idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate

TO BE FILED: From Vox:

"Global imbalances and the crisis: A solution in search of a problem

Michael Dooley Peter Garber 21 March 2009

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This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system.

The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
2. That the crisis was caused by easy monetary policy in the US.
3. That the crisis was caused by financial innovation.

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds¹ that do not generate systemic risks.

International capital flows

One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.² The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour.

If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.³ At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices.

We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets.

Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future.

Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system.

But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.⁴ The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.⁵ This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive.

Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour.

The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

Easy money and financial innovation

There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants.

Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis.

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.

Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books.

Conclusions

In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system.

References

Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11.
BIS 78^th Annual Report (2008).
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313.
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February).
Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009.
Economic Report of the President (2008)
Economist (2009) When a Flow Becomes a Flood,” January 22.
Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12.
Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations

Notes

1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be.
2. See Paulson (2008), Dunaway (2009).
3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices.
4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis.
5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior.

The fact is, banks do benefit from implicit and explicit government safety nets.

TO BE FILED: From the FDIC:

Speeches & Testimony

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Remarks By Sheila Bair Chairman, U.S. Federal Deposit Insurance Corporation; 2007 Risk Management and Allocation Conference, Paris, France
June 25, 2007

FOR IMMEDIATE RELEASE

Press Contact: Andrew Gray (angray@fdic.gov)
Ph: (202) 898-7192

Good morning, and thank you. According to the conference program, I'm to speak on "The Dream of a Single Global Standard." When they wrote that, I think someone must have had a sense of humor.

Or perhaps the question the conference sponsors really wanted to ask was: "When Will the Americans Finish the Rule?" Sorry to let you down. I'm not here to answer that question. But we are working on it. We want a consensus on appropriate safeguards that will allow our banks to implement Basel II.

Today, I would like to share my concerns about the advanced approaches. And then give you my sense of where we are in the process.

Eight years in the making

When I became FDIC Chairman last June, Basel II had been in the making since at least 1999, when the first consultative paper was published. Eight years is a long time for developing any regulation.

But the length of the process reflects the difficulty of building consensus on such an extraordinary and very complicated undertaking. Eight years of intensive technical consultation with large banks continues to this day.

There's also been significant evolution in the policy arena. The 1999 Basel Committee paper I mentioned, said there would be no reduction in capital requirements. That statement has since been modified, of course, to allow for some reduction in capital requirements to provide incentives to adopt the advanced approaches.

U.S. regulators have assured Congress that our intention was not to produce substantial reductions in capital requirements for the large banks adopting the advanced approaches. And my opinion on this has always been that we don't want capital reductions to be a tool of international competition. That is a game with no winners.

When I became Chairman, the Basel II process was already steeped in controversy in the U.S., and had been for some time.

As the new head of the U.S. deposit insurer, it was obviously my obligation to find out what the controversy was all about. So I learned as much as I could as quickly as I could. Frankly, the more I learned, the more uncomfortable I became. But given the long history of the process … I wanted to find a way to move forward. And the many safeguards that had already been built into the proposed rule helped give me comfort that we were moving ahead in a controlled and responsible manner. That is why I scheduled a meeting and voted to publish the Notice of Proposed Rulemaking just a few months after I became Chairman.

Protecting the capital cushion

The rulemaking included safeguards against unconstrained reductions in risk-based capital requirements. My support for the proposed rule was contingent on these safeguards.

The importance of the safeguards is not a personal point of view, but an institutional one. While all bank regulators are responsible for safety and soundness, the FDIC explicitly insures over $4.2 trillion in deposits. We also have a statutory mandate to promote public confidence in the U.S. banking system.

A critical point that everyone must keep in mind is that the Basel II framework was developed and debated during a very benign period of economic growth and strong bank profitability.

The recent trouble in U.S. sub-prime mortgages is a clear reminder of how fast and decisively market conditions can change. It points to the danger of thinking that banks will have enough lead-time to ramp up their capital as economic conditions deteriorate.

Some fear we may be approaching a more general turning point in the credit cycle. As regulators, we want to ensure that banks have a strong enough capital cushion to withstand a downturn.

For the last two decades, the Basel Committee keeps coming back to the same basic question: How much bank capital is enough?

The Four Risks

I don't think you can answer that question unless you consider four significant risks in connection with Basel II's advanced approaches.

Risk number one: The advanced approaches come uncomfortably close to letting banks set their own capital requirements. That would be like a football match where each player has his own set of rules. There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent.

The fact is, banks do benefit from implicit and explicit government safety nets.

Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure.

History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s.

The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.

Risk number two: The jury is still out on whether the Basel II advanced approaches can tie capital requirements to risk, as intended.

Why? Because the key risk inputs that drive the advanced approaches are subjective … unreliable and unproven.

Let me hasten to say that some large banks have internal risk-rating systems that do a good job of grading relative risks within their portfolios. But in the advanced approaches, if Bank A has a small capital requirement, and Bank B has a large capital requirement, we are supposed to assume that Bank A has a safer portfolio.

Unfortunately, in the advanced approaches, these two banks could simply be measuring identical risks in different ways. Regulators have taken appropriate care not to micro-manage internal ratings systems. But the resulting wide latitude in capital requirements could lead to inconsistency across banks. And it could lead regulators to accept capital requirements that are too low.

Risk number three: Even if banks and supervisors could somehow work together to average out the subjective and divergent risk inputs, the advanced framework may still deliver insufficient capital.

Let me use the U.S. residential mortgage market as an example, which all of you know is having problems. In our QIS-4 exercise, we looked at the potential capital impact of the advanced approaches. For all residential mortgages, the median reduction in capital requirements was 64 percent … and for home equity loans, it was 77 percent. More than a few of our 26 banks reported that their minimum risk-based capital requirement for mortgages went down by 90 percent or more.

To me, one of the most troubling aspects of Basel II is that a purely historic look at mortgage data might have justified such numbers. We also saw the same kind of aggressive reductions in capital requirements under the advanced approaches for most commercial real estate loans … and for many commercial and industrial loans … with median reductions exceeding 50 percent.

These kinds of results are simply unacceptable. Redefining capital requirements sharply downward in this way under the advanced approaches, risks increasing the fragility of the global banking system.

In response to such criticisms, many argue that supervisory diligence under Pillar 2 will somehow protect against inadequate capital under Pillar 1. More specifically, they say required stress-testing by banks will take care of any capital shortages under Pillar 1.

This brings me to the final risk on my list.

Risk number four: Despite the best of intentions … banks and supervisors may be ill-equipped to mitigate deficiencies in the advanced approaches. If the basic capital standards are unreliable, how can we have confidence that supervisory add-ons will be sufficient or consistent?

To put this in terms of the advanced approaches, neither banks nor regulators know how much stress to build into the capital calculations. This is far more than a technical problem for future research. There are real limitations on our ability to identify important changes in market practices as they are occurring and to think concretely about the implications.

Consider the U.S. sub-prime mortgage market that is having trouble. This market has some uniquely American characteristics, but it's a case study that all nations can learn from. Over the last few years, sub-prime mortgage lending grew dramatically as a percentage of the overall mortgage market. Most of us saw this as a very positive trend. It gave unprecedented access to home ownership and wealth, especially for low-income earners.

What we couldn't see until late in the game was how pervasive … and how quickly … risky lending practices had become. Borrowers with weak credit were offered loans with initial teaser rates that are now resetting at unaffordable higher rates, leaving these borrowers with mortgage obligations as high as 60 percent to 70 percent of income.

Loans were frequently made based on "stated income," without documentation. Many of these loans, some 2 million this year and next, will reset with the potential for widespread foreclosures.

I don't know of anyone in the regulatory community or the ratings agencies who really "connected the dots" on this problem until late last year. Certainly, we all knew sub-prime lending was a growing asset class. We all understood that borrowers were exposed to rising interest rates. And we all knew that home prices would not rise at double-digit rates forever. But it took a long time to see the problem, and now we're scrambling to fix it.

What's the lesson in all this?

If the regulators were behind the curve in discerning the risks in these widely-used and simple mortgage products, how can we expect to fully understand the risks in more complex and dynamic products, such as Collateralized Debt Obligations (CDOs), credit derivatives, and leveraged lending and hedge funds?

I believe the lesson here is that these products and markets pose risks and stresses that may be impossible to quantify. It's easy to assume that banks and supervisors will set a principles-based approach to build an appropriate level of stress into the advanced capital calculations. But I fear that in reality, the lag in identifying and understanding changes in market practices will make this very difficult.

To complicate matters, other incentives could emerge for some banks to boost return on equity, capture business and the like … which could drive stress-calculations the wrong way. The risk, of course, is that if we have an inadequate Pillar 1 capital requirement, supplemented by inadequate consideration of potential stress under Pillar 2, we will end up with inadequately capitalized banks.

Where are we?

So, where does that leave us? Wither Basel II? To be honest and frank, we don't yet know whether Basel II's advanced approaches will work. We don't know whether, or when, the risk inputs will become reliable. We don't know whether the level of minimum capital requirements will be sufficient. And nobody knows how to build enough stress into the capital calculations to address the non-transparent and ever-changing risks that banks are taking.

Given this uncertainty, regulators must proceed with caution. We're public servants, and that's our job. Safeguards against precipitous and open-ended declines in risk-based capital requirements should be removed only when the global framework has proved its capital sufficiency and reliability.

At this time we are still working through these issues in the United States, including whether to allow the standardized approach for all U.S. banks.

Conclusion

We've been at this a long time. But the stakes for our global banking system are very high. Today, our banks are strong and profitable. They are engines for job creation and economic growth. And I'm hopeful that we'll be able to resolve these four risks and move forward with Basel II in a way that assures the future health and stability of the global financial system.

Let there be no doubt. I support moving ahead with the Basel II framework and doing so expeditiously. No one wants this issue resolved more than I do. But I do not see how the FDIC can responsibly agree to remove important safeguards before we have evidence that the advanced approaches will work. That would be akin to trying to put the toothpaste back into the tube.

Thank you."