lost all their equity while the loss to taxpayers of the bad assets was minimal in the end. The operation was necessary to the recovery but what actually got the economy out of a very sharp and deep recession was the 25-30% devaluation of the krona which produced a long period of strong export-led growth. Needless to say, the US is in no position to emulate this aspect of the Swedish success story.

Perils, present and future

Strong contractionary forces are at work in the US emanating both from the capital and the income accounts. Stabilisation requires major policy actions on both fronts.

• First, the financial system must be recapitalised so as to remove the relentless pressure to deleverage from the banks.
• Second, a spending stimulus sufficient to reverse the rapidly worsening decline in incomes must be administered.

When the entire private sector is bent on shortening its balance sheet and paying down debt, the public sector’s balance sheet must move in the opposite, offsetting direction. When the entire private sector is striving to save, the government must dis-save. The political obstacles to doing these things on a sufficient scale are formidable.

If banking system losses are of the magnitude estimated by Goldman Sachs or Roubini, the banks need capital injections of at least another $200-300 billion. Even if injections equal to all their losses could be effected, the banks might still want to contract, now that they know how dangerous their leverage of yesteryear was.

US policy: A strangely contrived way out of a political impasse

The American public understands clearly that the present disaster was fashioned on Wall Street (albeit with some stimulus from Fed policy). Outright bail-outs are a “hard sell” therefore. But the American ideological taboo against “nationalisation” also stands in the way of dealing with the matter in the straightforward way that Sweden did. The present administration, like the last, would like to recapitalise the banks at least partly by attracting private capital. That can hardly be accomplished as long as the value of large chunks of the banks’ assets remains anybody’s guess. Government guarantees against (some part of) losses that may be incurred might solve this problem. But it would be a strangely contrived way out of a political impasse.

Fiscal stimulus + financial deleveraging = zero impact

Fiscal stimulus will not have much effect as long as the financial system is deleveraging. Even if that problem were to be more or less solved, the government deficit would have to offset both the decline in industry investment and the rise in household saving – a gap that is rising as the recession deepens. Here, too, the public is sceptical and prone to conclude that a program that only slows or stops the decline but fails to “jump start” the economy must have been a waste of tax payers’ money. The most effective composition of such a program is also a problem.

US states and local governments undoing the federal spending boost

Almost all American states now suffer under self-imposed constitutional balanced budget requirements and are consequently acting as powerful amplifiers of recession with respect to both income and employment. The states will have a spending propensity of one, as will a great many local governments. Income maintenance for unemployed and other low income households will also be effective.³ Tax cuts will have considerably lower spending propensities. However, the political prospects seem to portend a less than ideal program mix.

The danger of deflation, or inflation

If government programs end up not being large enough to turn the recession around, we have to look forward to a deflationary period of indeterminate length. If they do succeed, however, severe inflationary pressures may surface quite quickly.

The US ratio of federal debt to GNP is not particularly high at this time. But it does not take into account the very large off-balance liabilities of entitlement programs. Since the present crisis began, moreover, the Federal Reserve System and other federal agencies have made bail-out, loan and credit guarantee commitments totalling many trillions of dollars with uncertain eventual implications for the consolidated federal balance sheet.

If the US’s foreign creditors balk, inflation will be hard to contain

Much will depend on the willingness of the nation’s foreign creditors to continue to accumulate or at least to hold dollars at low rates of interest. Should this willingness falter, inflation will be hard to contain.

There is much to fear beyond fear itself.

References

Robert Barro, 2009, “Government Spending is no Free Lunch” (Wall Street Journal, January 22).

Leijonhufvud, 2009 “Two Systemic Problems,” CEPR Policy Insight No. 29, January

Richard C. Koo, 2003, Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and its Global Implications, Singapore: Wiley

Footnotes

1 The crowding out at full employment, Barro thinks, “most macroeconomists would regard … as a fair [test case] for seeing whether a large multiplier ever exists” (italics added). Most macroeconomists will presumably agree that World War II was not a free lunch but are not likely to agree to Barro’s test case inference.

2 There were plenty of bad loans but at that time they did not have the non-transparent “toxicity” that “sliced and diced” CDO’s were to generate in the present crisis.

3 Milton Friedman’s negative income tax proposal seems to have become anathema to conservatives by now. It would work in our present situation.

Me:

An Excellent Post

On February 13th, 2009 Don the liberta... says:

An excellent post. I agree that:
1) We should use a version of the Swedish Plan.
2) The stimulus was a poor mix with too much infrastructure and not enough incentives.
3) Social Safety Net spending is essential, including aid to states for essential services. If unemployment gets much higher and people don't feel secure, serious social disruptions and dislocations could occur. This would be very bad news.
4) We cannot overspend because we don't know at what point foreign creditors will balk. ( Buiter )
5) I am for a guaranteed income in any case, but it would certainly be useful here as a Negative Income Tax.
6) The use of WW II for comparison is strange. What can be conspicuous consumption in a recession can be seen as treason during a world war.
I differ in that I believe that we need to use quantitative easing to attack debt-deflation, a la Fisher. I also believe that a massive stimulus could work as Shiller believes, but we do not have the money to try it in these circumstances.