Asia Financial/Currency Crisis: 1997 - 1998
•Hot money – capital flight
•Vicious circles  Debt burdens  Bankruptcies  Depression
•Asset price collapse
•Currency depreciation
•Lender of last resort
•Conditionality: Tight money/austerity
•Unorthodox policy
•Exchange controls (?)
Financial Crises: East Asia 1997-1998
• Financial liberalization in the early 1990s:
– Lending boom/weak supervision/lack of expertise.
– Banks accumulated losses/net worth declined.
• Uncertainty increased
– stock market declines and failure of prominent firms
• Domestic currencies devaluated (1997).
• Rise in actual and expected inflation.
Subprime-Triggered Financial Crisis of 2007 - 2009
• Financial innovations in mortgage markets:
– Subprime and Alt-A mortgages
– Mortgage-backed securities
– Collateralized debt obligations (CDOs)
• Housing price bubble forms
– World savings glut
Increase in liquidity from cash flows surging to the US
– Subprime mortgage market  housing demand and prices up.
• Agency problems arise
– “Originate to distribute”
 principal (investor) agent (mortgage broker) problem.
– Commercial and investment banks/rating agencies
…weak incentives to assess quality of securities
• Information problems surface… A “Minsky Moment”
Housing price bubble bursts/Crisis spreads globally
http://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html
A “Global Saving Glut”
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Securitization
MBSs
Rating
Agencies
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Securitization
MBSs
Rating
Agencies
Vicious Spirals Unleashed
House Price –
Foreclosure
Spiral
Deleveraging – Debt Deflation
Spiral
Demand –
Jobs –
Wages –
Income –
Spiral
Government
Revenue –
Cutback
Spiral
Global Repercussion
Spiral
Macroeconomic Linkages
and
Feedbacks
Financial Crisis of 2007 - 2009 (cont’d)
• Banks’ balance sheets deteriorate
– Write downs
– Sale of assets and credit restriction
• High-profile firms fail
– Bear Stearns (March 2008)
– Fannie Mae and Freddie Mac (July 2008)
– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and
Washington Mutual (September 2008).
• Fed pumps up bank reserves: TARP/TALF,etc.
– Lend and lend freely
• Bailout package enacted
– House votes down the $700 billion bailout package (9/29/08)
 Stock market slumps  Bailout passes on October 3.
– Congress approves a $787 billion economic stimulus plan on February 13, 2009.
• Recession deepens
Responses
Lender of Last Resort / Spender of Last Resort
•
Tax Rebate $124 bil.
• Fed Fund Rate Cuts
• Fannie/Freddie $200 bil.
•
Bear-Stearns $29 bil.
• AIG $174 bil.
Fed “Facilities”
• Primary Dealer Credit Facility (PDCF) $58 bil.
• Treasury Security Loan Facility (TSLF) $133 bil.
• Term Auction Facility (TAF) $416 bil.
• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
• Money Market Investor Funding Facility (MMIFF) $540 bil.
• More Fed Fund Rate Cuts … Hold At ~0%
• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
• Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
• Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
• TARP II
• Stress Tests
Vicious Spirals Unleashed
Vicious Spirals Reversed? Tackle them all together!
Refinance
House
Price –
Mortgages
Stimulus
Demand –
Program
Jobs –
•Infrastructure
Spending
Wages –
•Tax Cuts
Foreclosure
Spiral
Deleveraging
Debt Deflation
Revive dual–banking
system
Cash for Trash
Spiral
Income –
Spiral
•Recapitalize banks
•Revive securitization
Federal Aid
Government
To States
Revenue
–
Cutback
Spiral
GGlobal
– 20 Repercussion
•Coordinated
Spiral Stimulus
Macroeconomic
Linkages
Macroeconomic Linkages
and
and
Feedbacks
Feedbacks
December, 2008)
8%
6%
10%
37%
12%
13%
31%
7%
3%
7%
9%
http://www2.fdic.gov/sdi/main.asp
16%
31%
10%
Off Balance Sheet Assets/Activities
•Structured investment vehicles (SIVs)
•Loan sales
•Fees for
•Foreign exchange trades for customers
•Servicing mortgage backed security
•Backup lines of credit/overdraft privileges
•Standby lines of credit guaranteeing securities/commercial paper
•Trading activities  Principal – agent problem
•Bond markets
•Foreign exchange markets
•Financial derivatives
Shadow Banking System
• Financial intermediaries that conduct maturity, credit, and liquidity transformation
without access to central bank liquidity or public sector credit guarantees.
–
–
–
–
–
–
–
–
Finance companies
Asset backed commercial paper (ABCP) conduits
Limited purpose finance companies
Structured investment vehicles (SIVs)
Credit hedge funds
Money market mutual funds (MMMFs)
Securities lenders
Government sponsored enterprises (GSEs)
• Interconnections with each other and traditional banking system
–
–
–
–
ABCP
Asset backed securities
Collateralized debt obligations (CDOs)
Repurchase agreements
• Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks.
http://www.ny.frb.org/research/staff_reports/sr458.pdf
Possible Reforms
• Increase/tighten capital requirements
• Trade derivatives only on public exchanges tranparency
• “Mark – to – funding” accounting
– Value assets relative to date their funding must be repaid
• Rapid “resolution” of TBTF institutions
– Make bankruptcy credible
– Put creditors at risk  eliminate moral hazard of TBTF
•McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching
•Interstate Banking and Branching Efficiency Act (1994) deregulates branching
•Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals
Glass-Steagall
Regulating Finance: Regulation and Its Discontents
• Lots of bases to cover
Cover one by regulation or deregulation
 Unintended Consequences
• Reactions to regulatory policies
 frustrate regulator intent
Regulate bank balance sheets  off-balance sheet activities
Emplace a safety net  bankers become skydivers
• Regulation spreads to cover innovations
 complexity  ineffectiveness
Win by gaming the system
Primary Supervisory Responsibility of Bank
Regulatory Agencies
• Comptroller of the Currency—national banks
chartered by Federal government since 1863
• Federal Reserve and state banking authorities—
state banks that are members of the Federal
Reserve System
• Fed also regulates bank holding companies
• FDIC—insured state banks that are not Fed
members
• State banking authorities—state banks without FDIC
insurance
Innovations: Response to Interest Rate Volatility
• Adjustable-rate mortgages
• Financial Derivatives
Innovations: Response to Information Technology
• Bank credit and debit cards
• Electronic banking
– ATM/Home banking/ABM/Virtual banking
• Junk bonds
• Commercial paper market … backed by banks
• Securitization
Innovations:Avoiding Regulation/Loophole Mining
• Sweep accounts … reserve requirements
• Money Market Mutual Funds … Regulation Q
Decline of Traditional Banking
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation  rise in interest rates and disintermediation
Low-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)
Information technology  less need for banks to finance short-term credit
and issue loans
IT  lower transaction costs for other financial institutions
Bank Responses:
•Riskier Lending … Commercial real estate, leveraged buyouts, takeovers
•Off balance sheet activities
Size Distribution of Insured Commercial Banks, September 30, 2008 ????
3,046
4,039
486
86
7,640
39.9
52.9
6.1
1.1
1.3
9.7
10.0
79.0
Bank Consolidation
Skirting
Skirtingbranch
branchrestrictions
restrictions
•ATMs,
•ATMs,Bank
BankHolding
HoldingCos.
Cos.
Interstate Banking
and Branching
Efficiency Act, 1994
 Geographic deregulation
• Benefits of bank consolidation
Increased competition  close inefficient banks
Efficiencies from economies of scale and scope
Lower chance of failure -- diversified portfolios
• Costs
Fewer community banks  less lending to small
business
Banks in new areas  increased risks/failures
Pre-Crisis Findings:
•Net interest margin up
•ROA, ROE up for big
banks
•Intrastate deregulation
more positive for all but
big banks
•Interstate deregulation
helps big banks most
•Non-performing loans
down for biggest banks
but up for smaller banks
•State of economy has
stronger impact on bank
performance than
branching deregulation
The U.S. regulatory regime: In need of reform?
Justice Department
• Assesses effects of
mergers and acquisitions on
competition
Financial, bank and thrift
holding companies
• Fed
• OTS
Fannie Mae, Freddie Mac, and
Federal courts
Federal Home Loan Banks • Ultimate decider of
• Federal Housing Finance
Agency
banking, securities, and
insurance products
Fed is the umbrella or consolidated regulator
National banks
• OCC
Primary/
secondary • FDIC
functional
regulator
Federal
branch
• OCC
• Host county
regulator
State commercial Federal savings Insurance
and savings banks
banks
companies
Securities
brokers/dealers
Other financial companies,
including mortgage
companies and brokers
• OTS
• FDIC
• FINRA
• SEC
• CFTC
• State securities
regulators
• Fed
• State licensing
(if needed)
• U.S. Treasury
for some products
• State bank
regulators
• FDIC
• Fed--state member
commerical banks
Foreign
branch
• Fed
• Host county
regulator
• 50 State insurance
regulators plus
District of Columbia
and Puerto Rico
Limited foreign
branch
• OTS
• Host county
regulator
Sources: Financial Services Roundtable (2007), Milken Institute.
Notes:
Justice Department: Assesses effects of mergers and acquisitions on competition
Federal Courts: Ultimate decider of banking, securities, and insurance products
CFTC: Commodity Futures Trading Commission
FDIC: Federal Deposit Insurance Corporation
Fed: Federal Reserve
FINRA: Financial Industry Regulatory Authority
GSEs: Government Sponsored Enterprises
OCC: Comptroller of the Currency
OTS: Office of Thrift Supervision
SEC: Securities and Exchange Commission
23
Asymmetric Information and Bank Regulation
Government safety net
• Deposit insurance and FDIC
– Short circuits bank failures and contagion effect
• Payoff method
• Purchase and assumption method
• Fed as lender of last resort: Too BIG to Fail
• Financial consolidation Exacerbates Too Big to Fail
• Safety net extended to non-bank financial institutions
Safety Net  Moral Hazard Problems
– Depositors don’t impose discipline of marketplace
– Banks have an incentive to take on greater risk
Safety Net Adverse Selection Problems
– Risk-lovers find banking attractive
– Depositors have little reason to monitor bank
Attempted solutions: Constrain banks from taking too much risk
• Promote diversification
• Prohibit holdings of common stock
• Set capital requirements … Capital as cushion
• Minimum leverage ratio
• Basel Accord: risk-based capital requirements
… but there’s regulatory arbitrage
Prompt corrective action: Close ‘em down when capital inadequate
• Monitor … CAMELS
– Capital adequacy
– Asset quality
– Management
– Earnings
– Liquidity
– Sensitivity to market risk
• Disclosure requirements
… mark-to-market issue
• Restrictions on competition … make banking boring
http://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdf
Failed Banks Update
Year
•
•
•
•
•
•
•
•
•
•
•
•
•
2000
2001
2002
2003
2004
2005/2006
2007
2008 QI+Q2
2008 Q3
2008 Q4
2009 Q1
2009 Q2
2009 Q3
Number
2
4
11
3
4
0
3
4
10
12
21
24
50