|The Future of Financial Regulation: Some Reflections|
|R K TALWAR MEMORIAL LECTURE|
|Rakesh Mohan / Mumbai August 17, 2010, 0:08 IST|
The world experienced the most severe financial and economic crisis in 2008-09 since the Great Depression. Although the crisis originated in the sub-prime mortgage market in the United States, it then spread to Europe and later to the rest of the world. The speed of the contagion that spread across the world was perhaps unprecedented. What started off as a relatively limited crisis in the US housing mortgage sector turned successively into a widespread banking crisis in the United States and Europe, the breakdown of both domestic and international financial markets, and then later into a full blown global economic crisis. Interestingly, however, although the emerging market economies (EMEs) in Asia and Latin America also suffered severe economic impacts from the crisis, their financial sectors exhibited relative stability. No important financial institutions in these economies were affected in any significant fashion. So this crisis should really be dubbed as the North Atlantic financial crisis rather than as a global financial crisis.
In any case the fall out of this financial crisis could be an epoch changing one for central banks and financial regulatory systems. The crisis occurred after an extended period dubbed as “The Great Moderation”: a period characterised by high global growth, huge financial sector expansion and low product price inflation, but accompanied by steep growth in monetary aggregates and asset prices, along with volatility in exchange rates. The prevailing monetary policy orthodoxy was inflation targeting or variants thereof, and light touch financial regulation. The price that the world has paid for the practice of such narrowly focused monetary policy, inadequate macroeconomic policy coordination, and neglect of financial regulation and supervision has been huge.
Dimensions of the Crisis
I focus first on the severity of the crisis. From an average annual growth rate of 4.1 per cent between 2001 and 2008, world GDP growth fell to -0.6 per cent in 2009. The unprecedented globally coordinated monetary and fiscal efforts launched after the Lehman episode have largely succeeded in averting the threat of an economic depression. Led by the rapid recovery of emerging market economies (EMEs), world GDP growth is now projected by the IMF (in its July 2010 World Economic Outlook Update) to recover to 4.6 per cent in 2010. That the world was taken by surprise by the developments in 2008 and 2009 is shown by the fact that as late as July 2008 the IMF expected world GDP to grow by 3.9 per cent in 2009. The reversal in expectations was so sudden that exactly a year later the forecast had been reversed to -1.4 per cent for 2009. Similarly, the growth forecast for 2010 was as low as 1.9 per cent in April 2009; the speed of the recovery now taking place in 2010 was also unexpected. The world economy has been beset with extreme uncertainty during the recent crisis period.
Global credit write downs were estimated by the IMF at $2.8 trillion in the October 2009 Global Financial Stability Report (GFSR), but have now been revised to $ 2.3 trillion in the latest GFSR update (IMF, 2010c). Despite the ongoing recovery the overall costs of the crisis have still been massive. First, households have suffered a severe reduction in overall wealth due to the marked decline in property prices. Second, fiscal expansion of the G 20 countries, relative to their 2007 levels, is of the order of about 6 per cent of their GDP in both 2009 and 2010; US fiscal expansion is much higher at just under 10 per cent of its GDP. Third, In containing the emerging North Atlantic financial crash in 2008-2009, the total support given to the financial sector in advanced economies was of the order of $7 trillion, including capital injections into financial institutions by governments, purchase of assets by treasuries, central bank liquidity injections and other upfront government financing, though some of these expenditures will of course be recovered (IMF, 2009b; IMF, 2010a).
Fourth, despite this massive effort unemployment levels still continue to be in the region of 10 per cent or higher across the developed world and are expected to remain at such high levels for an extended period of time. As assessed by the IMF, output levels in advanced countries will never go back to the pre crisis trends so there is a very large permanent output loss. Fifth, the average debt to GDP ratio for advanced economies is expected to increase to around 120 per cent by 2015, implying very large long term debt servicing costs and crowding out of private activity (IMF, 2010a). Of course, this expected increase in debt cannot all be attributed to the financial crisis; some of it is certainly due to ageing and the associated health and pension costs that are expected.
Sixth, we are also witnessing extended volatility in the exchange rates of major currencies and fragility in leading capital markets, leading to extended economic uncertainty and possible volatility in capital flows, with implications for financial stability.
So the cost of this crisis has been massive for the global economy, and its fiscal effects will be felt for some time to come. . It is therefore very important that we identify the causes of the current crisis accurately so that we can think of and act on the longer term implications for monetary policy and financial regulatory mechanisms. Consequent to the financial crisis of 2008-2009, along with the coordinated fiscal and monetary policy actions that were taken to avert a major crash, a comprehensive re-examination of the financial regulatory and supervisory framework is underway around the world. While some degree of normality has returned to global financial markets in 2009-10, in view of the very heavy costs that the world has had to pay, it is essential that governments and regulatory authorities do not fall prey to the natural temptations of complacency that such return to normality could entail.
Against this backdrop, I first provide a brief interpretation of how the crisis arose in terms of shortcomings in the extant practice of monetary policy and financial regulation, and then attempt to analyse the emerging contours of regulation of financial institutions with an emphasis on the emerging challenges and dynamics.
What Went Wrong with Financial System
Accommodative Monetary Policies
It is generally agreed that a variety of factors led to the crisis developments in the subprime sector, excessive leverage in the financial system as a whole in recent years, lax financial regulation and supervision, and global macro imbalances. What I have been particularly interested in is the role of lax monetary policy in the advanced economies, and particularly that in the United States. In examining the waves of capital flows to emerging market economies that have occurred over the last 30 years, it is noteworthy that almost each wave has been preceded by loosening of monetary policy in the advanced economies, usually led by the US, followed by tightening leading to the reversal of capital flows. In the period after the dotcom crash lax monetary policy led to excess liquidity and low interest rates worldwide. In previous episodes of such excess liquidity over the last 30 years it was emerging market economies that suffered from crises (CGFS, 2009).
But this time it rebounded on the North Atlantic economies. When there is an extended period of lax monetary policy and low interest rates, there is a natural search for yields leading to outward capital flows in search of higher yield. What happened during this recent period of monetary expansion is that with monetary policies being accommodative for an extended period in the US and other advanced economies, in addition to capital flows going outward in search of yields, the volume of liquidity generated was such that there was also a burst in financial innovation within these countries, so that higher yields could be obtained within. This search for higher yields within led to many of the irregularities observed. The consequence is that it is the advanced countries of the North Atlantic which have suffered from this financial crisis.
The other issue of note is that, partly because of large expansion in the global supply of goods from China and other EMEs – in the last ten years really, not just the last five years the accommodative monetary policy and increased liquidity did not lead to higher inflation as measured by the Consumer Price Index (CPI), or even higher inflation expectations as conventionally measured. It did, of course, lead to huge increases in asset prices of different varieties, particularly housing and real estate, not just in the U.S and Europe but in other parts of the world as well.
Being particularly focused on CPI or on core inflation, central banks felt no pressure to tighten until very late because they were not observing increases in CPI, or in inflation expectations. Being against the prevailing orthodoxy, they avoided reacting to asset price growth, and even to supply induced commodity price increases. To my mind, this is a major issue for central banks, financial regulators and academics to discuss. In the presence of low CPI inflation central banks typically come under significant public and market pressure not to raise rates. In what circumstances should monetary policy take cognizance of variations in asset prices and in commodity prices and how? What should also be the role of coordinated action through prudential regulation?
Shortcomings in Financial Regulation and Supervision
There is actually much greater discussion going on internationally on the existing regulatory practices and the future of financial regulation and supervision than on monetary policy. The intensity of discussion is reflected in the plethora of reports that have been issued by authoritative sources, both official and non official, in all the affected jurisdictions (CGD, 2010; CCMR, 2009; de Larosiere Report, 2009; Geneva Report, 2009; G-20, 2009; Group of Thirty, 2009; IIF, 2009; Turner Review, 2009; United Nations, 2009; United Kingdom, 2009; United States, 2009; Warwick Commission, 2009). What is common among all these dozen or so reports is the acknowledgement that regulation and supervision in the advanced economies was too lax in recent times; and that there needs to be considerable rethinking leading to much strengthened, and perhaps, intrusive regulation and supervision in the financial sector. Apart from the laxity in the supervision of banks there was a serious conceptual flaw in the approach to financial regulation. It was assumed that micro prudential regulation and supervision of individual financial institutions would also ensure systemic stability of the financial system. This approach ignored the possibility of the fallacy of composition. (See Blanchard and others (2010) for an excellent comprehensive discussion on possible new frameworks for monetary policy.) The increase in complexity of interaction of financial markets with even sound financial institutions could have negative systemic effects through cumulative negative externalities. Thus there is clear recognition now of the need for contra cyclical macro prudential regulation, and of the need to reduce moral hazard posed by systemically important financial institutions (SIFIs).
At the root of such re-thinking, though not always acknowledged as such, is really the questioning of the existing intellectual assumptions with respect to the functioning of markets, and the nature of financial risk. To quote the Turner Review (2009):
“At the core of these assumptions has been the theory of efficient and rational markets. Five propositions with implications for regulatory approach have followed:
(i) Market prices are good indicators of rationally evaluated economic value.
(ii) The development of securitized credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability.
(iii) The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk.
(iv) Market discipline can be used as an effective tool in constraining harmful risk taking.
(v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added.
Each of these assumptions is now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities”. (Turner Review, 2009, p.30) What were the specific developments in the financial system that arose from these broadly accepted intellectual assumptions that led to the ongoing global financial crisis?
Recurring Financial Crises: Build up of Excessive Leverage
Financial and banking crises have a long history, which is as old as the existence of the financial sector itself (Kindleberger and Aliber, 2005; Reinhart and Rogoff, 2009). All liquid markets can be susceptible to swings in sentiment, which can produce significant divergence from rational equilibrium prices. However, boom and bust in equity prices have surprisingly small consequences relative to boom and bust in credit instruments, unless investment in equity instruments is itself from heavily leveraged borrowed resources. What is common among almost all crises is the buildup of excessive leverage in the system and the inevitable bursting of the financial bubble that results from such leverage. What is ironic about the current crisis is that this excess leverage occurred over a period when greater consensus had developed through the Basel process on the need for and level of adequate capital required in banking institutions across all major jurisdictions. Furthermore, sophisticated financial risk management capabilities were also believed to have been developed within large financial institutions during this period of unusually high rapid growth in both the magnitude and sophistication of the financial system. This had some perverse results.
First, because of the perceived increase in sophistication in the measurement of risk, high quality risk capital in large banks could be as low as 2 per cent of assets, even while complying with the Basel capital adequacy requirements. Second, large financial institutions could maintain lower high quality capital because of the assumption that they had better risk management capacity than smaller less sophisticated institutions. The thinking now is moving in the opposite direction: to reduce moral hazard, and to reduce systemic risk, it is being argued that SIFIs should be subject to higher capital requirements and they should be discouraged from becoming too big to fail.
With financial deregulation in key jurisdictions like the United States and the U.K., along with most other countries, financial institutions also grew in complexity. Financial conglomerates began to include all financial functions under one roof: banking, insurance, asset management, proprietary trading, investment banking, broking, and the like. The consequence has been inadequate appreciation and assessment of the emerging risks, both within institutions and system wide. What were the factors that led to this emergence of excessive system wide and institutional risk?
Growth in Securitised Credit and Derivatives
Among the notable developments of the last decade has been the unprecedented explosive growth of securitized credit intermediation and associated derivatives (Yellen, 2009). The issuance, for example, of RMBS (Residential Mortgage Backed Securities) doubled from $ 1.3 trillion to $ 2.7 trillion between 2001 and 2003. The assumption underlying this development was that this constituted a mechanism that took risk off the balance sheets of banks, placing it with a diversified set of investors, and thereby serving to reduce banking system risks. As late as April 2006, the IMF’s Global Financial Stability Report noted that this dispersion would help “mitigate and absorb shocks to the financial system” with the result that “improved resilience may be seen in fewer bank failures and more consistent credit provision” The opposite actually transpired.
Although simple forms of securitization have existed for a long time, this assumption has already proved to be erroneous. Among the key functions of banks is maturity transformation: they intermediate shorter term liabilities to fund longer term assets in the non-financial sector. Banks are typically highly leveraged and hence trust and confidence is crucial to their functioning and stability. Traditionally, therefore, banks exercised sharp vigilance on the risk elements of their assets, which were typically illiquid, in order to ensure constant rollover of their shorter term funding liabilities. What securitization does is to turn illiquid assets into liquid ones, which in theory then disperses risks from the banks’ balance sheets and also reduces their requirements of banking capital. The incentive to monitor credit risk in the underlying assets also disappears. With assets themselves seen as liquid short term instruments, they began to be funded by ultra-short term liabilities, including even overnight repos whose volume increased manifold in recent years. The majority of holdings of securitized credit ended up, however, in the books of highly leveraged banks and bank like institutions themselves, and hence risk got concentrated rather than being dispersed. Systemic risk increased because traded instruments are inherently more susceptible to price swings depending on changes in market sentiment, and much of this trading was in opaque OTC markets. Moreover, at low levels small changes in interest rates and yields result in greater volatility in prices. What emerged was a “complex chain of multiple relationships between multiple institutions” (Turner Review, 2009) and hence the higher risk of contagion within the financial sector. Furthermore, liquidity risks in such markets were also not understood adequately. It was assumed that these liquid markets would always exist, and hence securitized assets were assumed to be inherently less risky than illiquid long term credit assets.
Financial innovation arising from the search for yields compounded this problem as second order derivatives proliferated. For example, CDO (collateralized debt obligations) issuance tripled between the first quarters of 2005 and 2007, reaching its peak of $179 billion in the second quarter of 2007, before collapsing to $5 billion by the fourth quarter of 2008. With the lack of transparency in OTC markets, their valuation became increasingly dependent on model valuation and credit ratings, rather than observable and transparent market valuation, and hence inherently more opaque. Thus, when problems arose in these markets and prices were not visible, valuation of the assets of banks and the shadow banking system became unobservable. Consequently, trust and confidence evaporated and markets froze.
Emergence of the Shadow Banking System
These problems got further compounded by the emergence of the largely unregulated shadow banking system that took off assets from the banks’ balance sheets; thereby reducing the latter’s capital requirements. Ironically, the increased attention to capital adequacy in banks itself led to a poorly capitalized financial system overall. The complexity and magnitude of intra-financial sector transactions exploded over this past decade. For example, issuance of global credit derivatives increased from near zero in 2001 to over $60 trillion in 2007; OTC interest rate derivatives grew from around zero in 1987 to about $ 50 trillion in 1997 and $ 400 trillion by 2007; global issuance of asset backed securities (ABS) went up from about $ 500 billion in 1997 to over $ 2 trillion; forex trading activity rose tenfold from about $ 100 billion to $ 1 trillion in 20 years between 1987 and 2007, and doubling after 2002; and trading