Crisis Talk - The World Bank Group

Today in Bubbles

The editors of the Financial Times appear to be concerned about bubbles. Three out of today's four op-eds are dedicated to the theme.

First, George Soros argues that the implosion of 2008 was an aggregation of a series of bubbles over the past decades, creating, in his words, a "super-bubble":

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

Crisis Viewing

Our friends at PBS have released a couple of interesting crisis-related television programs this week.

First, Charlie Rose has an excellent interview with Andrew Ross Sorkin (type Sorkin's name into the Charlie Rose search window to access the video). Mr Sorkin discusses his just-released book, Too Big to Fail, telling the story of last year's Wall Street meltdown through the window of Paulon, Blankfein, Geithner, and other members of Wall Street's ruling coterie.

Next, Frontline has a new program entitled The Warning, which traces the roots to the crisis back through the 1990s. Naked Capitalism has several posts that provide useful background information to the characters and themes of the show.

Both are well worth viewing, particularly if you don't have time to read through Sorkin's 600+ page monster.

Banks in Crisis: When Governments Take Temporary Ownership

Editor's Note: This is the ninth in a series of policy briefs on the crisis—assessing the policy responses, shedding light on financial reforms currently under debate, and providing insights for emerging-market policy makers.

About the author: David Scott is program manager in the Financial and Private Sector Development Vice Presidency of the World Bank Group.

The current financial crisis evolved quickly. In most of the developed countries affected, governments initially improvised solutions that eventually led to substantial investments in systemically important banks. Not all their actions are worth emulating, especially those undermining the ability of all shareholders to hold the banks’ board and management accountable. Lessons from earlier crises show that governments acting as temporary owners can minimize costs to taxpayers by sticking to sound commercial practices, good corporate governance principles, and competitive neutrality. Quickly developing and making public the exit strategy is also important.

Click here to read the full report. 

IFC Distressed Debt Update: China's On Board

Last week I discussed IFC's new plan to launch a vehicle to purchase toxic assets in emerging markets. The initial report indicated that much of the financing was expected to come from private sector banks. Reuters is now reporting that China's Sovereign Wealth Fund, China Investment Corp, is interested in participating in the project:

China has shown interest in investing in a new International Finance Corp program to acquire and restructure distressed debt in developing countries, World Bank President Robert Zoellick said on Monday.

Zoellick, speaking at a ceremony to launch the program that that aims to mobilize more than $6 billion to help banks and companies sell or restructure troubled assets, said he recently discussed the program with China Investment Corp, Beijing's sovereign wealth fund.

"They're interested in investing in distressed debt. They told us 'we can do it in the United States, but we're a little wary of doing it in the developing world because we don't want to be accused of anything'," Zoellick said. "To come in with us in a real restructuring program, they have some significant interest."

History Lessons

As the crisis enters its second year, the economic history books have already begun publishing an early account of first stages of the crisis. In particular, two articles have been released this week that serve as essential reading.

First, this month's Vanity Fair features an excerpt from Andrew Ross Sorkin's upcoming book, Too Big to Fail. Sorkin's piece gives a thrilling, minute by minute account of the chaos within the halls of Wall Street during the aftermath of the Lehman collapse. The article offers a view of the day's events through the perspective of the most important players in finance, including Timothy Geithner.

China's Crisis Response Goes Global

China has been an essential player in fostering a global economic recovery. As one of the first countries to announce a massive stimulus package last November, China brought increased stability to markets when it was dearly needed. Today's conventional wisdom holds that in order to ensure a stable global recovery, Chinese consumers must increase their consumption patterns to fill the economic void left by their battered American counterparts (see previous post).

Can the Chinese government succeed in boosting domestic consumption? Are there other initiatives that China can take to put the global economy in motion?

The answer to both of these questions is a tentative 'yes'.

The Fed's Next Move: Hibernation

Yesterday I commented on the role of inflation in the crisis, which was explored at length during a symposium on Dealing with America's Debt Overhang. Any good conversation about inflation has to be followed with a discussion about the Federal Reserve.

Liaquat Ahamed, author of Lords of Finance: the Bankers Who Broke the World, gave a summary of the Fed's exceptional role during the crisis, which can be broken down into three key areas:

1. Acting as a lender of last resort
2. Aggressively cutting interest rates
3. Lending against assets that would normally be considered unacceptable collateral

The Bernanke Fed has been lauded for having prevented another Great Depression, and many, including Barack Obama, consider Bernanke to have been the right man for the right job at the right time.

But times are changing, and now that we are no longer looking into the abyss, what's next for the Fed? What role should it play in the recovery?

Crisis Roundup: Financial Bureaucrats Edition

Tim Geithner wants tougher capital requirements...

...and seven of his European counterparts want to end banks' bonus culture.

Claude Trichet has a plan. So does Geithner.

Bernanke is the dollar's new father.

Volcker and Soros discuss innovation.

Finally, did miscommunication between the US and UK Treasuries push Lehman over the edge?

Systemic Risk and the Financial Sector

I'm being called Mr. Bailout. I can't do it again.

-Hank Paulson, September 2008.

The IMF held an unofficial conference yesterday on systemic risks in financial systems. Kay Giesecke from Stanford University presented a paper which argues that the the spillover effects from the failure of a financial firm play a prominent role in systemic risk, far greater than the failure or default of an industrial giant:

We find strong evidence for the presence of spillover effects in the US financial system during 1987-2008, after controlling for the exposure of firms to common or correlated risk factors.  The fraction of systemic risk explained by spillover effects can be substantial, and tends to be higher during periods of economic stress.

Bank failure clusters do not arise solely from exogenous shocks; rather, they are pushed over the edge by the failure of their peers. 

While it may seem obvious that bank failures pose a greater systemic risk threat then other sectors, it wasn't obvious enough to Mr Paulson.

Or, he just let it happen anyway.   

Central Bank Intervention, Volatility and the Interbank Market

The IMF held an unofficial conference yesterday on "The Effects of Central Bank Intervention on the Interbank Market During the Sub-Prime Crisis." The presentation was led by Economist Ceslo Brunetti from Johns Hopkins University. 

Brunetti and his team analyzed data from Milan-based e-MID, the only electronic, regulated interbank market in the world, in order to measure volatility in bid-ask spreads, transaction prices, and trading volume. They compared data from the pre-crisis period (Jan 2006-April 2008), and the first stages of the crisis (Aug 2007-April 2008).  

A contrast of these two periods found that whenever the European Central Bank took action, regardless of what it was, volatility increased. When new liquidity provisions were announced, vulnerable banks increased their borrowing from the ECB directly, leaving only large, sound financial institutions in the e-MID market, which reduced overall liquidity and increased volatility:

Making Goods vs Making Money: China, finance and rent-seeking

Simon Johnson has written an excellent essay contrasting the growth of traditional industry in China with America's fastest growing sector in the past 40 years: finance. 

Johnson argues that America's current bloated financial system absorbs more money than it produces, transforming it into a rent-seeking industry:

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Is Britain Back?

Paul Krugman and The Economist's Free Exchange blogger are beginning to think so. As is Daragh Maher, FX strategist at Calyon, who believes that sterling has become "the recovery currency":

Policy stimulus is helping drive a recovery in the UK. The catalyst for a re-think on sterling is already evident with early signs of improvement in the economic cycle and the financial sector.

The latest signs of health are coming from the services sector, which is growing at its fastest pace in over a year. Markets have been rapidly buying up Sterling, which has reached a 9-month high:

Dynamic Provisioning: The Experience of Spain

Editor's Note: The World Bank has released the seventh brief in its Crisis Response series. The latest contribution, written by Jesus Saurina, director of the Financial Stability Department at Banco de España, discusses anticyclical loan loss provisions.

Dynamic loan loss provisions can help deal with procyclicality in banking. By allowing earlier detection and coverage of credit losses in loan portfolios, they enable banks to build up a buffer in good times that can be used in bad times. Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole.

While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis. They could be an important prudential tool for emerging economies, where banks dominate financial intermediation.

Click here to download a PDF of the brief.

IMF and BIS Weigh in on US Response, Prognosis

The IMF has just released its annual economic review of the United States, which is prepared by staff economists in consultation with their US government counterparts. The paper provides an extremely thorough, technical overview of the birthplace of the crisis, with several case studies ranging from labor productivity to the performance of the dollar (which it finds "moderately overvalued"). It analyzes several fiscal indicators at the national and state level, concluding that America's fiscal (im)balance poses the greatest challenge to the nation's economic health.

Not surprisingly, the American authorities interviewed for the study were more optimistic about the prospects for quick recovery.

More on Russia's Recovery

Vladimir Putin has ordered Russia's top bankers to forgo any upcoming holidays and dedicate their summer time to making more loans. The Prime Minister has demanded an additional $16bn in fresh loans, arguing that increased lending is the only way to break the cycle of fear that has paralyzed the nation's banking system. According to Mr Putin:

The less lending goes on, the greater the risk is that loans won't be returned, because by ceasing to credit, you are strangling the real sector.

Charting a Path out of the Crisis

The World Bank Group (WBG) has just released the first batch of a series of policy briefs on the financial crisis, whose aim is to assess government responses to the crisis, shed light on the financial reforms currently under debate, and provide insights for emerging-market policy makers. The first three papers cover a lot of ground in a short amount of space—sizing up the global policy response, forecasting what future financial systems will look like as a result of these policy responses, and determining how financial regulation will evolve. They will be followed by papers, written by different authors inside and outside the WBG, that will take ‘deep dives’ in specific crisis-related financial sector topics.

• Dealing with the Crisis: Taking Stock of the Global Policy Response provides an overview of the immediate financial sector policy responses to the financial crisis—including emergency liquidity support, expansion of financial safety nets, and interventions in financial institutions—that have succeeded in stemming widespread panic. But the effort has generally been ad hoc and insufficient. Issues that remain include the resolution of problem assets, the restructuring of troubled, systemically important financial institutions, and the development of credible exit strategies. Only a handful of countries have attempted to tackle these issues head-on. As past experience has shown, that may well have negative repercussions for the duration and strength of a subsequent recovery.

• The Reform Agenda: Charting the Future of Financial Regulation reviews the crisis-induced shift toward a tighter and more macro-prudential approach to financial regulation. But the reform agenda still needs to address the role of supervisory (rather than regulatory) failures, while the institutional arrangements needed to implement the new framework remain to be worked out. For most emerging economies, the existing reform agenda—developing institutional and legal underpinnings for the financial system and promoting financial access—remains valid. But for those characterized by weak financial oversight structures and more volatile economic cycles, adopting capital “buffers” as part of a macro-prudential regime may be a useful complement.

• Safe but Smaller? The Shape of Financial Systems to Come describes how global trends taken for granted in recent decades—the big expansion in global financial assets compared with underlying economic activity, growing global financial integration, shrinking role of the state in financial systems, and rising share of cross-border ownership of financial institutions—may reverse over the foreseeable future. In addition, the structure of financial systems, particularly in developed countries, will likely become oriented less toward capital markets and more toward traditional (and simpler) banking activities. The impact on economic growth and overall welfare is likely to be negative—perhaps the price we have to pay for living in a brave new (and presumably safer) financial world.

Needed Urgently: Good Bankruptcy

As the crisis unfolds, the need for a good bankruptcy regime is starting to dawn on policymakers. No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies. Previous crises show that such bankruptcies lag behind the start of a crisis by a year or two. As demand falls, businesses try to cut expenses, restructure payments, renegotiate with suppliers. Ultimately, many live on. But some fail.

For these, it is useful to have an efficient bankruptcy regime so creditors do not have to write off the whole value of the loan. But bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options (for example, the use of asset-management companies) are needed.

A recent survey of previous experience in bankruptcy reform suggests a menu of possible reform choices while in crisis. The analysis is to a large extent based on the data from the Doing Business project, and its section on Closing a Business.

Here we present the section on dealing with systemic distress:

Stiglitz on Big Banks

Joe Stiglitz visited the World Bank yesterday and talked about needed changes to fight future crises. One controversial thought that has some merit: break up big banks so they do not pose a "too big to fail" risk.
 
There is anyhow a market-based movement in that direction. The days of the "supermarket bank" are over. It is not obvious what this huge diversification in the last 15 years has brought in the way of benefits. At least there are no studies I am aware of that make this case in a compelling way. More importantly, it is a lot more difficult to regulate and supervise big banks.
 
The question is who has enough power to break up the big guys. Noone in the US. Too cosy of a relationship with the regulators (says Stiglitz). What about Europe? Not clear either. In all likelihood, this idea will go the way of Stiglitz's super-bankruptcy idea: nowhere. Still, good someone is thinking.

The U.S. as an Emerging Market?

Simon Johnson, a prolific academic writer and former Chief Economist of the IMF, has come out with a relatively negative view on the U.S. financial system, both current and past. According to Simon, the personal interlinkages between the political and financial systems in the U.S. are very similar to those in many, if not most, emerging markets. And the policy approach towards solving the financial crisis has been dominated by attempts to minimize the pain for bankers, rather than for the overall economy. The bank-by-bank approach with generous bail-outs, while avoiding more drastic actions that might risk shareholders’ equity stakes and senior manager bonuses, has not really helped so far. In order to really get out of the slump, Simon recommends more decisive action in the banking sector, including temporary nationalization and clean up of banks, but also the breaking-up of the financial oligarchy with its links to the political system.

Bank Fragility in Spain

A recent article in the Economist points to the Spanish savings banks (cajas de ahorro) as cause for worry. The ownership and governance structure of these financial institutions is somewhat odd, as they are not really owned by anyone, but rather have the form of a private foundation, with a board of trustees that includes representatives of local governments, depositors and clients. 

While originally geographically restricted, many of these cajas are now active throughout Spain. These institutions have been very successful over the past years, growing their market share at the expense of the commercial banks (the largest of which looked for profits beyond Spanish borders, especially in Latin America). A recent paper found these savings banks to be less risk-loving and more stable than commercial banks in Spain. More recently, however, Spain’s savings banks started to tap wholesale funding markets to continue their expansion while commercial banks put on the brakes, which exposed the savings banks to new funding risks.

Sachs on the Latest Treasury Plan

Jeffrey Sachs apparently has no shame. In the last few years, he has made a name for himself by asking rich countries to double and triple development aid. Without answering the obvious concern: much of aid seems to be wasted (says Bill Easterly and a host of academic research), so tripling it without any reform of the aid architecture just triples the waste. But these are just details, and they have not prevented Professor Sachs from hooking up with Bono and Angelina Jolie to "raise awareness." A few years back they declared victory, only to find out recently that the total amount of official development aid has actually declined. Oh, well - off to the next big cause.

The View from Hong Kong (China)

I spent the last couple of days in Hong Kong (China), talking mainly with academics, but also with people closer to the markets. The recession (or is it already a depression?) has hit Hong Kong (China) quite hard, with exports dropping substantially. This has actually resulted in the challenge to find storage space for empty ship containers; well, as many ships idle in the port anyway, empty containers can just be left on the ships. Unemployment has increased, though still in the single digits. There has not been as much of an impact on peoples’ lives as perhaps in the U.S., as the savings rate is quite high and people can live off reserves.

One wonders, however, how long this will hold. Housing prices have already dropped by 20%, but with maximum loan-value ceilings of 70% – imposed by the regulators – this will not lead to immediate distress in the banking sector. The recipe applied so successfully after the East Asian crisis – export yourself out of the crisis – will be much harder to apply, as the target markets are certainly less willing customers this time around, which also makes a quick recovery unlikely. As In Europe, the Lehman insolvency has also left its mark in Hong Kong (China), with bearers of Lehman’s mini-bonds losing their shirt, and consumer complaints of sales techniques rising. Rather than bailing out customers, however, the Hong Kong (China) approach seems to force more transparency in the sales process, including audio-taping sales conversations. Of course, this might just lead to a migration of certain conversations towards bars and coffee shops.

Dutch Stimulus Package

Last week the Dutch government announced new anti-crisis measures, worth €11.5 billion. First, an increase of the retirement age from 65 to 67 years, to take effect in 2011. Second, a €5 billion cut in government expenditures, coming mainly from cutting the salaries of government workers and lowering benefits. This will take effect in the 2011 budget. Third, a reduction in the employer's share of social security. The announced cuts in social security payments by employers follow similar reforms in several other EU members: for example the Czech Republic and Germany. Fourth, €6 billion in incentives to build energy-efficient housing and scrap old cars. Fifth, €250 million will go towards fighting youth unemployment. Sixth, scrapping a tax on airline tickets, to help Schiphol airport. The rationale for this measure is that the environmental tax on airline tickets has undermined Amsterdam Schiphol airport's competitive position - with many passengers simply booking flights in neighbouring countries instead.

These come on top of a previous €6 billion fiscal package. That stimulus was designed to improve the liquidity of small companies, grant a temporary reduction of working hours for firms facing economic problems, and to speed up infrastructure projects, including the new Delta flood control works. It would also pay government bills charged by companies faster, which would be especially helpful for small and medium sized companies. In addition, the Dutch government established regional labor mobility centers to help prevent imminent layoffs.

Previously, the financial crisis had already forced the government to nationalize two major banks - ABN Amro and Fortis - in order to prevent their collapse. In addition, the economic stimulus package included €20 billion, which was injected into the money market to guarantee interbank transfers. Aegon, an insurance company, received €3 billion and ING, a commercial bank, has received €10 billion.

The Outrage Over AIG

A few days ago, AIG revealed the biggest beneficiaries of its rescue, with Société Générale, Germany’s Deutsche Bank, and Goldman Sachs near the top of the list. Public outrage over AIG's CDS counterparty payments and bonuses quickly followed, but all this could have been avoided had the company gone into bankruptcy - this would have turned both CDS counterparties with monetary claims and employees with guaranteed bonus packages into creditors and put them in line along with everybody else.

The excuse for not pursuing this option was allegedly the lack of a special bankruptcy regime for NBFIs and the negative repercussions of normal bankruptcy proceedings and the related shock to the financial system (as illustrated by Lehman). I don't know if there was a way for the government to intervene more aggressively/promptly, but I am sure that it will be debated in the future.

For those who have re-read Galbraith's book on the 1929 stock market crash, it is instructive to see the parallels (e.g. buildup of leverage - this was done via investment trusts back then, another version of the shadow financial system) and some of the same names implicated in the scandals.

Interventions in Financial Institutions in the US and UK

Rafael Pardo, Haocong Ren, and I put together a table of the major ad hoc interventions in financial institutions (FIs) in the UK and US since the autumn of 2007. The table (available here in Excel format) summarizes the basic characteristics of FIs that underwent an intervention as well as whether those government interventions resulted in the protection of different types of shareholders and debtholders.

A few obervations can readily be made from the table:

1. Policy responses have been in some cases inconsistent, particularly in the US. The classic example is Lehman Brothers, which was not rescued by the government (unlike market expectations from previous experience) and had to file for bankruptcy in September 2008. This triggered a global wave of financial markets uncertainty whose effects we are still witnessing.
   
   
2. Governments have been generally keen to protect FI debtholders. This is not surprising in light of the size (bank debt represents one-fourth of all investment-grade debt in the US) and composition (mostly institutional investors and foreign governments) of such debt. The Lehman experience has made governments even more averse to upsetting debt investors, although it raises basic issues of fairness since taxpayers then become the first (as opposed to the last) line of support after shareholders for systemically important financial institutions. Going forward, subordinated and hybrid capital (trust preferred stock etc.) will likely become the next battlefield between government and private investors for loss sharing.
   
   
3. Nationalization comes in different shapes and forms. One can contrast the 'official' nationalization of Northern Rock and B&B by the UK government with the conservatorship of Fannie/Freddie, the OTS/FDIC intervention in WaMu, and the significant state ownership in Lloyds, RBS, AIG, and Citigroup. It remains to be seen whether the behavior across the latter group of FIs will differ substantially as a result of the fact that they still have a semblance of private shareholders. It is also interesting to note that important government interventions do not always trigger CDS contracts - compare the conservatorship case of Fannie and Freddie (CDS trigger event) with the nationalization of Northern Rock (no CDS event).