The Financial Crisis: whodunnit

1
The Financial Crisis whodunnit?

• Howard Davies
• Director, LSE

Old Theatre 7 October 2009
2
Who is most to blame for the current financial
crisis?

Source Thisismoney.co.uk, June 2009
3
Some suspects

• economists - if anything needs fixing, its the
  sociology of the profession Dani Rodrik
  (Harvard)
• business schools the Guardian
• testosterone Scientific American risk-taking
  in an investment game with potential for real
  monetary pay-offs correlates positively with
  salivary testosterone levels and facial
  masculinity
• video games Professor Susan Greenfield of
  Oxford
• human greed Rowan Williams
• Jews

4
Who blames the Jews for the financial crisis?
Source N Malhotra, Y Margalit State of the
Nation. Boston Review, May/ June 2009.
5
Views of Members of the European Parliament

• blaming
• 49 US banks
• 29 Investment banks
• 29 Credit Rating Agencies
• 28 US regulators
• 25 Hedge funds
• 23 EU banks
• 6 EU regulators
• and the answer?

6

• 66 recommend deeper political union in Europe,
  as a key response
• to the crisis

7

• Bank failures are caused by depositors who
  dont deposit enough money to cover the losses
  due to mismanagement.
• Dan Quayle

8
The Credit Crisis A Five-Act Shakespearian
Tragedy
Act One Subprime Act Two Liquidity Act
Three Unravelling Act Four Meltdown Act
Five Pumping
9
Real GDP growth forecast, October 2008
Source Financial Times European Economic
Forecast.
10
Real GDP growth forecast, July 2009
Source Financial Times European Economic
Forecast.
11
The IMF forecast a modest recovery next year
Gross domestic product forecast ( change),
constant prices, 2007-2014
Source IMF World Economic Outlook Database,
October 2009.
12
But global unemployment is likely to continue to
rise
Unemployment (Million) and unemployment rate (),
1999 - 2009
Source ILO, Trends Econometric Models, December
2008.
13
What are the underlying causes?

• global imbalances
• loose monetary policy, leading to
• mispricing of risk
• credit bubble
• excess leverage, facilitated by procyclical
  regulation, and regulatory arbitrage
• excess unmanaged growth of the financial
  sector, which magnified risks, rather than
  diversifying them

14
Global current account imbalances grew rapidly
from 2003
Estimates of account balances for selected
countries ( Billion), 1993-2007
Source Datastream, FSA Calculations.
15

Monetary policy was loose, especially in the US
Deviation of policy rates from Taylor rule (),
2000-2009
Source Bank of England, Speech of Charles Bean
at the Annual Conference of the European Economic
Association, 25th Aug 2009.
16
(No Transcript)
17
Household debt as of GDP, 1987-2007
Household debt rose sharply
Source FSA, ONS, Federal Reserve, Eurodata,
Datastream
18
US house prices doubled in five years
Case-Shiller Home Price Index (2000 Q1 100),
Jan 1987 - 2005
Source Silverlake, Case-Shiller Price Index.
19

House prices rose rapidly in much of Europe also
Real house price changes over the last ten years
(), 1996-2006
Source ECB, National Statistical Offices, IMF,
EMF, Italian Ministry of Infrastructure, Morgan
Stanley Research.
20

Bank Balance Sheets expanded
Large-cap banks aggregate assets rose to 43x
tangible book equity
Source Silverlake, Capital IQ.
21
UK banks leverage grew sharply from 2003 onwards

Major UK banks leverage ratio, , 1998 - 2008
Note Leverage ratio defined as total assets
divided by total equity excluding minority
interest. Excludes Nationwide due to lack of
interim data.
Source Bank of England, Financial Stability
Report, Issue 24, 28 October 2008.
22

As did the securitised credit market
ABS volumes outstanding, Billion, 1996 - 2007
Source The Turner Review, March 2009.
23

And the outstanding credit default swaps
Credit default swaps, Trillion, H2 2004 H1
2008
Source The Turner Review, March 2009.
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Resecuritisation magnified credit creation
Capital Structure Containing Subprime Loans
Subprime Mezzanine CDO Containing BBB Subprime
Bonds
100
100
11
SUPER SENIOR AAA
CUMULATIVE LOSSES
8.6
40
AAA AA A BBB Equity
28
20
11
11
7
7
7
0
0
Source Morgan Stanley.
25

Private Equity Leverage Multiples grew
Debt/EBITDA, 2002 - 2007
X
Source Silverlake, Morgan Stanley, Capital IQ.
26

Growth in Hedge Fund Assets Leverage accelerated
Source Silverlake, Through Q308 HFR industry
report Q408 projections based on CS analysis.
27
This points to the need for monetary policy to
focus more on - credit growth - financial
intermediation, and - asset prices with a
stronger emphasis on the risk of financial
instability
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• Weak regulation may not have been the main cause
  of the crisis, but it is important to reform it
• trust in markets, and in regulation, has been
  affected, which damages investment and economic
  growth
• the global system does not meet the needs of
  global markets

30
Trust
Average response on a scale from 1 to 5 to the
question, How much do you trust, where 1 means
I do not trust at all and 5 means I trust
completely.
Source The Financial Trust Index.
31
Trust in financial markets, and government, has
fallen
Average response to the question, How has your
trust in some of these institutions changed in
the last three months? Would you say your trust
inhas 1) increased a lot 2) increased a little
3) decreased a little 4) decreased a lot or 5)
has there been no change in your trust.
Source The Financial Trust Index.
32

• The crisis revealed problems with
• the existing regulatory architecture
• Hopelessly complex global structure
• Lacking a central authority to drive
  co-operation and make changes happen
• US system balkanised and ineffective
• European system a fudge neither truly European
  nor truly national
• No two national systems the same

33
Global Committee Structure 2007 A Regulators
View
G-7 (Govts)
IMF World Bank (Govts)
OECD (Govts)
WTO
FATF (Money Laundering)
IASB (Accounting
IASC
Financial Stability Forum
Monitoring Group
IAASB (Audit)
PIOB
Bank for International Settlements (Central
Banks)
G-10 (Central Banks)
Basel (Banking)
IOSCO (Securities)
IAIS (Insurance)
IFIAR (Audit)
Source Adapted with permission from Sloan and
Fitzpatrick in Chapter 13, The Structure of
International Market Regulation, in Financial
Markets and Exchanges Law, Oxford University
Press, March 2007.
CGFS
CPSS
Joint Forum
34
National Regulatory Structures
57
3
Other bank regulators
49
Central Bank
10
35
Central banks as banking regulator
No Central Bank interest
7
54
Non-Central Bank
39
28
Central bank as one pillar
2
Source How Countries Supervise their Banks,
Insurers and Securities Markets 2007 Central
Bank Publications.
35

• And there were a number of regulatory failures
• US Financial markets regulation was
  uncoordinated and overlapping
• - Promoted regulatory competition
• European Regulation also at fault complex mix
  of European and national rules
• In the UK, weak FSA regulation of Northern
  Rock, and the Bank of England too distant from
  financial markets

36

• More regulatory failures
• Key markets were unregulated
• Non-bank private mortgage industry
• Credit Default Swaps
• No exchange, central clearing or capital
  requirements
• Insurance industry in the US was lightly
  regulated
• No federal regulator
• Missed one-sided credit insurance CDS risks
  taken on by AIG and others
• Basel II capital requirements were flawed
• Allowed too much leverage, over-reliance on
  credit ratings, and didnt encompass liquidity
• Pro-cyclical as asset prices rose, banks seemed
  to need less capital

37

G20 Summits

• Reshaping the global financial and regulatory
  system
• Financial Stability Board with standing
  committees
• Membership of FSB, Basel etc extended to BRICs
  and others
• Expanded coverage of regulation to include
  systemic hedge funds
• Tighter controls on offshore centres
• Tighter regulation of credit rating agencies
• More and better quality capital in the banking
  system
• Macro-prudential mechanism to respond to asset
  price bubbles
• Regulatory controls on bank remuneration

38
What about the bankers themselves?
39
Failures in the financial firms themselves may
have been even more important

• Poor risk management
• excessive reliance on Value at Risk Models
• herding behaviour
• inadequate hedging
• Flawed capital allocation mechanisms
• trading strategies under-capitalised
• Incentive structures which reward short-term
  risk-taking
• Weak corporate governance boards ignorant of the
  risks management were taking on

40
And, finally, there are major problems with
Economics and efficient markets

• Much of the past 30 years of macroeconomics was
  spectacularly useless at best, and positively
  harmful at worst
• Prof. Paul Krugman, Princeton
• The unfortunate uselessness of most state of
  the art academic monetary economics
• Prof. Willem Buiter, LSE
• The modern risk management paradigm held sway
  for decades. The whole intellectual edifice,
  however, collapsed in the summer of last year
• Alan Greenspan

41
How badly affected will the City be?

• On the one hand
• Financial sector expansion will be less rapid
  than in the recent past
• Some of our domestic institutions will contract
  sharply (RBS, HBOS) and others have disappeared
• Our regulatory system has suffered reputational
  damage
• More EU regulation is likely and logical, but
  some of it may be detrimental to London markets
• The political climate for financial services has
  changed (the Goodwin effect). Tax rates will be
  higher

42

• On the other.
• Competitiveness indices do not yet show any
  deterioration (indeed possibly the reverse)
• US regulation has suffered more
• While the environment in London may get tougher,
  it is not clear that it will be tougher than
  anywhere else in Europe
• There is even some anecdotal evidence of
  consolidation benefiting London

43
The Global Financial Centres Index
Source City of London Corporation, Global
Financial Centres Index, Report - 6, September
2009.
44

Such a complex failure has many parents

• Macro imbalances, loose monetary policy and
  financial innovation
• Rapid credit growth, asset price bubbles,
  overborrowing
• Global finance without global government
• Flawed assumptions about market efficiency and
  investor rationality

45
The Financial Crisis whodunnit?

• Howard Davies
• Director, LSE

Old Theatre 7 October 2009