Crisis Talk - The World Bank Group

Weekend Reading

"Good news for investors who like to lose all their money". LTCM 3.0 is here.

The dangers of ultra cheap money.

Is US Government debt actually "risk-free"?

Historically, a weak dollar has been deflationary.

Great charts from Calculated Risk and Barry Ritholtz.

The average unemployment period in the US is at an all-time high.

Another take on why bankers make so much money.

Is Paul Krugman Panda-bashing?

"If you are going to be doing business in a foreign country, particularly China, it pays to do so legally and it pays to have the right visa."

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.

Exchange Rate Movements in the Crisis and Beyond

Editor's note: Sebastian Weber and Charles Wyplosz are from the Graduate Institute in Geneva. They are the authors of a World Bank working paper on Exchange Rates during the Crisis.

A key leitmotiv as the financial crisis unfolded was to avoid a repeat of the policy mistakes of the Great Depression, including the beggar-thy-neighbour competitive devaluations which have had devastating effects causing rising protectionism and a collapse of international trade (Kindleberger, 1973).

Unlike in the 30s, only some 42% of countries are officially pegging their exchange rate today, implying that movements in the exchange rate do not necessarily reflect official decisions, but are rather market-driven. Furthermore, governments today have many more policy tools at hand, ranging from fiscal policy over labour markets to monetary policy measures, making them less reliant on measures that are perceived as beggar-thy-neighbour.

While exchange rates have moved a lot since the onset of the crisis, these movements have mostly been interpreted as a byproduct of expansionary policies and the move to ‘quality’. Sharp depreciations in countries like the UK or South Korea have not been welcomed by the authorities, at least not officially. Intentions, of course, are hard to detect and no one will argue that expansionary policies were not needed.

 

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. 

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.

Deposit Insurance, Blanket Guarantees and Exit Strategies

The World Bank held a discussion yesterday on the role of extraordinary deposit insurance schemes in the crisis. Fred Carns from the FDIC and David Walker from the CDIC (Canada) outlined the lessons learned, measures taken, and future policy recommendations for the world's deposit insurance schemes.

The main crisis driven deposit insurance arrangements include:

• More than one-third of deposit insurance programs around the world have adopted some form of enhanced deposit insurance protection during the crisis.
• Less than 20 percent of deposit insurance jurisdictions have provided blanket guarantees. Yet this minority is significant, and includes the United States. Some schemes apply only to selected categories of deposits, while a handful take the form of political promises as opposed to changes in law or regulations.
• Among jurisdictions that did not provide blanket guarantees but raised their coverage limits, the extent of the increases varies widely.

The Case for Inflation; or, The End of Orthodoxy

I attended a symposium this morning on America's Debt Overhang, hosted by the non-partisan New America Foundation (NAF). There were several interesting discussions about the present and future implications of America's ballooning public, private and household debts. I will return to these debates in greater detail tomorrow.

One presentation in particular stood out: Christopher Hayes, a fellow at NAF, presented a controversial paper entitled Overcoming America's Debt Overhang: The Case for Inflation.

Hayes argues that America's debt burden has become crippling. Indeed, household debt has risen from 48 percent of GDP in 1981 to 97 percent today. Meanwhile, corporate debt has grown from 22 percent in 1981 to 120 percent in 2009. The federal government is borrowing and spending at unprecedented peacetime rates. This toxic cocktail may spiral out of control:

One Year On

On the one-year anniversary of the Lehman Crisis, the biggest names in financial punditry have been voicing their thoughts and concerns on the most important issues facing the world economy.  Let's take a look:

Martin Wolf, who spent most of the crisis bringing attention to global imbalances, has become a China bull:

China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

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.   

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.

Blanket Guarantees: What next?

Editor’s note: The World Bank Group has just released the fourth paper in its Crisis Response series, which aims to chart a path out of the crisis. This current release discusses deposit insurance and government guarantees of other bank liabilities, and possible strategies for winding down the blanket guarantees issued during the crisis.

The expansion of deposit insurance and introduction of debt guarantees have played a crucial role in containing the financial crisis while giving governments time to develop suitable policy responses. But these measures do not address the root causes of the crisis, and they lead to competitive distortions, moral hazard, and large fiscal contingent liabilities. Rolling them back is likely to require an internationally coordinated effort—and an answer to the important question, “exit to what?”

To download a PDF of the paper, please click here.

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.

Kaufmann Takes Aim At Corruption

Dani Kaufmann, one of the pioneers of the governance agenda at the World Bank, discusses the role that corruption played in the financial crisis:

There are multiple causes of the financial crisis. But we can not ignore the element of "capture" in the systemic failures of oversight, regulation and disclosure in the financial sector. Concrete examples abound.

First, the way Freddie Mac and Fannie Mae spent millions of dollars lobbying some influential members of Congress in exchange for, among other things, lax capital reserve requirements for these mortgage giants.

Second, how AIG's "small" derivatives unit located in London managed to obscure its accounts, be governed by lax regulatory oversight, and take inordinate risks that effectively brought down AIG's empire of 100,000 employees in 130 countries, accelerating the global financial crisis...

Third, how giant mortgage lenders such as Countrywide Financial switched regulators so to fall under the lax oversight of the Office of Thrift Supervision, which was funded by fees paid by the regulated banks (and which also supervised AIG's derivative unit).

Fourth, how in April 2004, during a 55-minute-long meeting at the Securities and Exchange Commission, the largest investment banks persuaded the SEC to relax its regulatory stance and allow them to take on much larger amounts of debt.

Finally, Madoff's giant Ponzi scheme, some of which appears to be plain fraud, though system-wide irregularities also point to subtler forms of corruption and capture. Years ago the SEC knew that Madoff, who had served on the commission's own advisory committee, had multiple violations and was misleading it in how he managed the funds of his customers. Yet the SEC failed in unmasking the Ponzi scheme.

Worse yet, more governance challenges are yet to come, as fiscal stimulus packages present all kinds of opportunities for the ethically challenged. Kaufmann recommends far-reaching measures to improve transparency as an antidote. I agree with that but doubt that's enough.

Disclosure by Politicians

After three years in the making, we have just completed a large research project on the disclosure of conflicts of interest and business dealings by politicians in 175 countries. The resulting paper, Disclosure by Politicians, a joint effort with Rafael La Porta (Dartmouth), Florencio Lopez-de-Silanes (EDHEC Business School) and Andrei Shleifer (Harvard), is the first to look at what disclosures are required by law, which of these are made public, in which countries someone actually checks whether the disclosures are made or not, and what penalties exist in the event of faulty or incomplete disclosures.
 
The topic will undoubtedly raise heat in countries that don't do well. More relevant for the current crisis, however, one can imagine a call for similar types of disclosures by CEOs of publicly-traded companies and perhaps even privately-held financial companies. The scandals starting to emerge from the crisis - take Madoff and Satyam - suggest there is considerable sleaze in the private sector too.
 
The good news is that the methodology now exists and can be adapted to the captains of industry.

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

The Sacred Cows of Capitalism, Alive and Kicking

Wounded perhaps, but the sacred cows of capitalism are alive and kicking, according to a new World Bank working paper by Asli Demirguc-Kunt and Luis Serven. The authors of Are All the Sacred Cows Dead? argue that "the 'sacred cows' of financial and macro policies are very much alive...the on-going crisis does not simply reflect a failure of free markets, but a reaction of market participants to distorted incentives."

Demirguc-Kunt and Serven, however, aren't just adding another paper to the now large pile that do a post-mortem on the origins of the financial crisis. The approach is much more prospective than that. How are regulators and central bankers in emerging markets to deal with banking systems and financial markets facing severe stress? It's more of this type of analysis that's needed right at the moment.

On blanket guarantees (compare this to a recent post from Thorsten Beck):

It must be recognized that the short-term benefits of guarantees will vary with the fiscal strength of the guaranteeing government. To hasten the end of an insolvency driven banking crisis and to constrain the spread of insolvencies in the short term, the government must manifest a substantial capacity for absorbing losses. This is not a luxury most countries can afford since most governments do not have the required fiscal capacity. Depending on the depth of the systemic insolvency such support may not even halt the spread of crisis and delay healthy adjustments.

On government ownership of banks:

Given the extent to which lending policies are politicized, it is not surprising that state ownership appears to heighten the risk of crises instead of reducing it. If anything, research suggests that greater state ownership is associated with various measures of financial instability, including a greater probability of banking crises.

On market discipline and Basel II:

Many interpreted the crisis as a vivid example of market failure, evidence that there is no such thing as market discipline, reinforcing calls for stronger regulations through improvements in Basel II accord. But the crisis also spawned a growing argument about the role Basel I accord may have played in causing the crisis. Indeed, it is no secret that Basel I contributed to the growth in securitization by assigning lower capital charges and thus giving incentives to institutions to move their assets into off balance-sheet securitization vehicles. While advocates claimed that Basel II, had it been implemented earlier, could have lessened or prevented the turmoil, critics of the Basel approach to capital regulation pointed out that the crisis has simply reconfirmed fundamental flaws that have been evident in this approach.

>> Download a PDF of Are All the Sacred Cows Dead?

Is Deposit Insurance Really the Solution to Depositors’ Worries?

Deposit insurance is an attractive tool for politicians, especially in crises such as this one. Announcing (unlimited) coverage of deposits in the banking system can prevent depositors from bank runs. And as long as the authorities do not have to make good on their promise, it is also a cheap tool. By now, however, most economists are well aware of the moral hazard effects of generous deposit insurance, a product of reduced market discipline. The result? Aggressive and imprudent risk taking. But considering recent events in Russia, one should be careful about believing blindly in the confidence-creating effect of deposit insurance either.

Some months ago, a small Russian bank called Capital Credit simply refused routine withdrawals by their customers, thus clearly signaling its illiquidity (which normally comes after insolvency!). But the Central Bank of Russia (which is also responsible for bank supervision) did not take any action for several weeks despite heavy protests by depositors. Only when depositors threatened to demonstrate in front of the Central Bank did bank supervisors finally withdrew Capital Credit’s license, thus allowing depositors to start the process of recovering at least part of their savings from the deposit insurance.

The result: despite an explicit deposit insurance scheme and despite the government’s assurance that all deposits would be secure, a loss of trust and confidence in the banking system occurred. As long as bank supervisors are not strong enough to intervene into failing banks, deposit insurance schemes cannot help conserve or restore confidence in the banking system.

Reforming the Credit Rating Agency Industry

A lot has been said and written about the role of credit agencies in the current crisis. Almost everyone agrees that their role has been negative, understating the risk of many financial products and papers and misleading many investors. But how can the incentive structure of this industry be reformed? Is tougher regulation the response? Or perhaps more competition in a three company industry?

A recent theoretical paper by Patrick Bolton, Xavier Freixas and Joel Shapiro (The Credit Ratings Game) offers some suggestions towards reform of the industry, but also clearly shows that there are no silver bullets. As any theoretical model, it relies on simplifying assumptions, but it presents very clearly the incentives faced by different stakeholders, including credit rating agencies and issuers of securities, and how different policy measures will affect them. At the core of the incentive problem is the fact that it is the issuers who buy ratings rather than the "users", i.e. investors, and that issuers can shop around for good ratings.

Looking for Solutions in the Ukrainian Banking Sector

You’d have to follow Ukrainian news very closely to keep up with all the proposals to deal with the financial crisis that have been floated in the last few months. Many are the result of well-intentioned efforts at the Ministry of Finance and the National Bank to help mitigate the impact of the crisis on ordinary citizens. The question, though, is whether any of the proposals will have the intended benefit, or will they simply limit the ability of the private sector to find its own ways to continue business?

The proposals being floated fall mainly into two categories. The first target those who took loans in US dollars and are now facing repayment problems. The second target those with fixed-term deposits who face problems with withdrawing funds. Here is what’s been floated so far for the first group:

A European Contribution to Crisis (Management)

A lot has been written about the failures of bank regulation and supervision in the U.S., where the sub-prime crisis started, but what about Europe?  Problems abound here as well – bank runs in England, governance issues in state-owned banks, such as in Germany, where some of the first banks fell, and lots of interventions into failing banks. 

Unlike in the U.S., however, matters are complicated by the lack of a Europe-wide regulatory and supervisory framework despite the emergence of a pan-European banking system.  The consequence: national approaches, often resulting in nationalization, such as in Belgium and the Netherlands.  Private market solutions for large banks are not feasible as no bank strong and sound enough in the respective country exists to take on a large failing bank.  And private market solutions in Europe are impeded by the lack of a Europe-wide authority who could take the lead in organizing such a solution as the Federal Reserve or the FDIC do in the U.S. 

A Lapse of Reason

In last week's Wall Street Journal, two of the top financial economists wonder whether economists have lost their marbles. Oliver Hart (Harvard, and my co-author on a recent paper on bankruptcy regimes) and Luigi Zingales (Chicago) wrote an op-ed that starts with:

This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Their main argument is that the US government should let financial and auto companies enter bankruptcy procedures, rather than rely on ad hoc bailouts. Bankruptcy, Hart and Zingales argue, provides an opportunity for claimants to figure out whether the company's financial trouble was the result of bad luck or bad management, and to decide what should be done. Short-cutting this process through a government bailout is dangerous. Does the government really know whether a company should be saved?

As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.

Ways to Tackle Procyclicality in Banking

Ask most bank supervisors and bankers about the causes of the subprime-cum-financial crisis, and their responses are typically the same. Banking problems manifest themselves in a different way every time, and one can debate whether excessive risk-taking behavior by banks is primarily due to misaligned incentives or to irrational exuberance. However, they all confirm that such behavior is conditioned by, and contributes to, the business cycle. It is difficult for banks to follow more prudent policies during an economic upturn, especially in a highly competitive environment. Credit mistakes made during that period only become apparent in the downturn, resulting in the well-known privatization of gains during good times (excess earnings shared among bank shareholders and staff) followed by the partial socialization of losses during bad times (public bailouts).