Reflections on the Financial Crisis: Back to Fundamentals

F. Montes-Negret 1/

VUZF University, Sofia May 10, 2012

1/ The views are exclusively mine and do not represent those of the IMF or its Board of Directors.

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(Ambitious) Agenda

• Motivation: Dramatic changes in financial markets & banking• The theoretical framework frames the questions & the questions

limit the scope of the answers;• The “problem” of very low interest rates;• Financial viability in terms of cash flows;• Three critical financial ratios:

– Leverage (ROE); – (Loan/Deposit) ratio; and – Loan-to-Value (LTVs) ratio

• Credit underwriting standards and housing finance;• Pro-cyclicality and downward “spirals”;• Aligning incentives faced by different stakeholders;• Some conclusions – What happened, more than Why it happened?• Annexes: (1) Housing Crisis (Ireland & Spain);

(2) Reading Market Signals (CDS)

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Dramatic Changes in Financial Markets and Banking

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Dramatic Pace of Change in Finance

SOME CONSEQUENCES

Rise in marketability of bank assets (securitizations)Risks can change instantaneously

TBTF /LCFIs /Banks <–>Markets more intertwinedWeaker market discipline. More difficult to Supervise

Increased complexity: Organizationally and Inter-company and higher market exposures (inter-connectedness)Herding behavior, stronger correlation of risk exposures, and more systemic risk

IMPACT ON BANKINGDomestic & Cross-Border Banking Business Models

Conglomeration/ ComplexityRisk Management Governance

Herding Behavior

EXTERNAL FORCES

IT / Asset Marketability Expansion of Capital Markets Changing Incentives & RegulationsRapid Deregulation Entry of New players Rapid Innovation

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The emergence of a large “shadow banking” system

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US: Rapid Growth of Non-bank Asset Pools

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“Run” on Asset-Backed Commercial Paper

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Pro-Cyclical role of rising “haircuts”

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Downward pro-cyclical “spirals”: Margin Calls

The Theoretical Framework

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Different Theoretical Frameworks

Neo-Classical/ Monetarist & Neo-Keynesian

“Instability View “ (Minsky, Kindleberger, et.al)

-Financial system: Totally or Largely irrelevant - “Money View” (Friedman): Money has a

short-run but no long-run impact;- “Irrelevance View” (Modigliani-Miller):

Finance only a “veil”;- “Credit View”: Bank credit central as

a “propagator of shocks”-Macroeconomic outcomes largely independent of the performance and structure of the financial system-Inadequate to explain new era of “finance capitalism”? Structural changes in monetary and credit aggregates starting in the 1950s – (financial assets/ broad money) and leverage took off, while banks’ liquid assets declined.

-See: “Credit Booms Gone Bust: Monetary policy, Leverage Cycles and Financial Crises, 1870-2008”, M. Schularick & A. Taylor, NBER, November 2009.

-Financial System: Central-Financial factors have a strong and often dominant impact on the economy through endogenous credit booms leading to “bubbles”- Much larger (as % of GDP), complex, and leveraged financial systems -Paradigm shift not followed by policy shift-Stable relation between money and credit broke down:

- Monetary aggregates Price stability- Credit aggregates financial stability

- Lagged rapid credit growth a highly significant predictor of financial crises. (Ex.; EU bank assets rose by 98 percent of EU GDP between 2003-2007).

-See: Stabilizing an Unstable Economy, H. Minsky, 1985.

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Before & after: Effects of Financial CrisesBEFORE AFTER

Low interest rates => Search for yield Low policy interest rates => Scramble for safety

Rising asset prices (ex. housing “bubble”) Falling asset prices (ex. housing)

Rising debt levels (leverage): Households & banks Balance sheet repair (w/deleveraging) but still with high debt levels

Under-pricing of risks (low CDS) Extreme risk-aversion (very high CDS). High demand for “safe assets” and gold

Rapid credit growth & abundant liquidity. High bank profitability and equity prices.

Rapid deleveraging & scarce liquidity (during crisis) and below trend and volatile liquidity. Falling bank profitability and equity prices.

Rapid financial “innovations” & emergence of a large “shadow” banking system

Loss of trust. Retrenchment of some financial products (securitizations)

Euphoria Pessimism

Laxer credit underwriting standards Tight underwriting standards

Rapid GDP growth Rapid contraction of output followed by below-trend growth

Loss of competitiveness Efforts to improve productivity and devalue currency

Lax fiscal & monetary policies (pro-cyclical) Tighter fiscal policies & lax monetary policy (QE, ..)

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Upward pro-cyclical “spirals” (Euphoria)

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The “problem” of very low interest rates

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Some Consequences of very low interest rates for a prolonged period of time (the “Great Moderation”)

Macroeconomic Consequences:Encourages consumption over savings;Raises credit demand and possibly leads to

household over-leverage;Reduces cost of maintaining fiscal imbalances;Encourages bank leverage & riskier “search for yield”.Microeconomic Consequences:Distorts investment rules (see next slide);Leads to misallocation of resources (capital);Encouragers rising marginal (K/L) ratios;

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(Public Debt/GDP)

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Deficit Financing & Debt Rollovers

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Inter-Temporal Opportunities for Investment and Financing (with decreasing marginal productivity of capital)

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The IRR and Financial Interest Rates• Simple two-period model;• Optimal Investment rule: Invest up to the point where the marginal

productivity of capital (slope of the production function) is equal to the market (financial) interest rate (slope of M”M”’):

I₀ * = (Y₀ – P₀).• Yield in period 1:

(P₁ - Y₁)= (Y₀ – P₀) (1+ρ), where ρ= average productivity of invested capital. • To the left of D’ it is not rational to continue investing, since the return

will be below what it can be obtained from a financial placement.• If market interest rates fall (the slope of M”M”’ flattens), two things

happen: (i) present consumption becomes more attractive; and (ii) and more projects are “accepted’ by the decision rule. At the limit the rule become non-biding and possibly sub-optimal investment projects are selected (wasteful investments).

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Financial viability in terms of cash flows

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The Cash-flow problemFinancial viability: 1. “Hedge”: cash flows sufficient to meet all payment

commitments on outstanding liabilities;2. “Speculative”: balance sheet cash flows larger than

the expected income receipts, requiring rollover of obligations or increased debt;

3. “Ponzi”: increasing debt to pay debt. (2) & (3) require portfolio transactions to meet payment

commitments, exposing units to changes in financial market conditions.

Three Critical Financial Ratios

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Three Ratios that Almost Brought Down the Financial System

Three Critical Ratios:

– 1. Leverage: Return on Equity (ROE)

– 2. Funding: Loan to Deposits (L/D)

– 3. Credit Risks: Loan-to-Value (L/V)

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Profitability as Main Driver:“The Engine of Capitalism”

• Bank’s Return on Equity:

ROE= (π/K)= (π/A) . (A/K)= ROA x Leverageπ= Profits, K= Capital, A= Assets

• Not all the πs and As were real: misleading accounting and off-balance sheet operations;

• ROE contingent on a given level of risk: principal-agent problem & new misleading risk management technology;

• Provided main incentive for bank managers to induce an explosion in debt financing: negative systemic externalities.

“The private incentive to increase leverage created not only fragile institutions but also an unstable financial system” (BIS).

Reducing Banks’ Leverage: K

More Bank Capital: – For all banks (independent of sources of funding)? – For the largest only? Tier 1?– In all or some jurisdictions? – How about NBFIs? More disintermediation?– Effects on lending rates? Fairness/dilution?

• Lending rate needs to cover the cost of own and borrowed funds, any expected credit losses, all administrative expenses, net of some potential “relationship” and other benefits of making the loan.

• The sensitivity of the lending rate will vary to increases in capital, but more capital will make loans more expensive.

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Pricing implications of more K

Effective lending rates (L):

L(1-t) ≥ (K. rk) + [(D. rd)+ C + A -O)] (1-t)Where: t=marginal tax rate; K= proportion of K backing the loan,rk= required rate of return on marginal K;

D= proportion of debt and deposits funding the loan (L-E); rd= effective marginal rate on D, C= credit spread; A= administrative expenses; O= other offsetting benefits to the bank of making the loan.

Reducing Banks’ Leverage: A

• Reducing Bank Assets:– More disruptive to reduce leverage by reducing bank

assets than by increasing K: “credit crunch”;– “Fire sales” of less liquid bank assets can increase

losses and transmit contagion throughout system;– Cross-border implications;– Bringing off-balance sheet operations into banks’ BS

makes a net asset reduction even more difficult;

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Over-Leverage of all players: Banks

Jan-95

Aug-95

Mar-96

Oct-96

May-97

Dec-97

Jul-98

Feb-99

Sep-99

Apr-00

Nov-00

Jun-01Jan

-02

Aug-02

Mar-03

Oct-03

May-04

Dec-04

Jul-05

Feb-06

Sep-06

Apr-07

Nov-07

Jun-08Jan

-09

Aug-09

Mar-10

Oct-10

May-11

0

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100

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BGR Bulgaria EU-11HRV Croatia EU-11CZE Czech Republic EU-11EST Estonia EU-11HUN Hungary EU-11LVA Latvia EU-11LTU Lithuania EU-11POL Poland EU-11ROM Romania EU-11SVK Slovak Republic EU-11SVN Slovenia EU-11

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(L/D) Ratio and Market Share of Bank Foreign Subsidiaries

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100

50 100 150 200 250 300

Ukraine

LatviaHungary

Kazakhstan

Market share of foreign-owned banks(% of total assets)

Loan/deposit ratio (%)

Czech Republic

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High Leverage of EU Major Banks

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Credit underwriting standards and housing finance

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US Housing Bubble

* Taxes on capital gains of up to $0.5m were eliminated (Taxpayer Relief Act, 1997).* FED’s response to 2001 recession was to follow very expansionary monetary policy (very low Federal Funds rates, 2001-04).* Liquidity boom increases relative price of assets that become more liquid (real estate)

* Erosion of mortgage underwriting standards* Rating agencies accepted notion of ever-rising home values* Notion that risk was being reduced by asset values underlying loans was widely accepted* Housing prices doubled in a 7-year period but not reflected in CPI* Stagnant incomes* House price decline starts (2006).

* Start of delinquencies and defaults

* Limited risk for borrowers with low down payments* Large direct hit to the financial system* Great uncertainty about financial condition of banks paralyzed intermediation* Highly leveraged banks (A/K), huge financial system (A/GDP) and TBTF inter-linked institutions posing significant systemic risks

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US Housing prices and financial crisis

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US: Household Debt to Disposable Personal Income(135 in 2007)

20%

40%

60%

80%

100%

120%

140%

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Importance of Mortgage Financing in the BS of EU and USA Banks

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Depletion of Borrower’s Equity in FX Home Loans: LTV in local currency = [ (LCHF.FXR) / V (1- pd) ]

For loan-to-value ratios of 70% and 80%, depreciation of the exchange rate (FXR) or a reduction of property prices (p) leads quickly to negative equity values for bank borrowers (i.e.; numbers in excess of 100% in tables below).

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LTV= 70%

Price 10 20Declines 30

XR Depreciation0% 10% 20% 30% 78 86 93 101 88 96 105 114100 110 120 130

LTV=80 %Price 10 20 Declines 30

XR Depreciation 89 98 107 116100 110 120 130 114 126 137 149

Propagating Factors, Pro-cyclicality and downward spirals

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Crisis Propagating Factors: Accounting Rules (“Accounting for Bank Uncertainty”, Haldane, BoE, December 2011)

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De-stabilizing Pro-Cyclicality

“The striking feature is that leverage is pro-cyclical in the sense that leverage is high when balance sheets are large, while leverage is low when balance sheets are small. This is exactly the opposite finding compared to households, whose leverage is high when balance sheets are small”.

Adrian & Shin, 2009

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Perverse incentives: BanksUpswing phase:• Encourages leverage ( to max. ROE) and closely

associated bankers’ remuneration (not linked to risk-adjusted factors or ROA).

• “Search for yield” leads and more capital might lead to more risk-taking.

• Regulatory arbitrage and “shadow banking”.Downward phase:• Over reacting through de-leveraging and

excessive risk-aversion.

Aligning incentives faced by different stakeholders

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Result of Banks’ Perverse Incentives

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€15 tr. in total bank assets and €5 tr. of RWAs (2007)

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RWA over Total Assets (1998–2011) across Regions (in percent)

0

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-98

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-99

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-99

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Asia EU North America

North America 57%

Europe 35%

Asia 51%

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Markets penalized banks with high leverage

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High Dependence on CB Financing: Seeking a Viable Banking Model

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Differences in Funding the Corporate Sector: EU vs. USA

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Crowding out /Financial repression for Banks

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Disintermediation Risks: EU Banks and Corporates

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Some Conclusions—What happened more than Why it happened.

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Outcome: The “new normal”

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Where do we go from here?• Smaller financial systems?• Less leverage? Volcker rule, Vickers?• Less profitable banks? Less private sector credit?• Less growth? Slow, painful, recovery after financial crises;• Permanent output losses and back to growth “trajectories”?• Jobless recoveries? Examples in LAC (Mexico 1995-2000);• The greater the share of secured financing in banks’ balance sheets the more

pro-cyclical the system? Weakening of market forces? Impose limits on encumbered assets?

• Regulate minimum initial margins?• Higher trading book capital requirements• More and better quality capital – Basel III• Minimum liquidity requirements - LCR/NSFR – Would increase “herding” of

resources to public sector?• Monitor more closely deviation of variables from longer-term trends ex. (Credit/

GDP) and adjust capital and other macro-prudential tools in counter-cyclical ways.

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Stylized GDP Trajectories Following Recessions and Crises

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Prevention better than (ex-post) cure: Lenders

• The importance of solid “credit underwriting standards” for lenders => Credit Risk;

• Principal –agent problems => Governance;• Looming new forms of “financial repression”

to address sovereign debt crisis (financing)?• In financial markets, risk perceptions are as

important as reality => Managing expectations.

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Who works for whom? What should we do to contain financial instability?

“The value of the financial services industry lies in what it does for the rest of the economy, not in what it does for itself … the case for structural reform is based not on the needs of the banking industry but on the needs of other stakeholders”.

John Kay, “We should all have a say in how banks are reformed”, FT, June 16, 2010.

“… marketability created in banking via financial innovations has created a more opportunistic landscape prone to herding, fads and excessive risk taking. More instability seems an inherent part of this new reality …. Points to the need to find some “fixed points” in the financial system; not everything can be fluid. […] heavy handed intervention in the structure of the banking industry – building on the Volcker Rule- should ultimately be an inevitable part of the restructuring of the industry.”A. Boot, “Banking at the cross-roads”. Review of Development Finance, P. 181.

Credits & Bibliography• H. Minsky, Stabilizing an Unstable Economy, 1985.• R. Cobbaut, Theorie Financiere, 1997.• Financial Times, several issues.• D. Duffy, “Irish Housing: A Role for Loan-to-Value Limits?”, RENEWAL SERIES, PAPER 7, ESRI, February 2012.• Nomura Research, several issues.• A. Turner, Cass Lecture, March 2012.• Deustche Bank, “Sovereign default probabilities online - Extracting implied default probabilities from CDS

spreads”, Global Risk Analysis.• Barclays, Equity Research, “There must be some way out of here - Can European bank funding be fixed?”,

March 19, 2012.• T. Adrian and H.S. Shin, “The Shadow Banking System: Implications for Financial Regulation, Staff Report no.

382, FRBNY, July 2009.• T. Adrian and H.S. Shin, “Money, Liquidity, and Monetary Policy”, Staff Reports, no. 360, FRBNY, January 2009.• A. Boot, “Banking at the cross-Roads: How to deal with marketability and complexity?”, Review of

Development Finance (1), October 2011,167-183.• G. Gorton and A. Metrick, “Getting up to Speed on the Financial Crisis: A one Weekend-reader’s Guide”, JEL,

March 2012, pages 128-150.• S. King, “ From Depression to Repression”, HSBC, April 23, 2012.• A. Haldane, “ Risk off”, BoE, August 18, 2011• IMF, “Balancing Fiscal Policy Risks”, Fiscal Monitor, April 2012.• Bernanke, Ben S.; “Some Reflections on the Crisis and the Policy Response”, Board of Governors of the Federal

Reserve System, April 13, 2012.• Kothari, S.P. and R. Lester; ”The Role of Accounting in the Financial Crisis: Lessons for the Future”, MIT Sloan

School of Management, mimeo, December 14, 2011.• IMF, GFSR, Several Issues.

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Annex 1

Housing crises in the US, Ireland & Spain

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US- Case-Shiller 10-city Index Accumulated Surge (January, 1999 - June, 2006): 151%

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Spain: Unemployment and Housing NPLs

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Spain: Housing Market

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ANNEX 2

Reading Market Signals (CDS)

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CDS & Probabilities of Default

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CDS and Default Probabilities

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Thank You!