Crisis Prevention and Resolution: Lessons from This Previous Crises

Crisis prevention and resolution:
Lessons from this & previous crises
Patrick Honohan
Trinity College Dublin
LACEA-LAMES Meetings, Rio de Janeiro
23rd November 2008
Big losses in this crisis are due to long-standing issues
(especially incentive effects, moral hazard)
but activated by (banker and regulator) overconfidence
in the new formal risk management techniques
Now there’s revulsion:
no confidence in anyone’s risk models;
little interbank lending and trading in complex securities
and belief that counterparties may unknowingly be insolvent
The overconfidence was widely shared
Winner of Euromoney magazine’s “Global Best Risk Management
House” award for excellence in 2005
Northern Rock
Winner of International Financing Review’s prestigious “Financial
Institution Group Borrower of the Year” award for 2006
Regulators shared the same rose-tinted spectacles –
indeed Basel 2 implies that they buy into bank and/or
rating agency models
And then…
Interbank and riskfree rates (3-month) (LIBOR-OIS)
Dec 2005-Nov 2008
rate (2.15)
policy rate”
(OIS) (0.48)
Source: Bloomberg
Interbank and riskfree rates (3-month) (LIBOR-OIS)
Dec 2005-Nov 2008
rate (2.15)
This should have been the trigger
for intervention
policy rate”
(OIS) (0.48)
Source: Bloomberg
The standard prescription for containment &
Have legal powers enabling & requiring regulators to:
Intervene in undercapitalized banks,
requiring them to increase capital and to desist from unsafe
practices, and if necessary
take control of a failing bank and arrange for a sale, liquidation
or financial restructuring with the use of public funds.
Limited deposit insurance to insulate small depositors
from anxiety and loss.
Liquidity provision to stabilize monetary conditions,
including LOLR, but only for solvent but illiquid banks.
Legal powers: even UK & US were not ready
Northern Rock
EU state aid law; bank insolvency procedures
Lehman Bros
Briefings suggest that it was legal limitations that
ultimately forced the bankruptcy
Deposit insurance – did not play a
constructive role
Supposedly, deposit insurance is there to:
“Prevent contagious runs, ensuring market stability, and
protecting the assets and peace of mind of retail
In reality it may do no more than buy political acceptability
for a strict liquidation. Can only have a limited role when
it’s the wholesale funders that run.
Deposit insurance – did not play a
constructive role
Northern Rock
Co-insurance rule (first £2K covered in full, 90% of next £33K)
encouraged run by all but the smallest; made rescue politically
Indymac bank
Even covered depositors ran despite prompt payment record of
Cross-border issues unresolved:
Irish annoy neighbours by extending blanket guarantee…
…But only for Irish-controlled banks, disturbing level playing field
(and leaving banks on life-support)
Iceland fiasco: Branch in UK not subsid, and home authorities
could not afford to meet the insured liabilities.
Liquidity policy: central banks retain
independence but fail to control rates
Big expansion: Innovated in instruments, maturity, counterparties but
maintained “high” collateral standard (esp. ECB tightened in
Mostly stayed out of explicit rescue actions (exceptions: NR; Bear
Stearns; AIG)
Thus, unlike past crises, CBs are not obviously in the front line for
losses, though quality of their collateral may deteriorate.
And their operational independence and inflation-targeting not yet
However, they have been unable to control market interest rates with
Intervention and recapitalization
• Despite the persistent alarming indications, government
intervention in insolvent banks and loss allocation was
slow to start, reactive on a case-by-case basis and
• Previous banking crises around the world generated
huge fiscal (taxpayer) costs
• In the early stages of this crisis (i.e. until about midSeptember, 2008), despite big reported bank losses, the
taxpayer had not been implicated in a big way.
Systemic Crises 1970-2008:
Fiscal costs and GDP per head
Fiscal costs % GDP
Honohan (2008)
GDP per head $000 PPP (1997)
Banks hit by losses fall into four failure
Ruined gamblers
Too opaque to survive
Over-leveraged mortgage lenders
Diversified survivors (?)
Banks hit by losses fall into four failure
Ruined gamblers
Sachsen, IKB, IndyMac
Too opaque to survive in the market
Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis
Over-leveraged mortgage lenders
Fannie and Freddie, RBS, HBOS, Northern Rock (?),
Diversified survivors (?)
UBS, Citigroup, Barclays….
Losses: 3 waves
• Over-complex seniority-tranched asset-backed
securities and related derivatives
– From mid-2007
• Conventional property bubble-related losses
– From mid-2008
• Recession-related losses (credit cards, auto
loans, etc.)
– From September 2008;
– Avoidable as of Dec 2007?
Why it’s hard to predict ultimate mortgage losses
Moral hazard: could have been worse
Heavy losses incurred by:
bank shareholders (for example in AIG, Fannie Mae and Freddie
Mac, IndyMac, Fortis, and several banks that have not failed, but
saw their share price tumble by 80-95 per cent…RBS, Citi, Bank
of Ireland),
debtholders (in Wachovia Bank and Lehman Brothers, among
others), and even
(iii) depositors (in the Icelandic banks)
So although the current “standing recapitalization facilities” clearly
entail moral hazard; the policy response on average to date may
not have been so bad
For the future (1)
Market info and intelligence good for micro-supervision
Supervisors need better ways of collecting and processing
information and opinions about systemic risk
FinStab reports are not doing the job
FSAP stress tests fight the last war
There are contrarians and some of them have a point – typically
dismissed because they do not know inside details
Organizational economics may help (cf. Caricano/Posner JEP 05)
For the future (2)
More regulation?
Much more capital
Over-complex and opaque instruments may be
(over-reaction likely)
Find a viable and effective way of reducing
reward asymmetry
But easy to game and downside hard to enforce
But above all, apply the textbook rules
Summary (1)
The recognition lag was too long despite alarming
indications (from August 2007) in interbank rates that
things were badly wrong.
Interventions were reactive to cash crunches and dealt with
on a case-by-case basis as liquidity issues.
Why? Because regulators had bought into the
overconfidence in risk management tools that drove the
excessive expansion of capital and liquidity leverage –
and they were slow to realize that revulsion had set in.
Summary (2)
What would have been better: textbook approach.
Mandatory early intervention in undercapitalized banks,
writing shareholders equity down to zero, selling the
viable parts of the bank, allocating losses to other
claimants and the taxpayer.
This approach would have allowed the large pools of
capital unaffected by the US and other housing markets
to enter with confidence and to make profits. (SWF and
others). It would have avoided the 3rd wave of mark-tomarket value declines and the recession.