Thorvaldur Gylfason
Joint Vienna Institute Course on
Macroeconomic Policies in
Times of High Capital Mobility
Vienna, Austria
May 16–20, 2011
1. The Great Crash and its consequences
2. What is a systemic banking crisis?
3. Main origins of a crisis
4. From crisis recognition to crisis
management
5. Theories of financial crises
6. Policy responses in financial crises
7. Banks and incentives
8. Twelve lessons from recent crisis


The Great Depression 1929-39 produced a
deep slump in output in the US and
elsewhere, with dramatic consequences
It also triggered reforms that reduced
volatility in output, reducing the likelihood of
another great crash


Stabilization of output
Regulation of banks and other financial
institutions
0
2003
1999
1995
1991
1987
1983
1979
1975
1971
1967
1963
1959
1955
1951
1947
1943
1939
1935
1931
1927
1923
1919
1915
1911
1907
1903
1899
1895
1891
1887
1883
1879
1875
1871
Change in Canada’s per capita GDP from year to year 1871-2003 (%)
20
15
10
5
-5
-10
-15
-20
Source: Maddison (2003).
 Standard
deviation of per capita GDP fell
from 6.6% 1871-1945 to 2.3% 1947-2003

Yet per capita GDP growth remained virtually the
same (2.1% vs. 2.2%)
 In
postwar period, active stabilization was
the norm plus careful federal rather than
decentralized financial supervision
 Canada’s banks are universal, offering both
commercial and investment banking services


Even so, recent financial crisis passed Canada by
Firewalls between commercial banking and
investment banking were not in place in Canada
0
2003
1999
1995
1991
1987
1983
1979
1975
1971
1967
1963
1959
1955
1951
1947
1943
1939
1935
1931
1927
1923
1919
1915
1911
1907
1903
1899
1895
1891
1887
1883
1879
1875
1871
Change in US per capita GDP from year to year 1871-2003 (%)
20
15
10
5
-5
-10
-15
-20
-25
Source: Maddison (2003).
 Standard
deviation of per capita GDP fell from
6.4% 1871-1945 to 2.4% 1947-2003

Yet per capita GDP growth remained virtually the
same (2.3% vs. 2.1%)
 From
the 1960s onward, active stabilization
was the norm, as was federal as well as local
financial supervision from 1933 onward
 Automatic stabilizers helped


From 1870 to 1914, federal expenditures decreased
from 5% of GDP to 2%, rising back to 5% by 1929
From 1945 to date, federal expenditures doubled
from 10% of GDP to 20%
0
1831
1835
1839
1843
1847
1851
1855
1859
1863
1867
1871
1875
1879
1883
1887
1891
1895
1899
1903
1907
1911
1915
1919
1923
1927
1931
1935
1939
1943
1947
1951
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
Change in UK per capita GDP from year to year 1871-2003 (%)
15
10
5
-5
-10
-15
Source: Maddison (2003).
0
1821
1826
1831
1836
1841
1846
1851
1856
1861
1866
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Change in French per capita GDP from year to year 1821-2003 (%)
50
40
30
20
10
-10
-20
Source: Maddison (2003).
10
0
1851
1855
1859
1863
1867
1871
1875
1879
1883
1887
1891
1895
1899
1903
1907
1911
1915
1919
1923
1927
1931
1935
1939
1943
1947
1951
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
Change in German per capita GDP from year to year 1851-2003 (%)
20
Stefan Zweig (1942)
Die Welt von Gestern
-10
-20
-30
-40
-50
Source: Maddison (2003).
0
1821
1826
1831
1836
1841
1846
1851
1856
1861
1866
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Change in Swedish per capita GDP from year to year 1821-2003 (%)
10
5
-5
-10
-15
Source: Maddison (2003).


The emergence of systemic banking crises
has been associated with the liberalization
of financial systems worldwide
However, since the mid- to late 1990s a
number of crises have been of
unprecedented scale and consequences:




Mexico 1994
Asian Crisis 1997-1998
Russia 1998, Ecuador 1998, Turkey 2001,
Argentina and Uruguay 2002
US 2007 and its aftermath, including Iceland
A
banking crisis is systemic in nature if a
loss of confidence in a substantial portion
of the banking system is serious enough to
generate significant adverse effects on the
real economy
 The adverse effect on the real economy
arises from disruptions to the payments
system, to credit flows, and from the
destruction of asset values
 Let’s look at some evidence which
demonstrates the devastating nature of
systemic crises
Banking Problems Worldwide 1980-2002
Banking Crisis
Significant Banking Problems
No Significant Banking Problems/Insufficient Information
2001
150
1999
150
1997
5,000
1995
175
1993
175
1991
10,000
1989
200
1987
200
2000
1995
5,000
1990
10,000
1985
15,000
1980
15,000
1975
20,000
1970
20,000
In billions of local currency
Finland
Finland
Indonesia
Indonesia
150
150
600,000
600,000
Trend GDP
Trend GDP
GDP
GDP
500,000
125
500,000
125
100
400,000
400,000
300,000
300,000
200,000
200,000
100,000
100,000
100
Source: IMF.
2001
1998
1995
1992
2000
1996
1992
1988
1984
50
1980
50
1989
75
1986
75
In billions of local currency
Sweden
Thailand
Sweden
Thailand
2,500
2,500 5,000
5,000
Trend GDP
Trend GDP
2,250
2,250
GDP
GDP
4,000
4,000
2,000
2,000
1,750
1,750 3,000
3,000
1,500
1,500
Source: IMF.
2001
1998
1995
1992
1989
1986
2001
1998
1,000
1995
1,000 1,000
1992
1,000
1989
1,250
1986
1,250
1983
2,000
1980
2,000
In billions of local currency
Ecuador
Ecuador
40,000
300
300
Trend GDP
35,000
GDP
275
275
30,000
250
250
225
225
200
200
10,000
175
175
5,000
150
150
25,000
20,000
Source: IMF.
2001
1999
1997
1995
1993
1991
1989
1987
2000
1995
15,000
In billions of local currency
Korea
Norway
Korea
Norway
600,000
600,000
1,250
1,250
Trend GDP
Trend GDP
GDP
500,000
500,000
400,000
1,125
1,125
GDP
1,000
1,000
875
875
750
750
625
625
500
500
400,000
Source: IMF.
2000
1996
1992
1988
1984
2001
1998
1995
100,000
1992
100,000
1989
200,000
1986
200,000
1980
300,000
1976
300,000
Need
to distinguish between
 Causes
and origin of a systemic crisis
 Trigger of the crisis
Two
views (or schools of thought) on
origins of systemic crises
 Institutional
failure leads to systemic
crisis (classical view)
 Common exposure of financial sector to
certain risks (endogenous cycle view)
 Some
weak banks in the system, they stay
above water until an external shock hits


E.g., weak management, weak risk management
systems, leading to balance sheet deficiencies,
mismatches
External shock can be anything (e.g., exchange
rate shock, political crisis)
 Weak
banks go under and, through contagion,
pull others into problem zone

Crisis become systemic
 Helps

explain some crises, but not recent ones
Source: Diamond and Dybvig (JPE, 1983)
 Systemic
crisis follows from fact that
banks have common exposures to
macroeconomic risks
 Origin of scenario leading to
endogenous cycle may differ from crisis
to crisis, but …
 … pattern of response is similar

I.e., how they get these common exposures

Sources: Minsky (1982), Kindleberger (1996)
Starting point: Economic conditions are
considered favorably
 Risk evaluation is also favorable
 Access to credit is relaxed (subprime!)
Endogenous or
 Profits go up
self-feeding cycle
 Generalized state of euphoria
Procyclical
behavior
 Boom in asset prices and markets
(amplification)
 Asset price bubble is forming
 Risk perceptions remain favorable
 But, imbalances start to emerge here and there …
 … and suddenly the situation goes into reverse


E.g., through a change in mood
 The

trigger can be anything
E.g., change in mood, bad economic or political
news, problems in neighboring countries, rumors
 Irrespective
of origin, a crisis first emerges as
a liquidity problem in one, some, or all banks

Symptoms




Bank goes repeatedly to interbank market
Bank calls repeatedly upon lender-of-last resort and
requests roll-over
When the rumors spread, liquidity problems
trigger deposit withdrawals (Asia) or credit lines
that are being cut (Turkey)
Liquidity problems are typically symptoms of
underlying solvency problems
Start
of crisis often seems chaotic
 When

a problem arises in one bank
Is it an isolated case or will it spread?
 It
takes time to assess situation and
recognize that it is systemic
 Lack of preparedness on the authorities’
side

Vested interests in delaying recognition,
i.e., in avoiding fiscal costs as well as in
accepting blame
Indonesia 1997-present
Chile 1981-1983
Thailand 1997-present
Turkey 2000-present
Korea 1997-present
Ecuador 1998-2001
Mexico 1994-1995
Venezuela 1994-1995
Finland 1991-1993
Malaysia 1997-2001
Sweden 1991-1993
Gross Cost
United States 1984-1991
Net Cost
Norway 1987-1989
0
Sources: IFS, WEO and national authorities.
10
20
30
40
50
60
 Liquidity

If banks prove insolvent, and can’t repay liquidity
support received earlier from central bank
 Deposit

recapitalization
Through the government


insurance
Government pay-outs as part of deposit insurance
scheme or blanket guarantee
 Bank

support
If the government agrees to assist in recapitalizing the banks
through some scheme
Through restructuring of impaired assets

A (government) asset management company buys impaired assets
from banks in exchange for government bonds
% of GDP
Billions of USD
Liquidity support
provided by central
bank, and taken over
by budget
12
20
Recapitalization,
including blanket
guarantee
23
40
Purchase of NPLs and
capital provided to
asset management
company
12
20
Interest cost (for the
budget)
3
5
51
85
Total
 How
long it takes politicians to recognize that
they are face a crisis (+) …
 … and the time from the point of recognition to
the time of action
 Quality of institutions (-)
 Level of corruption (+)
 Efficiency of judicial system (-)
 Restructuring approach (+/-)
Strict vs. accommodating strategy (moral hazard)
 Types of incentives given during recapitalization

 Handling
of impaired assets (+/-)
 Possible payback to government (+/-)
Source: BIS (2009).

Need for political leadership and
coordination

Managing a financial crisis



Is a macro-undertaking with lots of microdecisions
Involves tackling a number of politically
contentious (vested interests), and often
technically complex, issues
Involves burden sharing and redistribution
of wealth, with most parts of society
affected

Economic theories of financial crisis have tended
to follow events


Recent theories tend to reflect failure of markets
to avert socially costly outcomes, with focus



Different models correspond to specific country cases
On problems in the markets themselves (particularly in
asset markets) due to asymmetric information/agency
problems, etc.
On the role of economic policymakers (esp. central banks)
that, in attempting to control credit creation to stabilize
economy, unwittingly amplify boom/bust cycles
On why markets do not always produce optimal
solutions, see



Freefall (2010) by Stiglitz
The Origin of Financial Crisis (2008) by Cooper
This Time Is Different (2009) by Rogoff and Reinhart
Large deficits
 Current account deficits
 Government budget deficits
Poor bank regulation
 Government guarantees (implicit or explicit), moral hazard
Stock and composition of foreign debt
 Ratio of short-term liabilities to foreign reserves
Mismatches
 Maturity mismatches (borrowing short, lending long)
 Currency mismatches (borrowing in foreign currency,
lending in domestic currency)
Increased inequality
5
0
-5
-10
-15
-20
-25
-30
-35
-40

Many crises are characterized by over-leveraging

Increases vulnerability of debtors to external changes


Usually, crises involve debt repayment difficulties
for government, households, or corporate sector

Debt servicing tends to become harder as crisis develops


I.e., risk aversion, interest rate/exchange rate changes
Foreign credit dries up, banks need to deleverage, value of
collateral falls, trade credit becomes more difficult, etc.
Does this help crisis prediction or crisis prevention?
Extent of debt depends on interest rate/exchange rate
 What appears to be a manageable situation, proves
unmanageable when variables change
 Debt levels change and so, too, does bank capital

Net External Debt (% of GDP)*
1000
900
800
700
600
500
400
300
200
100
0
500
450
400
350
300
250
200
150
100
50
0
2004 2005 2007 2007 2008m 2008
*Excluding risk capital
International Investment Position (% of GDP)*
1000
900
800
700
600
500
400
300
200
100
0
0
-20
-40
-60
-80
-100
-120
-140
-160
-180
2004
2005
2007
2007
2008
*Including risk capital
Source: Union Bank of Switzerland
10
9
8
7
6
5
4
3
2
1
0
Switzerland
Iceland
8
7
6
5
4
3
2
1
0
Months
% of short-term debt
140
120
100
80
60
40
20
0
 Increased
inequality in distribution of
US income and wealth during roaring
1920s

Bubble conducive to higher incomes at
top end of distribution, and vice versa
 Crisis
of 2007
Subprime lending supported and made
possible in part as compensation for
increased inequality (Rajan)
 If so, inequality helped trigger crisis

45
40
35
30
25
20
15
10
5
0
Source: Internal Revenue Directorate.
 To
restore confidence in a financial
crisis, a policy program needs to be
announced that is seen by creditors as
comprehensive and fully financed
 First policy dilemma

How to halt pressure on currency while
bolstering domestic demand



Should interest rates be temporarily raised?
Should fiscal policy be tightened?
Should capital controls be introduced?
Second


policy dilemma
Should financial and firm-sector problems be
tackled up front or left until later?
Should banks be recapitalized with public funds?



Perhaps no choice
Solvency issues
Forms of restructuring
Should there be regulatory forbearance?
 Should public or private debts be restructured?
 Should government be involved in corporate
restructuring?

 Pros
and cons
 Increasing rates




Helps external adjustment, reduces capital flight
Deflationary when domestic demand is already in
decline
Places further stress on over-leveraged firms
Middle class bonus
 Reducing



rates
Exerts greater pressure on exchange rate
Obscures/postpones structural problems
Credit supply constrained by banking problems
 “Mistake”


Rationale for tighter fiscal policy
Fiscal space in Iceland program 2008
 Fiscal


policy in Korea
Difficulty of running a deficit
Social programs in Asia
 Fiscal

in Thailand IMF program 1997
policy in Argentina
Size of haircut and extent of fiscal adjustment
 Preparing
for post-crisis vs. getting
through the crisis
 IMF’s
conditional support for fiscal stimulus
 Short-run constraints on fiscal policy



Time lags
Credibility
Type of fiscal action
 Longer-term
issues of debt sustainability
 Difficulty of specifying a medium-term
framework in the midst of a financial crisis


Different speeds of recovery
Impact on potential output
 Exit

from fiscal stimulus
Economics and politics
Speculation
 Experience
in Asian crisis
of Malaysia and Hong Kong
Malaysian speculation
 Capital flight
 Mahathir’s controls
 Hong Kong and the hedge fund
conspiracy

 Transparency
short selling
and regulations against
Mexico,
Korea,
Mexico,
Thailand,
Venezuela,
Turkey,
Venezuela,
Argentina,
Malaysia,
Indonesia,
Argentina,
'93-95
'96-97
'81-83
'96-97
'87-90
'93-94
'92-94
'88-89
'86-89
'84-85
'82-83
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
10% of GDP
5% of GDP
4% of GDP
0
10
20
30
40
Billion dollars
Source: Finance and Development, September 1999.
50
60
 Growing
acceptance of use of prudential
regulations to limit systemic risk in
banking system and, more generally, in
national and international economy

Countercyclical use of prudential ratios


Liquidity ratios


Differentiated by currency
Reserve requirements


Blanchard
Differentiated by maturity
Limitations


Regulatory arbitrage
Nonfinancial sector flows
 Recent
cross-country evidence on
effectiveness of capital controls
Controls tend to have short-term impact, over time
market participants find ways of circumventing
 Controls tend to change composition rather than
overall volume of flows
 But, Ostry et al. (IMF Staff Position Note 10/04) find
that “in the recent crisis the output decline of the
countries that had maintained capital controls in the
run-up to the crisis was lower than in other countries
without capital controls”
 There are difficulties in empirical testing – how to
measure capital control, what measures introduced at
same time, what was counter-factual?

Source: Global Financial Stability Report, IMF, April 2010.
 Financial
globalization is often blamed for
crises in emerging markets

It has been suggested that emerging markets
had dismantled capital controls too hastily,
leaving themselves vulnerable
 More
radically, some economists view
unfettered capital flows as disruptive to
global financial stability
These economists call for capital controls and
other curbs on capital flows (e.g., taxes)
 Others argue that increased openness to
capital flows has proved essential for countries
seeking to rise from lower-income to middleincome status

 Capital
controls aim to reduce risks
associated with excessive inflows or
outflows
Specific objectives may include
Protecting a fragile banking system
Avoiding quick reversals of short-term capital
inflows following an adverse macroeconomic
shock
 Reducing currency appreciation when faced
with large inflows
 Stemming currency depreciation when faced
with large outflows
 Inducing a shift from shorter- to longer-term
inflows


 Administrative

Outright bans, quantitative limits, approval
procedures
 Market-based



controls
Dual or multiple exchange rate systems
Explicit taxation of external financial
transactions
Indirect taxation

E.g., unremunerated reserve requirement
 Distinction


controls
between
Controls on inflows and controls on outflows
Controls on different categories of capital
inflows
 IMF
(which has jurisdiction over current
account, not capital account, restrictions)
maintains detailed compilation of member
countries’ capital account restrictions
 The information in the AREAER has been
used to construct measures of financial
openness based on a 1 (controlled) to 0
(liberalized) classification
 They show a trend toward greater financial
openness during the 1990s
 But these measures provide only rough
indications because they do not measure
the intensity or effectiveness of capital
controls (de jure versus de facto measures)


Structural characteristics can sometimes be seen as root cause
of a crisis

In Korea, exceptionally high debt-equity ratios, low profitability of
corporate sector, and increasing use of foreign currency bank loans to
shore up finances in largest chaebol were viewed as indicative of structural
problems, including lack of corporate governance, nonstandard accounting
rules, directed lending, barriers to entry in various industries, failure of
prudential regulation, etc.

But many of these problems had been integral parts of the previously
successful model of development
IMF program 1997/98 contained many structural reforms to
tackle these problems, some relevant, some dubious

The criticism of these structural conditions was that their implementation
prolonged the crisis; they were not immediately necessary.

The counter-argument was that if changes had not been made at that time
they would not have been introduced at all

Only in the midst of a crisis could political support be mobilized to effect
large institutional changes
 The
case of Indonesia and crony
capitalism

Too many conditions, too political
 IMF
programs and political stability
 Streamlining of structural conditionality
 Recent IMF programs and structural
measures
 Linkages between structural measures
and macroeconomic stability
 Testing

banks for solvency
How big is too big to fail?
 Closing
banks in the absence of a deposit
guarantee

Indonesia
 Public

ownership of private banks
What conditions are needed?
 Purchasing
“bad assets”– finding a price




Proposals for regulatory reform in previous crises
focused on widening coverage to prevent regulatory
arbitrage and separating regulators and enhancing
independence of supervision so as to reduce
influence of governments and central banks
The theme emerging from the global financial crisis is
different in that prudential regulation was seen to
pay insufficient attention not only to the risk
management techniques of financial institutions but
also to the build up of systemic risk
Regulators need to look at a wider view of risk than
from focusing on stability of financial institutions in
isolation
One proposal is that regulators focus rather on
macro-prudential monitoring of the financial system
as a whole
While some calls have been made for changes
that place regulators back within central banks,
other recent proposals (in US House of
Representatives, US Senate, UK, EU) call for the
creation of councils, each comprising existing
supervisory authorities and national central
banks within their country (area), that would
monitor the buildup of domestic financial
systemic risk
 For the banks themselves, most authorities see
the need for larger capital requirements,
particularly for systemically important
institutions, i.e., those with high degree of
interconnectedness within the system
 However, consensus on the modalities of capital
surcharges has not yet emerged

 Corporate
programs

debt restructuring and IMF
Korea, Indonesia, more recently Latvia, Iceland
 Case
for government intervention
 Three different approaches
Case-by-case market-based approach
Across-the-board with direct government
involvement
 Intermediate approach with government
financial incentives


See Thomas Laryea: Approaches to Corporate Debt Restructuring
in the Wake of Financial Crises, IMF Staff Position Note,
January 2010
 Government’s
role in allocating the
costs of a crisis
Tax policies
 Social programs and redistribution during
crisis
 Subsidies to financial institutions and
enterprises
 Socializing losses and inter-generational
effects

 Impact
of government policies on
future incentives
Insurance
and externalities of crisis
mitigation
IMF and allocation of costs of crisis
between countries
Incentive effects of “bailouts”
Future crisis prediction and
prevention
Different
causes in each new wave of
crises
There are limits to individual country
risk analysis
Cross-section econometric
techniques
 Market Pressure Indices
 Mecagni et al. (2007)
Index = -(FXt – FXtrend) – ln(NEERt/NEERt-1) + St – Kt

Combines individual indicators

FX (international reserves)
 NEER (nominal effective exchange rate)
 S (secondary market spread on sovereign bonds)
 K (net private capital flows as a ratio to GDP)
All variables are standardized with their mean = 0 and their
standard deviation = 1
The aim is to show deviations from normal levels of the
components
The start of a crisis is identified as the first of two consecutive
quarters in which the value of the index is positive





Financial Stress Indicators (IMF, 2008) rely on
financial variables for 17 countries
Equal-variance weighted average of seven
variables
1.
2.
3.
4.
5.
6.
7.

Banking-sector beta
TED spread
Inverted term spread
Corporate spread
Stock decline
Time-varying stock volatility
Time-varying real exchange rate volatility
Financial stress if index is one standard
deviation above its trend
Typical
Signal Indicators:
 Overvaluation
of currency in real terms
 Financial liberalization
 Low output growth
 Fall in asset prices
 Weak exports
 High interest rates
 Rise in inequality
 See Kaminsky and Reinhart (1999)
Type
I and Type II Errors
 Both
probability models and signal
extraction models give too many false
alarms
 Particularly difficult to get timing right
In
general, the empirical record of
crisis prediction remains poor,
particularly in out-of-sample tests
Desirable
elements to help prevent
crises
 Sound
macroeconomic policies
 Sound financial sector regulation and
regular surveillance
 Sufficient international reserves
 Rigorous debt sustainability analysis
International Monetary Fund. “What Happens
During Recessions, Crunches and Busts?”, Stijn
Claessens, M. Ayhan Kose and Marco E. Terrones,
Working Paper WP/08/274, December 2008
 International Monetary Fund. “The Role of
Indicators in Guiding the Exit from Monetary and
Financial Crisis Intervention Measures —
Background Paper”, IMF Policy Paper, January
2010
 International Monetary Fund. “Lessons and Policy
Implications from the Global Financial Crisis”,
Stijn Claessens et al., Working Paper WP/10/44,
February 2010

 Paul
Volcker, Chairman of the Fed 1979-87,
said 8 December 2009 at a conference
organized by the Wall Street Journal:

“I wish someone would give me one shred of
neutral evidence that financial innovation has
led to economic growth – one shred of
evidence.”
 He
added that in the U.S. the share of
financial services in value added had risen
from 2% to 6.5%, and then asked:

“Is that a reflection of your financial innovation,
or just a reflection of what you’re paid?”
“The Best Way to Rob a Bank is to Own One”




1.
2.
3.
4.
When a senior officer deliberately causes bad loans
to be made he does not defraud himself
He defrauds the bank’s creditors and shareholders, as
a means of optimizing fictional accounting income
It pays to seek out bad loans because only those who
have no intention of repaying are willing to offer
the high loan fees and interest required
Grow really fast
Make really bad loans at higher yields
Pile up debts
Put aside pitifully low loss reserves
“The Best Way to Rob a Bank is to Own One”




1.
2.
3.
4.
When a senior officer deliberately causes bad loans
to be made he does not defraud himself
He defrauds the bank’s creditors and shareholders, as
a means of optimizing fictional accounting income
It pays to seek out bad loans because only those who
have no intention of repaying are willing to offer
the high loan fees and interest required
Grow really fast
Make really bad loans at higher yields
Pile up debts
Put aside pitifully low loss reserves
1. Need legal protection against predatory
lending because of asymmetric information
 Like laws against quack doctors, same logic
 Patients know less about health problems than doctors, so
we have legal protection against medical malpractice
 Same applies to some bank customers vs. bankers,
especially in connection with complex financial deals
2. Do not let rating agencies be paid by the banks
 Fundamental conflict of interest
 Also, prevent accountants from cooking the books
3. Need more effective regulation of banks and
other financial institutions
 Work in progress, Paul Volcker in charge
4. Read the warning signals
 Four rules, or stories
 The Aliber Rule
 Count the cranes!
 The Giudotti-Greenspan Rule
 Do not allow gross foreign reserves held by the Central
Bank to fall below the short-term foreign debts of the
domestic banking system
 Failure to respect this rule amounts to an open
invitation to speculators to attack the currency
 The Overvaluation Rule
 Sooner or later, an overvalued currency will fall
 The Distribution Rule
• The distribution of income matters
45
40
35
30
25
20
15
10
5
0
Source: Internal Revenue Directorate.
5. Do not let banks outgrow Central Bank’s
ability to stand behind them as lender – or
borrower – of last resort
6. Do not allow banks to operate branches
abroad rather than subsidiaries, thus exposing
domestic deposit insurance schemes to
foreign obligations
 Without having been told about it, Iceland suddenly
found itself held responsible for the moneys kept in
Landsbanki by 300.000 British depositors and
100.000 Dutch depositors
 May violate law against breach of trust
7. Central banks should not accept rapid credit
growth subject to keeping inflation low
As did the Fed under Alan Greenspan and the
Central Bank of Iceland
 They must restrain other manifestations of latent
inflation, especially asset bubbles and large
external deficits
 Put differently, they must distinguish
between “good” (well-based, sustainable) growth
and “bad” (asset-bubble-plus-debt-financed)
growth

8. Erect firewalls between banking and politics
 Corrupt privatization does not condemn
privatization, it condemns corruption
9. When things go wrong, hold those
responsible accountable by law, or at least
try to uncover the truth: Do not cover up
 In Iceland, there have been vocal demands for an
International Commission of Enquiry, a Truth and
Reconciliation Committee of sorts
 If history is not correctly recorded if only for
learning purposes, it is more likely to repeat itself
 Public – and outside world! – must know
 National Transport Safety Board investigates every civilaviation crash in United States; same in Europe
10. When banks collapse and assets are wiped
out, protect the real economy by a massive
monetary or fiscal stimulus
 Think outside the box: put old religion about
monetary restraint and fiscal prudence on ice
 Always remember: a financial crisis, painful though
it may be, typically wipes out only a small fraction
of national wealth
 Physical capital (typically 3 or 4 times GDP) and human
capital (typically 5 or 6 times physical capital) dwarf
financial capital (typically less than GDP)
 So, financial capital typically constitutes one fifteenth or
one twenty-fifth of total national wealth, or less
National
wealth
Human
capital
Physical
capital
Financial
capital
11. Shared conditionality needs to become more
common
 As when the Nordic countries providing nearly a
half of the $5 billion needed to keep Iceland
afloat imposed specific conditions on top of the
IMF’s conditions
 This may come up again elsewhere
 E.g., in Greece now that the EU and the IMF have been
called on to support Greece together
 For this, clear and transparent rules tailored to
such situations ought to be put in place
12. Do not jump to conclusions and do not throw
out the baby with the bathwater





Since the collapse of communism, a mixed market
economy has been the only game in town
To many, the current financial crisis has dealt a
severe blow to the prestige of free markets and
liberalism, with banks having to be propped up
temporarily by governments, even nationalized
Even so, it remains true as a general rule that
banking and politics are not a good mix
But private banks clearly need proper regulation
because of their ability to inflict severe damage on
innocent bystanders
Do not reject economic, and legal, help from abroad