The World Financial Crisis: How Did it Happen? – Timo Henckel

Issue 1 | 28 January 2009

On Wednesday 28 January 2009, The Sydney Institute held an early evening seminar to discuss the causes of the Global Financial Crisis then unfolding. The speakers were Mark Johnson, a former Chairman of Macquarie Bank, Dr John Edwards, Chief Economist with HSBC and Dr Timo Henckel, a Research Fellow with the Centre for Applied Macroeconomic Analysis at the Australian National University. The function attracted a capacity audience and The Sydney Institute announced further discussion seminars on the GFC would be organised throughout 2009.

THE WORLD FINANCIAL CRISIS:  HOW DID IT HAPPEN?

Timo Henckel

It is an honour to be here and to have the opportunity to convey my thoughts on the global financial crisis, which sadly is no longer a financial crisis but a global economic crisis. The list of factors proffered as the causes of the developed world’s severest financial crisis since 1929 is long and expanding. Each one of them might warrant a stand-alone lecture and there is a vigorous debate about whom and what is to blame.  Truth is – the crisis is best explained as a “perfect storm”, a confluence of numerous contributing factors. Airplane disasters are rarely attributable to a single cause; crash investigators typically refer to a “chain of catastrophic events”. So it is with the current mess we are finding ourselves in.

I will briefly discuss each of the most prominent explanations but, given time constraints, will have to pass on the details.

There are nine microeconomic failures:

1. Sloppy oversight by prudential regulators and supervisors – Authorities tolerated the existence of a rapidly growing shadow banking system, comprised of structured investment vehicles, conduits, etc., which were shielded from regulatory controls. Core banks, those institutions subject to bank regulation, took advantage of this regulatory vacuum, going “off-balance sheet”. This was, of course, a smoke screen. Off-balance sheet items were ultimately “on-balance sheet” items
2. Overly complex and misinformed securitisation – Bank loans, formerly non-marketable, were lumped together, tranched, sliced and diced and sold on as mortgage backed securities. These asset-backed securities were often sliced and diced again for a further round of securitisation. This process (“originate and distribute”), heightened by a vibrant derivatives market, reduced incentives for banks to screen their customers and created a confusing menu of financial instruments whose risks were not fully appreciated.

   In the words of US Senator Robert Menendez, “credit rating agencies are playing both coach and referee”. Their decisions move markets and their power has not been harnessed to the benefit of society.

3. Flattering risk ratings by misguided and fundamentally conflicted rating agencies – Many fingers have been pointed at the credit rating agencies – in my opinion, deservedly so. They bought into the Panglossian paradigm, lacking imagination when profiling risks. They are hampered by conflicts of interest, acting as raters, advisors, underwriters and sponsors. In the words of US Senator Robert Menendez, “credit rating agencies are playing both coach and referee”. Their decisions move markets and their power has not been harnessed to the benefit of society.
4. The pro-cyclical nature of internationally imposed capital adequacy requirements and the marking-to-market of illiquid assets – In a downturn, where fair values are neither reliable nor verifiable, asset prices quickly lose value, forcing financial institutions to shed them in order to meet capital adequacy requirements, which in turn lowers the assets’ values and so on. This vicious cycle is exacerbated by some quirky details contained in the Basel I and II regulations. Thus, static risk-based capital regulation with concurrent marked-to-market accounting is inherently pro-cyclical and destabilising.
5. Insufficient liquidity requirements – Banking regulation, by focusing on capital adequacy, neglected the importance of liquidity. Once again, regulators lacked imagination in failing to anticipate the possibility that markets for entire asset classes may collapse. In bad times cash is king; he is too readily deposed of in good times.
6. Inappropriate accounting standards – Imperfect auditing and accounting rules strengthened the incentive to push items “off-balance sheet” and to underinsure against various risks associated with financial institutions’ portfolios.
7. Skewed reward structures for investment managers that encouraged excessive risk taking – Inadequate corporate governance, myopic and asymmetric reward structures in many financial institutions, performance benchmarking and a revealing disrespect for risk management led to excessive risk taking. Incentives for individual market participants typically were not aligned with the greater good.
8. Narrowing profit margins due to greater international competition – Greater competition is mostly desirable subject to an appropriate regulatory environment. Financial markets, we must remember, are characterised by strong informational asymmetries and deficiencies that make them different from standard goods markets. Letting the market rip without adequate institutional safeguards leads to instability.
9. Misguided government policy such as the national mortgage associations and the “Community Reinvestment Act” in the US –Financial markets are the most heavily regulated markets in the world. Government sponsored enterprises such as Fannie Mae and Freddie Mac distorted the market through their sheer size as well as their excessive risk-taking, joisted by an implicit government guarantee. A strengthening of the Community Reinvestment Act in the 1990s encouraged a loosening of lending standards that fuelled the sub prime mortgage sector.

All these led to an excessive supply of credit, often to unbankable customers.

Many of these causes are specific to the US; afterall, it was the sub prime mortgage sector in that country that lit the fuse. And many of the above failures were the side effects of otherwise well intended policies. For example, the Community Reinvestment Act was drafted to reduce discriminatory credit practices against low-income neighbourhoods (“redlining”) in an attempt to reduce inequality and poverty. And the imposition of capital adequacy requirements and marking-to-market practices was supposed to strengthen financial institutions by making their balance sheets more transparent, realistic and resilient, in an attempt to prevent the ever-greening of bad debt such as we saw in Japan a decade and a half ago.

These examples highlight two key lessons. They are obvious but should feature on a post-it note attached to every desk in every government department: 1) Well intended policies often have unanticipated adverse side effects; 2) Different policies interact with each other in wondrous, surprising and sometimes devastating ways. Among the macroeconomic failures the following three are particularly salient:

1. Underinvestment in many emerging market countries, especially in Asia and the oil-producing countries, leading to a global savings glut – After the 1997/8 East Asian crisis regional investment never recovered to pre-crisis levels. Add to that the integration of a number of high-savings countries, notably China, and rapid wealth accumulation in commodity exporting countries and you have the global savings glut economists started worrying about several years ago. As a consequence, long-run global interest rates have been exceptionally low.

   successful inflation targeting firmly anchored the public’s inflation expectations, so that the CPI remained close to its target. This was interpreted as confirmation that the interest rate (the policy rate) was at its correct level. It was not.

2. Overly loose monetary policy by the Federal Reserve and other central banks following the collapse of the 2000 dotcom bubble – The Federal Reserve and other key central banks were quick to lower policy rates in the wake of the bursting dotcom bubble but slow to raise rates once the storm clouds had passed. In days gone by central banks would have observed excessive credit growth feed into inflation of the consumer price index (CPI) and responded accordingly. However, successful inflation targeting firmly anchored the public’s inflation expectations, so that the CPI remained close to its target. This was interpreted as confirmation that the interest rate (the policy rate) was at its correct level. It was not. How to deal with asset price bubbles is one of the major challenges for central banks.
3. 15+ years of uninterrupted economic expansion in most developed economies which instilled complacency and excessive optimism in investors – Investors and the public have limited memory. Good times breed complacency and dull the imagination. Risk profiles, based on recent averages, as opposed to long-run averages, are distorted; events in the tails of distributions – the “black swans” – are overlooked. Over time risk premia fall, there is an intense search for yield, asset prices appear to know only one direction – up. References to new paradigms, whether technological or policy, are as common as they are wrong.

So how did this crisis turn global? Through four main avenues:

1. Other countries were experiencing their own home-made crisis, similar to the US;
2. Their banks had directly invested in the toxic securities that brought down the US banking system;
3. The high degree of global financial interconnectedness, at levels never seen before in history, damaged foreign banks’ balance sheets;
4. Traditional spillovers into the real economy affected imports, exports, cross-border investment and overall confidence.

The long line-up of culprits suggests that this financial crisis is special. Is it? Or are there some deeper, underlying origins of the crisis? Recent research on financial crises spanning the past 150 years suggests a commonality among them:

• Financial crises are the tail end of ever-present boom-bust cycles in the market for equities, commodities, currencies and other assets.
• These cycles are financed by credit.
• There is an intimate, if unstable, relationship between credit-fuelled boom-bust cycles and the business cycle.

The problem is that these stylised facts do not sit well with the neoclassical paradigm of economics. Financial markets are supposed to be efficient, self-correcting and intrinsically stable. Believing in the infallibility of financial markets in 2009 rather stretches one’s faith. Of course, several economists have criticised this notion, and it is therefore not surprising that the theories of John Maynard Keynes, Hyman Minsky and others are being rediscovered by those seeking answers to current events.

Minsky was particularly prescient, seeking to replace the “Efficient Market Hypothesis” with the “Financial Instability Hypothesis”, the idea that modern financial systems are intrinsically prone to bouts of speculation which often end in crises. Why is this? How is this inherent instability generated?

The underlying premise of the “Financial Instability Hypothesis” is the refutation of the “Efficient Market Hypothesis”, the idea that asset prices are always and everywhere correct, to be explained by fundamentals alone. Empirically, the “Efficient Market Hypothesis” is extremely difficult to sustain but economists are loath to abandon it; its intuitiveness and formal rigor are too beguiling. The “Efficient Market Hypothesis” derives its legitimacy by appealing to the most fundamental proposition in economics: every market has a downward sloping demand curve and an upward sloping supply curve, whose intersection determines a market-clearing price.

However, credit markets are unlike goods markets. Informational asymmetries may be so severe that basic Econ 101 principles no longer apply. In credit markets, demand curves may be upward sloping as greater credit fuels asset price inflation which, along with collateralisation and marking-to-market, triggers higher demand for credit. Because financial markets exhibit positive feedback effects, a fractional reserve banking system necessarily leads to self-reinforcing asset-debt cycles. Government intervention, monetary policy in particular, has rarely been helpful, not least because policy makers are ideologically conflicted. Central banks are endowed with multiple objectives which may at times conflict: to keep inflation in check and to act as lender-of-last-resort if need be.

The debate rages on and a growing number of economists are drawn to at least some aspects of Minsky’s theories. But the million-dollar question is: what are the policy lessons we can draw from this, in particular for central banks, being at the head of the financial system? Does the pendulum need to swing away from laisser-faire and back towards more regulation and government intervention? Let me give you three very broad but important lessons:

1. Policy makers need to adopt the correct model of the financial system. In my view it will be some rendition of the “Financial Instability Hypothesis” though considerably more research is necessary to arrive at a coherent, rigorous, practical model. Investors will then have a letter appreciation of extant risks and policy makers can formulate more appropriate policies.

   Central banks must adapt better to their conflicted roles as demand manager and as guardian of macro-financial stability.

2. Central banks must adapt better to their conflicted roles as demand manager and as guardian of macro-financial stability. In practice, they must consider credit and asset prices in addition to consumer prices. (The two major graduate textbooks on monetary policy, published in 2003 and each no less than 600 pages long, amazingly do not mention financial stability once!)
3. Prudential regulation needs a serious overhaul; it needs to change from being pro-cyclical to becoming counter-cyclical. Policies between central banks and prudential authorities need to be better coordinated.

The final destination is not a land of milk and honey where boom-bust cycles are mythical concepts but one where modest cycles are accepted as an intrinsic feature of our economies.

As with any policy, the devil is in the detail. We are not (yet) in a position to define a new best practice for managing financial systems. All the pundits who claim to be in possession of the Philosopher’s Stone are going out on a limb. Much like it took three decades to arrive at the current best practice of inflation targeting, so it may take as long or longer of groping for a best practice of crisis prevention and management. Provided the more pressing need for reforming prudential regulation is addressed, that is making it counter-cyclical, not pro-cyclical, I am confident central banks will be able to rise to the challenge. We must only be patient and dare to make mistakes along the way.