Bank of Greece Workshop on 14 May 2010 in Athens
The Global Financial Crisis and SEE: Lessons for
Macroeconomic Policy and Financial Stability
Preserving financial stability – the
supervisors‘ perspective
Contribution by Franz Pauer
Preserving Financial Stability:
What have we not learned and why?
1. What do we know about financial crises?
2. What has hampered the transfer of
knowledge into distinct action?
3. Conclusions
The views expressed by the author
do not necessarily reflect the
official viewpoint of the OeNB.
Bank of Greece Workshop
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franz.pauer@oenb.at
Many lessons learned from the recent financial crisis …
• Address systemic risk adequately!
• Improve supervisory co-operation (cross-border and cross-sector)!
• Increase transparency of financial institutions and products!
• Reduce the degree of leverage!
• Reduce incentives for moral hazard!
• Reduce short-termism in remuneration systems!
… have already been drawn from earlier crises
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The general patterns of financial crises are well known
• Excess liquidity is always at the origin of financial bubbles. Despite
the fact that it is often used to finance per se economically sound
developments (innovations), it leads to over-investment if too much
capital flows into these promising investment opportunities.
• Consequently, the marginal efficiency (profitability) of the capital
invested declines. Given the expectation of future profits and
(demand driven) asset price increases, this is, however, disregarded.
• The emerging bubble is further inflated by declining risk-awareness
and deteriorating risk management, rising moral hazard and
increasing herding behaviour.
• Finally, the bubble bursts, losses have to be realized, the euphoric
feeling turns into a gloom-and-doom mood, the risk appetite declines
dramatically and funding becomes extremely difficult.
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A few examples of financial crises
economic reasoning (sound origin of
signs of irrational
investment opportunities)
excess liquidity exuberances
International
debt crisis
in developing and emerging
countries, capital is the
scarcest production factor
“recycling of
petro dollars” via
banks
investments are not made
in the producing sectors or
are not profitable
Japan crisis
deregulation improves the
allocation of capital and its
efficiency
strong domestic
credit expansion
asset prices rise to absurdly
high levels, 9 out of 10
largest banks are Japanese
“New
economy”
bubble
“first movers” produce new
goods and services with
prospects for high demand
global excess
liquidity
market value of loss-making
new economy firms soars
Sub-prime
crisis
no basic economic innovation,
only financial innovations used
to disguise risk
global excess
liquidity, savings
glut
escalating indebtedness of
private households in the
U.S.
SEE bubble
freeing of market forces,
catching-up potential, EU
integration process
liquidity inflow
from foreign
banks and FDI
consumer credits expand
fastest, high good will at
bank acquisitions
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Despite the fact that financial authorities knew
* from earlier financial crises what to do and
* how financial bubbles generally develop
they were not able to prevent the recent crisis!
Why?
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Preserving Financial Stability:
What have we not learned and why?
1. What do we know about financial crises?
2. What has hampered the transfer of
knowledge into distinct action?
3. Conclusions
Bank of Greece Workshop
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franz.pauer@oenb.at
Financial authorities took measures,
but they had little effect

• Regulators established new (complex) rules to prevent a repetition
of preceding financial crises, however
– regulated institutions immediately searched for ways to circumvent new regulations by moving (risky)
business …
– from regulated to non-regulated activities (e.g. from on-balance to off-balance sheet),
– from highly regulated to little or non-regulated institutions (e.g. from banks to the shadow banking system
including leasing companies) and
– from countries with tougher supervisory regimes to countries with lighter regimes.
Regulating risky financial activities is like chasing mosquitoes:
Each time you think, you have finally caught one, it instantly
appears somewhere else and continues its annoying activity!
Bank of Greece Workshop
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franz.pauer@oenb.at
Financial authorities took measures,
but they had little effect

• Financial authorities have extended their macro-prudential
analysis considerably (e.g. performing stress tests, publishing
Financial Stability Reviews), however the results of the analysis
– triggered only insufficiently effective supervisory action (see next points) or
– triggered no intervention from financial authorities at all (for the reasons see slides 11 to 13).
• Financial authorities issued recommendations and warnings (on
the basis of their macro-prudential analysis), however
– the instruments of self regulation and corporate governance controls in financial institutions turned out
to be too weak to effectively implement supervisory proposals (e.g. best practices) and
– in a situation of widespread market enthusiasm (irrational behaviour), warnings are ignored anyway.
Bank of Greece Workshop
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Financial authorities took measures,
but they had little effect

• National authorities took distinct supervisory measures to
dampen developments that had the potential to lead to financial
fragility in their respective domestic markets, however
– the close integration of the domestic into the global market reduced the effectiveness of these
interventions,
– e.g. prudential measures to reduce excessive credit expansion of local banks were circumvented by
increased cross-border lending of foreign parent banks.
• Financial authorities have even extended formal cooperation on a
bilateral and multilateral basis (e.g. MoUs, Lamfalussy process),
however
– the exchange of essential information and the implementation of joint measures remained the exemption
(for the reasons see especially slide 13)
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Financial authorities were hesitant to take measures

• Financial authorities wrongly assumed that all market
participants behave rational and thus were too complacent in
their attitude to certain financial products and to certain users, e.g.
– they assumed that professional investors would not purchase financial instruments, which are extremely
intransparent (e.g. structured products),
– they were not sufficiently aware that many private households do not (intuitively) understand what risk
actually means and thus tend to ignore it in the decision making process, e.g. when borrowing in foreign
currency.
 In both examples we see a systematic under-perception of risk which would have justified (stronger)
interventions of financial authorities.
• Uncertainty about the existence of a financial bubble (new bubbles
usually wear new masks) made authorities to postpone the decision
to intervene. However, this was in fact a(n implicit) decision in favour
of erring on the side of allowing too much expansion (following the
approach of cleaning-up after the bubble has burst).
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Financial authorities were hesitant to take measures

• Financial authorities usually face widespread resistance against
measures directed at curbing irrational exuberances. Nearly all
economic agents benefit (at least in the short run) from an ongoing
bubble and do not like the party to be spoiled:
– (Risky) borrowers have easy access to credit.
– Owners of financial and real assets see the market value of their investments on a continuous upward
trend.
– The financial industry generates large revenues.
– Companies’ profits are pushed up by strong demand.
– The labour force benefits from increasing employment and income.
– Governments enjoy rising taxes, falling social expenditure and easy financing for their favourite political
projects.
If you think that you are in paradise, you do not want to
hear that you are right on the way to hell!
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Financial authorities were hesitant to take measures

• National financial authorities show strong loyalty to “their”
banks. This may conflict with the necessity to take financial stability
measures if they are painful for (domestic) financial institutions.
– In multilateral financial forums, national financial authorities tend to draw an overly positive picture of
their respective domestic financial systems instead of openly discussing critical developments => global
risks may be underestimated and potential spillovers may be overlooked
– When new internationally binding financial rules are discussed, national financial authorities often act as
lobbyists of the interests of their respective financial institutions (e.g. regarding competitive advantages
or disadvantages) => weak and very complex supervisory regulations incapable of preventing future
financial crises
– National financial authorities are reluctant to “persuade” domestic parent banks not to circumvent
lending restrictions imposed on their foreign subsidiaries => financial stability measures of host
supervisors become ineffective
Bank of Greece Workshop
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Preserving Financial Stability:
What have we not learned and why?
1. What do we know about financial crises?
2. What has hampered the transfer of
knowledge into distinct action?
3. Conclusions
Bank of Greece Workshop
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franz.pauer@oenb.at
Conclusions
• There is a need for principal-based (less complex) regulations which
have the potential to cover new developments, especially all attempts
to circumvent them. This means that the rules are at the discretion of
financial authorities (strengthening of pillar 2), which have to apply
them and to take (proactive) decisions and measures.
• There are (national) financial authorities, which are hesitant to
intervene due to existing uncertainties, fierce resistance from vested
interests, strong loyalties to their domestic banks, insufficient
cooperation of foreign authorities etc.
 This causes a dilemma: Additional power should be lent to
institutions which so far have shown little eagerness to use it.
 A possible way out could be a shift of decision making powers from
national authorities to a supranational institution. The new European
supervisory architecture could be a first step into this direction.
Bank of Greece Workshop
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