Emerging from the Crisis

Transcription

1 Emerging from the Crisis i Franklin Allen University of Pennsylvania Elena Carletti European University Institute Louvain-La-Neuve May 6, 2010

2 What caused the crisis? The conventional wisdom used to be that the basic cause of the crisis was bad incentives in the mortgage gg industry But now we know much more was going gon The large global impact of the crisis suggests that the problems with subprime mortgages were a symptom rather than the cause The main problem is that there was a bubble in property prices in the U.S., Spain, Ireland and elsewhere, and we are now suffering the fallout from the collapse of that 2

3 Current Crisis: Case-Shiller 10 Cities Composite Source=S&P 3

4 Percentage Change in Case-Shiller 10 Cities Composite Source=S&P 4

5 What caused the bubble? The monetary policies of central banks particularly the U.S. Federal Reserve and ECB in some countries were too loose they focused too much on consumer price inflation and ignored asset price inflation Global imbalances the Asian crisis of 1997 and the policies of the IMF led to a desire among Asian governments to save funds 5

6 Reserves: A Comparison 6

7 To summarize: The first aspect of the problem was the development and bursting of the property bubble The second aspect was that this problem was considerably exacerbated by the poor functioning of the financial i system in the crisis i How much of the disruption to the real economy is due to the bursting of the bubble and how much is due to the financial crisis? 7

8 Spain One of the largest property bubbles occurred in Spain The bursting of this bubble has devastated the real economy unemployment has doubled to a level of almost 20% BUT the financial system, and in particular the banks such as Santander and BBVA have come through the crisis very well until the problems in Greece This suggests that the bursting of the bubble can cause tremendous damage to the real economy even if the financial system stem remains strong 8

9 Spain s property bubble Real House PriceIndices (1996=100) ce Index House Pri France Germany Greece Italy Portugal Spain UK USA 9

10 % in quarterly GDP quarter on quarter 2 % 0 Q Q Q Q Q Q Q Q Q Q Q Q US Japan France Germany Spain 10

11 Unemployment % Jan-2007 Mar-2007 May-2007 Jul-2007 Sep-2007 Nov-2007 Jan-2008 Mar-2008 May-2008 Jul-2008 Sep-2008 Nov-2008 Jan-2009 Mar-2009 May-2009 Jul-2009 Sep-2009 Nov-2009 Jan-2010 US Japan France Germany Spain 11

12 Why has the financial system performed so poorly? Why didn t regulation help? Banking regulation is different from other kinds of regulation in that there is no wide agreement on the market failures it is designed to correct It is backward looking in the sense that it was put in place to prevent the recurrence of past types of crises 12

13 Regulation What are the benefits and costs of regulation? The Basel agreements illustrate the lack of a widely agreed theoretical framework What exactly are the market failures? Panics Contagion Mispricing due to limits to arbitrage 13

14 Policy responses Central banks and governments need to be much more focused on preventing bubbles and global imbalances than in the past this is the real cause of the crisis Banking regulation needs to focus on correcting market failures rather than being imposed ad hoc as has been done historically 14

15 Preventing bubbles One of the main focuses of policy should be to prevent asset price bubbles because as Reinhart and Rogoff (2009) document this is the main cause of financial crises Frequent causes of asset price bubbles are Loose monetary policy Excessive availability of credit 15

16 Reform of central banks Central bank independence works well for combating inflation but not for financial stability The private sector is being criticized for taking so much risk but it is really the Federal Reserve, ECB and other central banks that took the risks, e.g. low interest rates in 2003 and currently quantitative easing There needs to be some check and balance mechanism such as a Financial Stability Board that helps to control public sector risk taking 16

17 Global imbalances Self-insurance by Asian countries through large reserves is optimal lfor them, e.g. South hkorea However, it is a very inefficient mechanism from a global perspective Reform of the IMF? Global currency? Regional risk sharing Bilateral swaps to give foreign exchange safety net Rmb as a reserve currency 17

18 Banking regulation Capital regulation main tool for regulation in recent years What are the market failures this regulation is solving? Basel agreements are silent on this issue Contagion is one of the most important market failures capital regulation can help prevent 18

19 Banking regulation (cont.) What is the cost of capital buffers i.e. why is equity more costly than other forms of finance? Most plausible explanation of the high cost of equity finance is that there is a tax subsidy to debt in the form of interest deductibility If this is the case then the best policy is to remove the interest deductibility of debt so that large capital buffers are both privately and socially optimal it is not clear there is any good justification for the tax deductibility of interest 19

20 Systemically important financial institutions Too big to fail is not Too big to liquidate The government needs to guarantee the short term commitments of failing banks to prevent contagion When a bank fails or is close to failure the government should step in, take it over and resolve it the top 5 executives should be removed immediately all employee pension claims should be eliminated over the next few years the bank should be liquidated International issues 20

21 Resolving large cross-border financial institutions Eliminate cross-border branches and require subsidiaries Regulators should monitor the degree of mismatch between assets and liabilities within the country with significant mismatches leading to posting of collateral Large equity buffers of 20 percent in terms of accounting and market capital Banks resolved when equity falls below 5 percent 21

22 Limits to arbitrage and the mispricing of assets Many ypeople p believe that prices of securitized products broke free from fundamentals and this is why prices fell so low TARP and many other plans were designed to restore prices to their proper level more effective policies need to be developed to ensure asset prices reflect fundamentals Mark-to-market versus historic cost accounting 22

23 Competition in financial services There is much discussion about bankers compensation but the real issue is how banks are able to make so much money that they can pay such high compensation What is really needed is a full competition review that establishes how they make so much money Market structures that are anticompetitive? Front running in the bond market? Conflicts of interest e.g. Goldman Sachs Swapping privileged information about takeovers and so forth with other institutions to make high profits on their proprietary trading? 23

24 Performance of M&A targets relative to the market around deal announcement

25 Problems in the Eurozone Will Greece default or muddle through? How much will the Germans pay? IMF conditionality is very severe and the population may not accept the cuts they impose Why didn t the Eurozone/IMF team include restructuring? Why can t they do what Ireland did? What would a default look like? Great uncertainty about how the default will proceed means financial effects may be large Significant contagion to Portugal/Spain/Italy Bankruptcy mechanism for Eurozone countries is needed 25

26 A bankruptcy mechanism for the Eurozone Mechanism should be designed to allow default without a bailout When the country defaults it is allowed to issue debt that is senior to defaulted claims so that it can support its banking system similarly to debtor-in-possession financing Team from ECB/Commission decides how much the debt will be written down so that the recovery path is sustainable with exit if the country disagrees 26

27 Preventing booms in Eurozone countries Spain and Ireland s economies have been wrecked by a monetary policy that was too loose for them and this led to property bubbles To prevent this in the future have limits on loan to value ratios that fall if property prices are rapidly rising Tax property transfers with a tax that steadily increases as property price inflation rises 27

28 What about other PIIGS and countries? Ireland No default Portugal Severe problems Spain Need to cut expenditure now Italy Unstable The UK and US? 28

29 Will the Eurozone survive? Yes, but with modifications But Keynesian Economics will not 29