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7/30/2019 Prof. Howard Davies Presentation
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Lessons of the financial
crisis: what have welearned?
Howard Davies
Professor Sciences Po
Vilnius3 May 2013
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Source: IMF Working Paper WP10/213Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09
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Source: IMF Working Paper WP10/213Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09
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Source: IMF Working Paper WP10/213Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09
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1. What went wrong?
2. Where have we reached broadconsensus on a response?
3. Which major issues remain unresolved?
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Source: The Economist, March 20, 2012 - http://www.economist.com/blogs/graphicdetail/2012/03/focus-2
The crisis delivered a sharprecession, and now a double-dip
in some placesGDP Growth 2007-11
7/30/2019 Prof. Howard Davies Presentation
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With a large increase inunemployment
Global unemployment trends: 2000-2011
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As severe as in any post-warrecession
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Source: This Time its Different, Rogoff, K. and Reinhardt, C.M., 2009
Cycles of past unemployment and banking crises
Recessions which begin in the financialsector are severe and long-lasting
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The crisis boosted governmentdebt in developed countries
Source: MGI Jan 2012Debt and deleveraging: Uneven progress on the path to growth
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- Global imbalances- Growing inequality leading to consumer
borrowing- Loose monetary policy, leading to
mispricing of risk credit bubble
- Excess leverage, facilitated by procyclicalregulation, and regulatory arbitrage
- Excess unmanaged growth of the financialsector, which magnified risks, rather thandiversifying them
What are the underlying causes?
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Global current account imbalancesgrew rapidly from 2003
Estimates of account balances for selected countries ($ Billion), 1993-2009
Source: http://www.fsa.gov.uk/pubs/other/at_29oct09.pdf Datastream, FSA Calculations.
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European banking assets grewrapidly
Assets of European listed banks, 1987-2009
0
5
10
15
20
1987
1990
1993
1996
1999
2002
2005
2008
Totalassets(EU
Rt
r)
Danske Bank A/S
Nordea Bank AB
Banco Bilbao VizcayaArgentaria, S.A.
Dexia SAIntesa Sanpaolo SpA
Commerzbank AGUniCredit S.p.A.
Societe Generale Group
Banco Santander, S.A.
Lloyds Banking Group plc
Deutsche Bank AG
Barclays plc
Credit Agricole SAHSBC Holdings plc
Royal Bank of Scotland GroupplcBNP Paribas
1988
1991
1994
1997
2000
2003
2006
2009
1989
1992
1995
1998
2001
2004
2007
Source: Capital IQNote: Chart shows total assets over time for top 16 listed European banks. The bank ranking used wa
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Derivative volumes exploded
Source: Datastream, BIS/ Financial Stability Report October 2008 by Bank of England
Outstanding Notional amounts of Derivatives
WorldGDPUS $
trillions
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Household debt as % of GDP, 1987-2007
Source: FSA, ONS, Federal Reserve, Eurodata, Datastream
Household debt rose sharply
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Act One: Subprime
Act Two: Liquidity
Act Three: Unravelling
Act Four: Meltdown
Act Five: Pumping
The Credit Crisis: A Five-ActShakespearian Tragedy
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Whom do the British blame for thefinancial crisis?
28
24
10
2
3
11
9
12
1
Bank executives
Governments
Financial regulators
The media
Central Banks
Thatcher and Reagan 1980s deregulatory
reformsConsumers for borrowing too much
Everyone (democratic society for its collective
failure to policy the above)
Other
%
Source: Thisismoney.co.uk, June 2009
Question: Who is most to blame for the current financial crisis?
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Macro imbalances, loose monetary policy andfinancial innovation
Rapid credit growth, asset price bubbles,overborrowing
Badly managed and unscrupulous financial firms
Flawed assumptions about market efficiency andinvestor rationality
Global finance without global government
Such a complex failurehas many parents
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What has changed?
- The global regulatory system has beenoverhauled
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The system was widely perceived tohave failed in the run-up to the crisis...
Structural problems revealed by the crisis
- Warnings of trouble ahead were ignored
- Needed reforms took years to agree, leaving acknowledgedvulnerabilities uncorrected
- The system was over-complex and there was no discipline orauthority among the different bodies
- The membership was unrepresentative and out of date
- The US was excessively dominant, and the EU spoke with many
voices- The system left too much scope for regulatory competition and
arbitrage
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G7 G20
Source: BBC
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G20
- Formed in 1999 as a group of finance ministersand central bank governors. Top 19 countriesby GDP, plus EU, IMF and World Bank. Spain
and Netherlands also invited- Became Heads of Government meetings in
2008 and replaced G8 as main economicdecision-making body
- Six-monthly meetings
- Rotating chair, no permanent secretariat.
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What has changed?
- The global regulatory system has beenoverhauled
- The Basel Committee has increased thecapital banks must hold, to make themsafer
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In, but not of, the Bank for InternationalSettlements, the BCBS is the mostimportant global standard-setter
- Formerly G10, now G20
- Central Banks and Supervisors (whereseparate)
- Sub-groups on capital, liquidity, etc
- Capital Accords legislated in EU,implemented on best endeavoursbanks elsewhere
- Apply in theory to large cross-borderbanks (but now in practice to all banks)
Committee of Governorsand Heads of Supervision
Basel Committee ofBanking Supervision
The Tower of B asel
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There have been three BaselCapital Accords
Basel II Basel IIIBasel I
1988 1996-2006 2010-2011
-Cooke ratio-8% minimum-Simple, but not
very risk-sensitive
-10-year gestation-3 pillars-Overall system capitalassumed to remainconstant-Several versions,highly complex-Heavy reliance oninternal models
-Higher capital-Varies throughthe cycle
-Additional capitalfor systemic firms-Tough rules onthe quality ofcapital
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What has changed?
- The global regulatory system has beenoverhauled
- The Basel Committee has increased thecapital banks must hold, to make themsafer
- Regulation has been overhauled in manycountries
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- Financial firms would have an incentive not tobehave imprudently, to ensure their ownsurvival and profitability
- The private sector control mechanisms wererobust
- Intrusive and rigorous regulation would be
damaging, and costly in terms of foregonegrowth
The regulatory system wasconstructed on the assumption that:
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The Dodd-Frank Act is presented asa major reform of US regulation
Dodd-Frank Act
- 2300 pages of legislation
- Structural changes to US regulatory system
- Enhanced powers (and financing) for manyregulators
- Reforms of the Federal Reserve
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The Changing Lexicon ofRegulation
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Unresolved issues
1. Too Big To Fail
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State aid measures in the context ofthe financial and economic crisis
Source: Likanen report October 2012
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Moral hazard is at the root of the'too big to fail' problem
Moral hazard
- Any situation in which one person makes thedecision about how much risk to take, whilesomeone else bears the cost if things go badly(Paul Krugman)
- In banking, riskier loans, and higher leverage canbe expected in good times to raise profits andtherefore remuneration for managers. In bad timestaxpayers will bail out the banks to avoid theadverse economic and social consequences ofbank failures. That is especially true of retailcustomers, whose deposits are largely guaranteed.
Past efforts to offset moral hazard
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Past efforts to offset moral hazardhave not been very successfulToo big to fail: possible remedies
Capital requirements/leverage ratios:
- Did not work efficiently pre-crisis
- Can encourage riskier lending to maximise return from givenleverage.
Supervision of risk-taking:
- Not very effective in the past
- Supervisors do not know enough, and perhaps cannot
Constructive ambiguity:
- Central banks may saythey will not intervene, but may be forcedto do so in the event.
Control of incentives/compensation:
- Is it possible to control incentives closely without becomingshadow directors?
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So more radical ideas have beenadvocated (1/2)
Moral hazard: new proposals
- Volcker rule to restrict proprietary trading
But:
affects only a small part of investment banks' portfolios
- 'Ring-fence' retail activities and restrict lender of last resortsupport to retail activities
But:
Is it credible to deny any possibility of support to commerciallenders?
Does it create safer retail banks, or reduce diversificationeffects?
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So more radical ideas have beenadvocated (2/2)
Moral hazard: new proposals
- Enforce separation of retail/small business lending
But:
May be costly for the system on the whole and create lessdiversified banks which are riskier
- Limit public support to 'narrow banks' undertaking a range ofsafe-keeping activities
But:
Increases the risk of the rest of the system
May raise credit costs for all other borrowers
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Unresolved issues
1. Too Big To Fail
2. Ethics and rewards in banking
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How much was Lloyd Blankfein(Chairman of Goldman Sachs)
paid in 2007?
$0
$22 million$45 million
$54 million
$73 million
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Historical Excess Wage in the Financial Sector
Source: NBER Working papersWages and human capital in the US financial industry, January 2009
Relative pay was at an all-time high in 2010
Only Premier League football clubs paid out as
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(Pay as a % of revenues)
Source: The Economist, special report on International banking, May 2011
Only Premier League football clubs paid out asmuch to their staff
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But job security may not be high
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- Incentive payments can drive risk-seekingbehaviour which causes institutional failure,financial instability and imposes costs ontaxpayers
- It may be a symptom of other competitive orregulatory problems
- Growing income inequality may contribute tosocial resentment and instability
Why should we care about high pay?
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There are five lines of attack:
1. Transparency: name and shame
2. Regulatory controls on incentivestructures
3. Empowering shareholders to controlmanagement
4. Higher marginal tax rates or pay-relatedlevies
5. Direct limits on remuneration
How effective have these
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- Annual payments to top Wall Street tradershave fallen, but remain in 8 figures
- Senior Executives have taken significant pay
cuts (though largely because profitability hasfallen)
- Some activities are moving out of traditional
centres, and/or regulated firms, to avoiddisclosure and pay constraints
- Overall, financial sector rewards remain
remarkably high
How effective have thesemeasures been?
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Unresolved issues
1. Too Big To Fail
2. Ethics and rewards in banking
3. The EMU dilemma
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Bruegel 2012/01 The Euro crisis and the impossible trinity
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So far, EU leaders have:
- Rejected mutually guaranteed borrowing- Rejected a fiscal union
- Resolved to create a banking union, but
- Without a centrally funded resolutionauthority, or
- A mutually guaranteed deposit protection
scheme
This looks to be an inadequate response
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Lessons of the financialcrisis: what have we
learned?
Howard Davies
Professor Sciences Po
Vilnius3 May 2013