Global Financial Crisis

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GLOBAL FINANCIAL CRISIS
ISHRAT HUSAIN
July 12, 2012
AGENDA
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CONTEXT AND BACKGROUND
BRIEF CHRONOLOGY OF KEY EVENTS
CONTRIBUTORY FACTORS
WHAT WENT WRONG
RESPONSE TO THE CRISIS
IMPACT OF CRISIS IN PAKISTAN
SALIENT FEATURES AND LESSONS LEARNT
LESSONS ON CORPORATE GOVERNANCE OECD FINDINGS
LESSONS FOR SHAREHOLDERS KEY QUESTIONS TO ASK –
BOARD ASS...
2
Context and Background
 World economy has recorded fastest growth in the last 50
years ushering in an unprecedented era of prosperity for
the majority of the population. Even in this decade of slow
growth the global economy will grow to 10 to 20 percent
faster than it did a decade ago, 60 percent faster than it
did two decades ago, and five times as fast as it did three
decades ago.
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Context and Background
(Continued)
 Developing and emerging economies which were
impoverished and faced with poverty, hunger, illiteracy
have been able to make a remarkable turn around and
increased their share of world GDP from almost
negligible proportion to almost 50 percent. In 1980, the
number of countries that were growing at 4 percent a
year was around 60. by 2007, it had doubled to 120. even
now, after the financial crisis and recession the number is
more than 80. Then annual average growth rate in the
last decade was an impressive 6.4 percent.
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Context and Background
(Continued)
 Poverty has been reduced more in the past 50 years than in
the previous 500 years. About one billion people have
been lifted out of poverty since 1980. The proportion of
people living below the poverty line has dramatically fallen
from 52 percent to about 20 percent in this period.
 Between 2005 and 2010 both the poverty rate and the
number of people living in extreme poverty have fallen in
all the six developing countries, the first time that has
happened.
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Context and Background
(Continued)
 The World Bank projections show that the global
target of the Millennium Development Goals (MDG)
of halving World poverty has been achieved five years
early.
 Rising agriculture production has kept ahead of
population growth. World Food Production Index
rose by 75% in the last 20 years while population grew
by 50 percent in the same period.
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Context and Background
(Continued)
 Mobility of people, capital, ideas, goods and services
across country border has never been as high as in
the last two decades.
 Technological revolution inform of Internet, mobile
phones, cable and satellite TV, networking, have
made communication and connectivity easy and
physical distances shrink. Cell phones today have
more computing power the Apollo Space Capsule.
7
Context and Background
(Continued)
 World Trade growth has consistently outpaced world
output growth; Capital flows in form of portfolio
investment, loans equity investment, remittances,
official aid have risen sharply.
 This increased mobility of factors and integration of
markets would therefore have consequences – both
positive as well as negative.
8
Context and Background
(Continued)
 Financial markets have peculiar characteristics and
the spillovers and contagion effect are more
pronounced and highly destabilizing if triggered by a
negative shock.
 The correlation between distant markets and
different types of assets has increased.
9
Context and Background
(Continued)
 Financial innovation and financial engineering based
on complex models gave rise to new products that
has transformed the basic landscape of Derivatives,
credit default swaps, collateralized debt obligations,
securitization were developed as instruments to
manage and mitigate risks.
10
Trigger Point Sub-Prime lending
Defining it
A loan made to someone with weak credit
Little or no down payment
Teaser rates and adjustable rates
“Liars’ loans”
11
Brief chronology of key events
March 2008
Bear Stearns is sold to J.P. Morgan for $ 240 million with Fed backing.
A year ago it was valued at $ 35 billion.
12
Brief chronology of key events
(Continued)
 October 2008
 UK government announces a $ 88 billion rescue plan for the
financial system.
 Takes major stake in UK banks.
 US government approves a $ 700 billion plan.
 European and Asian governments follow suit.
 Iceland takes over a third bank and obtains IMF assistance to
cope with the financial crisis.
 Contagion, spillovers, linkages and herd instincts proved to be fairly
strong and the EDEs also suffered output and export losses.
However, they recovered much quickly than the AEs.
13
Contributory factors
(Continued)
Other factors were:
 Excess global liquidity and globalization of investment flows
 Federal reserve policy response of monetary easing
 Asset inflation (housing and commodities bubbles)
 Poor and incomplete supervision and oversight of shadow banking system
 Pressure to grow revenues by taking more risk
 Excessive leverage
 Pervasive reliance on mathematical models
 External credit ratings substitute for banks own due diligence
 Deficiencies in the “Originate to distribute” model vs. previous “Originate
to Hold” model
 Over-extended borrowers
 Vulnerable to unscrupulous lending practices
14
What went wrong?
Banking System
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Poor governance practices
Short term focus of remuneration packages
Use of ROE based indicators led to excessive leverage
Risk and business units operating in “silos”; Risk given back seat
External ratings replaced internal risk assessment
Over dependence on short-term funding sources - Widening
maturity gaps
Securitization and innovation; “Originate to Distribute” slice and
dice model had flaws
Unethical mortgage brokers and lending practices
15
What went wrong?
Shadow Banking
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In the absence of regulatory oversight and supervision excessive risk taking on
leveraged funds.
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Rapid sale of assets in a crisis caused liquidity spirals
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Moral hazard created by “asymmetric fee structure” of hedge funds
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Contributing to greater systemic risk
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What went wrong?
Credit rating agencies
 Significant underestimation of the risks of structured products
 Conflict of interest
 Relationship conflicts: Long, established relationships with CDO and MBS issuers
 Issuer-paid model: “… paid by the very people whose products they rate”
 Advisory business: CRAs advised banks on structuring MBSs leading to good rating
 Exacerbating the asset price spirals
 Mass downgrades during late 2007 triggered the limits of many institutional investors,
leading to forced selling
 Pro-cyclical nature of credit ratings
17
What went wrong?
Flawed Theoretical Assumption
 Efficient Market Hypothesis (EMH) has been the predominant theory
governing financial markets. The assumption that market prices are
based on rationality has proved wrong in practice. Individual
rationality does not ensure collective rationality.
 Individual does not always behave rationally but in network economy
his/ her behavior depends on what others are doing. Herd instinct is a
common observable trait.
 Securitization was believed to improve financial stability. In actual
fact, trading in these marketable instruments made them vulnerable
to market sentiment.
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What went wrong?
Flawed Theoretical Assumption
(Continued)
 Mathematical models and algorithms would allow financial
innovation, ease in manufacturing and trading in complex
derivatives such as credit default swaps (CDSs) and collateralized
Debt Obligations (CDOs). The models made the assessment of
credit quality of underlying loans quite difficult and complicated.
There were serious omissions in the specifications of models such
as complete exclusion of high risk events, systemic risks and nonlinearity.
 Information asymmetry and Moral hazard have been studied
extensively in economics literature but their application in
designing new financial products
was far from satisfactory.
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What went wrong?
Regulators
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Missing macro-prudential supervision
Pro-cyclical capital requirements
Built-in reliance on rating agency opinions
Little attention to liquidity risk and the risk of trading book of banks
During the crisis, many weak banks were allowed to merge with
other banks. This in turn created many “too big to fail” institutions
 Creation of deposit insurances has exacerbated the moral hazard
problem
 Weak regulatory framework for market infrastructure – Payment
and settlement systems
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Response to the crisis
A summary of responses
Business
activities and
ownership
Compensation
Regulators‘ response
Response by the industry
» Supervisors are challenging:
 Underwriting standards
 Rating process
 Securitization markets
» Central bank funding replaces
interbank market
» Better operational infrastructure
» New deposit protection schemes
» Significant state involvement in
the banking sector
» Rethink business model
» Aggressively reduce balance
sheet
» Increased cost of doing business
» Shifting focus to domestic
markets
» Reduced risk appetite
» Shift towards earning greater fee
based income
» Greater oversight
 Avoid undue risk-taking
» Guidelines on compensation
practices
» Overhaul remuneration approach
» Greater symmetry between risk
horizons and compensation
» Claw-backs
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Response to the crisis
A summary of responses
Risk
management &
control
Regulators‘ response
Response by the industry
» Supervisors are demanding:
 Greater Board/management
oversight
 Better understanding of risks
 Stronger risk aggregation
» Strengthening guidance relating
to risk management
» Supervisors are challenging:
 Historical risk measures in an
‘originate-to-distribute’ model
 VaR models and stress testing
scenarios
 Assumptions of new product
risks
» Supervisors are hiring more
specialists in risk management
and control
» Rethink reliance on sophisticated
modeling
» Capture ‘tail-risks’
» Intensify direct dialogue of Board
members with supervisors
» Improve risk reporting:
 Content
 Frequency
 Addressees
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Response to the crisis
A summary of responses
Regulators‘ response
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Capital and
leverage
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Liquidity
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Response by the industry
Additional capital buffers
Backstop leverage ratios
Changing treatment of
securitization and trading book
Greater scrutiny of
capital/balance sheet planning
» Rapid
deleveraging
and
divestitures
» Greater capital buffers
» Reconsider capital allocation
models
» Long-term funding
» Capital with government support
Improved
management,
oversight and governance of
liquidity risk
Contingency planning
Additional reporting
Link capital with liquidity
Better
liquidity
risk
management
» Enhance models, stress testing
and contingency planning
» Identify alternate funding
mechanisms
» Develop
stringent
internal
controls on liquidity risk
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Response to the crisis
A summary of responses
Regulators‘ response
Response by the industry
Strengthened risk disclosures
 Rigorous valuation processes
 Robust valuation disclosures
» Reassessment of the contribution
of MTM to pro-cyclicality
» Use of measures like Mark-tofunding
» Benchmark risk disclosures and
valuation practices against other
financial institutions

Valuation,
Accounting and
Disclosures
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Impact of the crisis on Pakistan
 Financial sector reforms in the pre-crisis period had strengthened
the Financial soundness Indicators of the banking system.
 Private sector ownership and management brought about
efficiency but a strong regulatory regime did reform its watchdog
function in continuing exercise risk taking.
 Plain Vanilla Derivatives were introduced gradually on a case-bycase basis.
 Cautious liberalization particularly on capital account convertibility
insulated the banking system from contagion shock.
 Non-banking system was a minor player in the game and could not
cause any ripples.
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Impact of the crisis on Pakistan
(Continued)
 Banking sector had little lending exposure in troubled
countries
 Trading book almost non-existent
 Exposure to securitized products was limited
 However, an indirect (and in some cases the direct) impact is
felt
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There is a lag effect
Liquidity dried up (or cost of funding increased)
Concentration in portfolios
Name lending portfolio quality is uncertain
FDI flows are not certain - Linked to economic growth
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Salient Features and Lessons Learnt
 The question therefore arises as to what were the salient
features that distinguished the US and European systems from
those in Canada, Australia and New Zealand and the EDEs and
what are the lessons learnt?
 First, Bank lending forms the bulk of financial sector lending in
EDEs and Capital markets are not so well developed unlike the
US and Europe. The contagion risk and transmission effect of an
interconnected world capital markets in the EDEs remained
muted.
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Salient Features and Lessons Learnt
(Continued)
 Second, Asian countries had learnt the hard way from the crisis
they face in 1997-98. Prudent macroeconomic management,
credibility of policy makers, open trading and investment
regimes, accumulation of sufficient foreign exchange reserves
combined together to maintain an enabling environment for
growth and stability.
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Salient Features and Lessons Learnt
(Continued)
 Third, the banks in EDEs relied upon low cost and stable deposits
for financing their assets rather than wholesale funding that was
volatile and expensive. This permitted maturity transformation,
ample liquidity to the system and preserved confidence among
investors. In the US and Europe, abrupt withdrawal of wholesale
funds led to a vicious cycle of distressed sales of assets, falling
asset values, shortages in capital adequacy and difficulties in
raising fresh capital from the private sources.
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Salient Features and Lessons Learnt
(Continued)
 Fourth, the Central banks in EDEs had developed the capacity to
draw the rules of the game and enforce them in a way that was
orderly and least disruptive. The quality of banks’ portfolio had
improved as a result of the Central banks vigilance and
continuous watchdog monitoring. Mark-to-Market accounting,
loan-loss provisioning and capital infusion helped the
strengthening of the banks.
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Salient Features and Lessons Learnt
(Continued)
 Fifth, the bank lending in EFEs avoided exotic products such as
derivatives, loans to hedge funds, private equity, credit default swaps.
Capital infusion from time to time helped strengthen the balance sheets.
 Sixth, partial capital controls and lack of full capital convertibility in
China, India, Pakistan, did not allow large exposure to foreign currency
denominated assets. The market share of the large financial
conglomerates was kept limited by design and therefore direct
exposure of the significantly important financial institutions was quite
low.
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Salient Features and Lessons Learnt
(Continued)
 Seventh, as the markets in EDEs are generally considered
imperfect or incomplete and market failures loom large on the
horizon the intellectual foundation of contemporary financial
theory – efficient market hypothesis – did not assume a pivotal
role as in the developed markets and therefore, did not lead to
the widespread belief and practice in Market is self correcting
and therefore, a hands-off approach by the regulators.
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Lessons on Corporate governance
OECD Findings
1. Independence of Boards is a necessary, but not a sufficient
condition for good governance
2. Shareholders nominate Board members; involved in their
appointment and evaluation
3. Separation of the Chairman/CEO position
4. Board member liability; no consensus on existing practices
5. Identifying skills-sets of Directors best suited for the Bank’s Board
6. ‘Fit and proper’ should include general governance and risk
management skills
7. Independence can be affected by the time board members have
served under the same CEO or Chair
8. Adopt voluntary practices to improve Corporate Governance
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Lessons for Shareholders
Key questions to ask – Board assessment
Risk oversight
Board composition
Director qualifications
» Is risk management a key
component in the company’s
overall strategy?
» Has the Board articulated its risk
strategy?
» What mechanisms does the
Board have in place to evaluate
risk?
» What is the role of the CRO and
the reporting structure?
» What changes has the Board
made to its structure as a
response to the crisis?
» How
effective
are
the
committees or the Board in
overseeing risk?
» Has the Board appointed
sufficient independent Directors?
» Are
long-tenured
directors
serving on the Board?
» Is the Board equipped with
adequate risk expertise?
» Is the Board considering director
qualifications in the nominating
process ?
» What process does the Board
have to train NEDs on risk
management?
» Do the Directors adhere to a
minimum time commitment?
Disclosure practices
Compensation practices
Conflicts of interest
» What steps has the Board taken
to improve transparency of the
bank’s risk-taking initiatives?
» Are risky instruments fully
disclosed to shareholders?
» Does the Bank have an updated
Disclosure policy?
» Does the Bank disclose Board
meeting minutes, attendance
etc.?
» What percentage of pay is
skewed toward short-term
individual performance?
» Do pay practices include “clawback” provisions?
» Does the Bank have an updated
Remuneration policy?
» Does the Board have a Conflict of
Interest policy which mitigates
potential conflicts that could
distort
the
Board
and
management’s understanding of
potential risks?
» Are all related party transactions,
conflicts of interest disclosed?
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