Economic commentary – Jac Laubscher, Group Economist: Sanlam Limited

 6 October 2008

The global financial crisis Part 2: Reinventing the financial system

The financial crisis that has engulfed the world since August 2007 has yet to run its full course but it is has already irrevocably changed the financial landscape, especially in the Anglo-Saxon countries. The investment banks that have been part of the US financial architecture for more than seventy years have disappeared, the world’s largest insurer is now 85% in government hands (at least temporarily), important mortgage finance institutions in the USA and the UK have been nationalised,  more than one institution has been forced into being taken over by another institution with a more healthy capital position, and the use of public funds to recapitalise the banking system seems inevitable.

Many commentators have interpreted these events as an indictment of financial capitalism, if not in general then at least the more laissez-faire Anglo-Saxon variety. Those who see much of the activity in the financial sector as “unproductive” are crowing and clamouring for the “bloated” financial sector to be cut down to size. Greater regulation of and government involvement in the financial system are widely touted as the solution.

However, those inclined towards triumphalism should be careful not to turn a blind eye to the shortcomings of the solutions they are now proposing. Surely this is the biggest financial crisis for the world since the 1930s, if purely because of the size of the US financial sector and the dominant role it plays in the global financial system. But it is not the first such crisis, with other similar crises having occurred in countries with diverging economic systems, in many instances characterised by extensive government involvement in financial institutions and markets.

Examples of banking crises

According to Laeven et. al. (2008) there was 124 systemic banking crises between 1970 and 2007.  They also observe that “government ownership of banks is common in crisis countries, with the government owning about 31% of banking assets on average. In many cases, government ownership may have become a vulnerability as problems at state-owned banks have been major contributors to the cost and unfolding of the crisis, with many exhibiting low asset quality prior to the onset of a crisis”.

A few examples will suffice to illustrate the point.

In the early 1990s the world had to deal with the Scandinavian banking crisis occurring in social democratic countries. The causes of the crisis differed from country to country, with Sweden probably being closest to the current situation in the USA. The intervention by the Swedish government in the banking system initially amounted to 7% of GDP, but the final cost was a mere 0,5% of GDP. However, in Finland the cost to the fiscus amounted to 17% of GDP.

At the time of the Japanese banking crisis in the 1990s, which followed the bursting of the asset price bubble, the government of “the world’s most successful communist country” admitted that non-performing loans amounted to $400 billion (9% of GDP) although private estimates put it at double this amount. The cost to the fiscus exceeded 12% of GDP.

A common theme of the banking crises in Sweden, Japan, and now the USA is that they followed a period of financial liberalisation without an appropriate adjustment in regulation and supervision. The Japanese crisis also holds the lesson that regulatory forbearance can prolong the crisis and raise the eventual cost of its resolution.

The Asian crisis of 1997-98 (generally in so-called developmental states) was as much a banking crisis as an exchange rate crisis, and the governments in question played no small part in precipitating the crisis. Implicit exchange rate guarantees encouraged banks to engage heavily in short-term offshore borrowing and in many cases investing the proceeds in dubious ventures, with the approval if not the active encouragement of government – those were after all the hey-day of crony capitalism (or “relational banking” if one prefers to use a nicer term). The fiscal cost of the banking crisis amounted to 28% of GDP in South Korea, 35% in Thailand, and 55% in Indonesia, from 1997 to 2002.

The fiscal cost of systemic banking crises, net of recoveries, has averaged 13.3% of GDP from 1990-2007. By comparision, Kenneth Rogoff, a past chief economist of the IMF, has estimated that the cost of the current crisis to the US fiscus could be between 6% and 7% of GDP.

Furthermore, those people who are seeing in recent events further evidence of the shift in economic power from the West to the East, noting the contrasting calm in the Chinese banking system, are conveniently ignoring the vast problem of non-performing loans in China’s state-owned banks that once threatened to bring that economy to its knees. From 1990 to 2002, 50% of all loans ended up as non-performing loans, costing the fiscus 47% of GDP to write them off. The IMF estimated the stock of non-performing loans at 25% of GDP at end 2005, with the expectation that under current lending practices 16% of future loans will become non-performing. Furthermore, the asset recovery ratio on non-performing loans in China amounts to approximately a quarter, compared with two thirds in the USA savings-and-loans crisis in the early 1990s.

China, along with other Asian countries, suffers from a vast misallocation of resources brought about by a financial system which is not guided by market principles in its intermediation function (another example of “relational banking”!). Government involvement in the banking system furthermore encourages financial repression which acts as a brake on economic development.

Apart from massive injections of capital from public funds to enable the write-down of non-performing loans, the solution was found in market-enhancing reforms and in welcoming the very same international banks that are now being vilified to set up operations in China in order to learn from them.

The evidence is quite clear: state-owned banks are prone to political interference, in particular in their lending practices, with devastating consequences. In a South African context one only needs to be reminded of the current position of the Land Bank. Its latest annual report “provides the most frank account yet of a breakdown of internal controls, poor lending practices, wasteful expenditure, irregular appointments, fraud, negligence and gross misconduct”, according to Business Day of 30 September 2008.

That there has been an unprecedented breakdown in the market-based financial system in the West that needs to be addressed, cannot be denied, but the solution should be sought in strengthening the market system and not in introducing socialism into banking. In the final analysis the crisis is the result of human failure, as were the other crises mentioned above, and the market system is still the best system for bringing human failure to light and dealing with it in a dispassionate way. And as the current crisis is demonstrating, it is possible to structure public support in such a way that the financial system is protected without doing the same for the shareholders of failed institutions.

What shareholders need to do

So what needs to be done? Let us start with the business side of the equation.
Although much is made of the moral hazard problem, viz. that bailing out private institutions using public resources will encourage reckless behaviour, it is doubtful that business executives will purposely follow suicidal business practices, if only to avoid reputational damage and to protect the franchise value of their businesses. However, what is clear is that incentives need to be watched closely, especially to avoid an excessive emphasis on short-term profits, which are often purely on paper. 

With regard to the indignation expressed about the large bonuses paid to financial executives, the issue will resolve itself. Nothing can be done about past remuneration, and with the future financial architecture promising to be less profitable it will no longer support the level of remuneration to which some people are now objecting. “Remuneration schemes that limited downside risk with high upside potential, that are unrelated to conservative ex ante risk measures, and, above all, that front-loads payments” (Borio, 2007), will become untenable.

What has also become clear from recent events is the extent to which financial economics, in line with economics in general, has become overconfident in its ability to quantify everything that is relevant. The simplifying assumptions that usually underlie quantification are often ignored or not scrutinised sufficiently, the histories on which they are based are too short, and the dependence of models on the past repeating itself can be a death trap. The artificial valuation of assets by using marking-to-model in the end had to succumb to the real world of actual demand and supply. In short, abstract quantification is no alternative to confronting the real world.

But these are matters for shareholders to attend to, not government regulators. And make no mistake – the massive losses that shareholders in major financial institutions have suffered recently serve as a powerful encouragement to reinvent their business models. In the extreme, some types of financial businesses, including hedge funds and private equity firms, could turn out to be unsustainable due to their heavy reliance on leverage, which is no longer going to be available.

The question that should rather concern regulators is the extent to which they are prepared to rely on self-regulation by the financial sector as opposed to formal regulation. Self-regulation can work only up to a point. The models on which it is based are inherently flawed, and even in so far as they are useful the wrong incentives can still result in inconvenient truths being suppressed. (The trading scandal at Societé Général earlier this year is a case in point.)

What regulators need to do

The other side of the equation is the massive regulatory failure that has been brought to light by the crisis. At the heart of this failure is the dramatic lack of transparency with regard to position-taking in the markets and the actual location of risk. For regulation to work, the regulators need accurate and timely information. On the one hand innovation in financial markets ran ahead of the ability of regulators to regulate, and they were too slow in adjusting their information requirements. On the other hand they were just lax, as exemplified by Alan Greenspan’s unqualified approval in April 2005 of the development of the sub-prime market. To quote: “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.”

Regulatory reform is, of course, a vast subject that cannot be treated in full in this commentary, so only a few guiding principles will be laid down.

Regulators would do well now not to respond only to the regulatory shortcomings that became evident as a result of the idiosyncrasies of the sub-prime crisis (notably the role of structured credit products and the originate-and-distribute business model), but rather to reconsider regulatory models from first principles, guided by the need to protect the trust that makes it all hang together. To put it another way: they should focus on the underlying causes and not on the symptoms.

To quote Borio (2008): “All instances of financial distress have evident episode-specific elements, often linked to the type of financial innovation that precedes them. And yet, what is common to the episodes is more important, as it hints at the more enduring factors underlying the dynamics of financial instability”.

Furthermore, “all episodes of financial distress of a systemic nature, with potentially significant implications for the real economy, arguably have at their root an overextension in risk-taking and in balance sheets in good times, masked by the veneer of a vibrant economy. This overextension generates financial vulnerabilities that are clearly revealed only once the economic environment becomes less benign, in turn contributing to its further deterioration. The risk that builds up in good times simply materialises in adversity”.

In other words, the financial system is inherently pro-cyclical, and regulation and supervision therefore should be counter-cyclical, implying they should be tightened during the good times.

The aim should be to safeguard stability without suppressing innovation. The way in which this aim is achieved should focus on increasing transparency in financial markets rather than prescribing behaviour through a list of do’s and don’ts. According to Borio (2007), “financial liberalisation and innovation are critical for a better allocation of resources and long-term growth: the serious costs of financial repression around the world have been abundantly documented”.

Financial market failures

However, that there is a role for financial regulation is not to be argued. To quote Houben, et. al. (2004): “Although finance would no doubt exist and bestow benefits without public intervention, it would be less supportive of economic activity, wealth accumulation, growth, and ultimately social prosperity. Put differently, finance may not automatically lead to efficient outcomes if left entirely to market forces”.

They continue to list five sources of market failure in the financial economy that justify government intervention:

Financial stability and the trust it entails are a public good.

Finance involves significant externalities, positive (greater efficiency) as well as negative (systemic risk).
 Incomplete and asymmetric information results in price misalignment, resource misallocation, adverse selection, and moral hazard.

Incomplete markets are typified by non-price discrimination and illiquidity.

Imperfect competition stems inter alia from economies of scale, which can be exacerbated by prudential regulation.
The financial economy has been characterised by four major trends in recent years that reveal these market failures in some form or another which require a regulatory response.

Firstly, the financial economy has expanded much more rapidly than the rest of the economy. The implication is that the impact of financial instability on the real economy will be much larger than in the past and that more attention therefore needs to be paid to financial regulation, requiring more resources.

Secondly, the composition of the financial system has changed to include an increasing share of non-monetary assets, implying greater leverage of the monetary base. The increased marketisation of finance also implies that issues of liquidity and counterparty risk have become crucially important. In the words of Houben et. al., “there is the danger of too much finance being built on too little certainty or trust about the future fulfillment of financial contracts”. It is therefore not enough to regulate only commercial banks, and other financial institutions that lurk in the shadow banking system also need to be brought into the net.

Thirdly, increasing cross-industry and cross-border integration has resulted in a more interwoven financial system, nationally as well as internationally. The issues of whether there should be a single regulator or multiple regulators and where they should be positioned thus need careful consideration. Where issues of financial stability are at stake, a single regulator, possibly situated in the central bank, seems to be the route to go. One of the reasons why the failure of Northern Rock in the UK was dealt with so inefficiently was the split in regulatory oversight between the Bank of England and the British Financial Services Authority.

International surveillance also needs to be improved, possibly under the umbrella of the Bank for International Settlements. It will be politically difficult to establish a global regulatory authority, but there is clearly a need for more formal coordination. 

Fourthly, the financial system has become more complex and diverse and financial instruments have become more intricate, resulting in risk becoming very mobile. It has therefore become more difficult to track the development of risk, with increased danger of contagion, requiring more intense monitoring and greater cooperation among a larger number of authorities. This further strengthens the conclusions mentioned above, especially the acute need for improved transparency.

The financial stability policy framework should therefore be aimed at (i) the early identification of potential vulnerabilities, (ii) preventive and timely remedial steps to avoid financial instability, and (iii) resolving instabilities when preventive and remedial measures fail. Clearly too little attention was paid in the USA to the first two elements in recent years, and it now finds itself scrambling to enact the third leg of the policy framework.

As difficult and as complex as it is, the early identification of vulnerabilities is possible and preventive and remedial policies can be implemented. Houben et al. (2004) provide an example from the Netherlands in the late 1990s where the central bank responded in a timely manner to a housing price boom that was perceived to potentially threaten financial stability. Steps taken to counter this threat included intensified surveillance of the housing and mortgage markets, the development of stress tests, increased supervisory attention to banks’ administrative systems and internal controls, capping the loan-to-value ratio, regular household surveys to monitor their use of mortgage credit, and moral suasion through public discussion of the issue. If only the US had done this…. And it is not a matter of hindsight – the BIS, for one, has repeatedly warned about excessive risk-taking since 2005.

However, apart from regulatory policy, monetary policy will also have to be reconsidered. After all, monetary policy can play an important role in the build-up of financial imbalances through the influence it has on the cost of liquidity. The question needs to be asked whether monetary policy should at all times focus on inflation only, or whether its mandate should be broader. But note: this does not imply laxness in fighting inflation, but rather that policy should not be too loose during periods of low inflation.
 
Conclusion

To conclude: yes, business models and practices in the financial sector became seriously flawed in the process of financial innovation; yes, there has been a massive failure in oversight and regulation; yes, the financial economy is prone to market failures that point to government having an essential role to play in setting the rules of the game. But it would be wrong to conclude that heavily regulated, government-dominated systems are better than market-based systems.

No financial system will ever be perfect, but a market-based system is more likely to self-correct when things go wrong, and to provide the necessary support to development and growth. In fact, one could argue that the abnegation of free-market principles contributed to the crisis, as demonstrated by the experience of Fannie Mae and Freddie Mac, which was characterised by implicit government guarantees combined with weak regulatory oversight.

Instead of indulging in the highly satisfying emotion of schadenfreude, governments in emerging market economies should be asking themselves what lessons are to be learnt from the current crisis for the development of their own market-based financial systems. The starting point is that financial liberalisation should continue, but it should be accompanied by the necessary pillars of regulatory and supervisory support being put in place.

Bibliography

Blundell-Wignall, Adrian & Atkinson, Paul (2008). The Subprime Crisis: Causal Distortions and Regulatory Reform. Reserve Bank of Australia.
Borio, Claudio E. V.  (2007). Change and constancy in the financial system: implications for financial distress and policy. Bank for International Settlements Working Paper no. 237. October.
Borio, Claudio (2008). The financial turmoil of 2007-?: a preliminary assessment and some policy considerations. Bank for International Settlements Working Paper no. 251. March.
Houben, Aerdt; Kakis, Jan; Schinasi, Garry (2004). Toward a Framework for Safeguarding Financial Stability. IMF Working Paper WP/04/101. June.
Kanaya, Akahiro & Woo, David (2000). The Japanese Banking Crisis of the 1990s: Sources and Lessons. IMF Working Paper WP/00/07. January.
Kane, Edward J.  (2008). Regulation and Supervision: An Ethical Perspective. NBER Working Paper 13895. March.
Laeven, Luc and Fabien Valencia (2008): “Systemic Banking Crises: A New Database”. IMF Working Paper WP/08/224. September.
Noy, Ilan (2005). Banking Crises in East-Asia; The Price Tag of Liberalization? East-West Center Analysis no. 78. November.
Rochet, Jean-Charles (2002). Why are there so many Banking Crises?  BP lecture at the London School of Economics. 21 May.
Rose, Thomas (Date?). Managing Bank Crises in Other Countries. Federal Deposit Insurance Corporation Panel Discussion.
Ueda, Kazuo (1998). The Japanese banking crisis in the 1990s. Bank of Japan.

About Jac Laubscher       
 
 Jac Laubscher, Sanlam Group economist, discusses topical issues in the South African economy. 

As Sanlam’s Group Economist Jac Laubscher provides strategic economic input to the various companies in the group in support of their business strategies. He completed his economics studies at Stellenbosch University and he was the first South African economist to qualify as a Chartered Financial Analyst with the CFA Institute in the USA.

Jac still maintains strong links with leading academic institutions, and is well known as an independent and leading analyst of events and emerging trends in the South African economy and financial markets. His analyses are based on fundamental research.