Forbidden questions on the crisis

Franco Bruni (Bocconi University and ESFRC)

London Financial Regulatory Group, LSE, 17 November 2008

Previous title …• “Regulatory Reactions to the Crisis”• But in the meantime the crisis deepened and

proved to be longer • Emergency crisis management dominates• Regulatory reactions for “normal times” are still

in a starting-hesitating-confusing state (see over), both in practice and in theory

• Major-general-puzzling-forbidden questions come to one’s mind …

Among reregulation initiatives• March 08: Paulson’s Blueprint (following similar “Obama

principles”) for the US• FSF programme and its monitoring (see appendix)• Basel Committee: (slowly) towards Basel 2.5? (see appendix). In

the meantime: calls to put Basel 2 on hold in the US• EU’s governments-induced IASB October decision to amend

mark-to market rules and US Emergency Stabilisation Act allowing SEC to suspend fair value accounting and requiring a review report (both IASB and FASB nervous about the measures)

• EU’s High Level Group (see appendix): first report scheduled for April 2009…

• EU’s Commission preparation for CRD amendments including 5% minimum holding of securitised products

• EU’s Commission legislative proposal to register CRA with CESR and regulate them

• US Congress, SEC and EU Commission at work on Central Counterparty Processing and Clearing for CDS and other derivatives

“Forbidden” questions …• … as they deal with aspects often “left

aside”,• as they reveal weaknesses and

uncertainties of theory,• as they inspire non-orthodox answers

here : emphasis on questions, for discussion, not on the (often lacking) answers!

Sparse questions in five domains

• Monetary policy• Regulation • Supervision• Crisis management• Crisis-induced doubts on “fundamentals”:

capitalism, markets, etc.

Monetary policy• IS IT AT THE ROOT OF THE

CRISIS, AND OF THE CURE?• “Too low rates for too much time…”: a frequent,

seemingly compulsory statement, with poor follow-ups (not a single world in the G20 document!)

• Monetary policy, risk aversion and the pricing of risk

• Weaknesses and holes in the monetary policy “orthodoxy” developed since the ’80s

• Should we plan research to suggest a new global paradigm for the cure?

No coincidence ….

Monetary policy rates and attitudes towards risk

• Raghuram Rajan (2006): macroeconomic disequilibria, excess liquidity, competition for assets management (to buy illiquidity), selling β pretending that it is α, etc. …

• … but do we have a polished, classroom treatment of the various links between exogenously set risk-free rates, micro and macro portfolio choices, equilibrium spreads and system-wide risk premia (in differently imperfect markets)?

• Is there a lack of operational theories on the influence of monetary policy on the productivity and the risks of the allocation of resources? Are we narrowing down too much our attention to the issue of asset-prices?

The risk free rate and the spread on risky assets (with opaque intermediation)

• Let i be the risk free rate and r the equilibrium rate on risky assets with probability of default p and loss-given-default L .

• Suppose pure competition (zero expected profit) between risk-neutral, opaque “intermediaries”, able to borrow at rates driven much more by the risk-free rate than by the risks incurred in their lending. For simplicity consider the extreme case where i is their borrowing cost:

(1+i) = (1-p)(1+r) + p(1-L)(1+r), or r-i = (1+i)pL/(1-pL)

• The spread (“risk premium”) is positively related to the level of the risk free rate: a low interest rate policy favours the flattening of the spreads.

• The derivative of the spread with respect to pL is (1+i)/(1-pL)2, also increasing with i : low risk free rates also favour a decrease of the sensitivity of spreads to credit risk.

Risk free rate, the spread and the capital ratio (with opaque intermediation)

• As above, but the funding of the “intermediary” comes also from its own capital k < 1.

• “Competition” pushes r towards a level allowing a minimum required yield y on capital:

k(1+y)=(1-p)(1+r)+p(1-L)(1+r)-(1-k)(1+i), or:

r-i = [i(pL – k) + ky + pL]/(1-pL)

• The positive relation between the risk-free rate and the spread still holds when the capital ratio is smaller than the expected loss (or: when, for a given capital, the opaque gamble looks riskier). In this case a low i also allows a high y for any given spread: easy money has also favoured an unsustainable Roa in opaque banking!

• The derivative of the spread with respect to pL is: [i(1-k)+(1+ky)]/(1-pL)2 , always increasing with the risk-free rate.

Therefore a lowering of the latter decreases the sensitivity of the spread to credit risks even when k is high enough to cause an inverse relationship between the risk free rate and the spread allowed by the competition between the intermediaries.

Received monetary orthodoxy (progressive convergence of thoughts after the

“great inflation” of the ’70s)• Weaknesses, non-homogeneities, lack of enforcement,

as regards:– price stability as the primary objective– the role of asset prices– the role of monetary aggregates (should keynesian instability of

money and credit demands discourage monetarist ambitions to take them into account?)

– independence and accountability– costs and benefits of a fine tuning mentality (as generated by

Taylor-type reaction functions)– compatibility of international differences in monetary policy styles– ….– ….

Monetary policy and the cure• Bretton Woods 2 (?): sharing a global paradigm

and streamlining homogeneous reaction functions, as a substitute to “fixing” exchange rates?

• Monetary policy and financial stability: towards a detailed-operational version of the BIS approach? (by the way: the merits of the BIS analyses of the last 7-8 years are insufficiently recognised and known only in too small circles; most people cannot even separate the good BIS from the bad Basel II)

• …• …

Regulation• QUALITATIVELY INADEQUATE

FINANCIAL REGULATION: ALSO QUANTITATIVELY SCARSE?

• In other words: is the regulatory crisis an argument against the reliability of the market mechanism?

• Many authoritative sentences (including Greenspan, King and Draghi) stating the unexpected “failure of markets and intermediaries in self-regulating”: do these statements really mean something (deep and new)?

• I don’t know. I can only try to list facts and arguments that tend to support the idea of a “quantitative” inadequateness of regulation, an “excess of liberalisation/deregulation”, as well as facts and arguments against this idea.

In favour of ‘excessive deregulation’• A permissive tendency of the logic of Basel II for large banks …• … also favouring low capital ratios with credit insurance contracts …• … and much lower ratios for trading books (vs banking books)• Basel regulation based on unregulated privately contracted ratings• No incentives/rules for countercyclical liquidity buffers• SEC allowing large increases in the leverage of investment banks (+

Commodity Futures Modernisation Act of 2000 prohibiting SEC from regulating swaps ?)

• Unregulated and non-supervised leverage of hedge funds• Excessive freedom to use OTC derivatives (including CDS) as opposed to

compulsory use of central counterparty clearing or organised/regulated open markets

• Excessive reliance on “competition in regulation” (especially in the US) coupled with insufficient attention to home-host issues (especially in “large” Europe)

• Weak regulation/supervision (by the IMF?) of capital flows to certain developing countries (+Island?)

• Lack of limits to securitisation decreasing incentives to monitor (a controversial point: consider the “originate and TRY to distribute” issue, credit enhancement originating incentives to monitor, reputational incentives, etc.)

• …

Against the idea of “excessive deregulation”• US subprime lending: powers and responsibilities to moderate it were in

place; Fanny and Freddy pushing policies had nothing to do with loosely regulated private markets!

• Basel II (in spite of its defects) if applied in US would have limited regulatory arbitrage via special vehicles

• China’s resistance to floating renmimbi not an excessive “reliance on markets”!

• Marking to market (to the extent that it contributed to destabilisation) was … a strong regulation!

• Markets/competition “lacking” in corporate control, rating services and, in a certain sense, even in investment banking.

• Central counterparty processing and clearing for CDS would be more market-competition oriented than OTC (this is why some lobbies oppose it!)

• 1999 Gramm-Leach-Bliley Act, even if formally a “deregulation” (repealing Glass-Steagall) cannot, in itself, be interpreted as a move towards a more permissive prudential setting.

• The “boundary problem”: stricter regulation create disintermediation and arbitrage in good times … My reading of Goodhart’s (NIER October) subtle argument supports the idea that the right way to see the issue is in terms of quality of regulation, not of its quantity …

• …

Supervision• Well known failures …• … but here is “forbidden” question 1 (fq1): how to deal with the apparent

contradiction between the following two facts?– No regulation can be effective without a “pillar 2”-type judgmental and

detailed supervision; in other words: “discretionary” supervision has a central role, compared to regulation is perhaps more important

– Internationalisation of supervision is essential and cannot but be rule based , using standards etc. (principle-based discretion and judgment cannot be the working style of “colleges” and cannot give rise to an international trustable low-cost level playing field for global finance)

• fq2: in academic thinking PCA should be a reliable wall between supervision and crisis management. This crisis, in spite of its systemic nature, would have allowed a massive recourse to PCA-type interventions. Is it correct to state that very little PCA (the UK bank capital injections?) has been done? Are we witnessing an exercise in forbearance (complicated by the “stigma” problem suggesting to the banks to avoid signalling their difficulties)? Why?

• fq3: large banks (TBTF): more regulation or more supervision? • fq4: have market disruptions during the crisis weakened the Shadows’ case

for subordinated debt as a signalling device for supervisors?

Crisis management• LoLR super-activism: has it prevented the self-fixing of the

interbank market? Has the narrowing of the Ecb corridor (especially of its lower part) been a mistake, prolonging the liquidity trap and acting as an incentive to credit rationing?

• Burden sharing: has the crisis shown that (at least in Europe) we are very far (more than we thought to be) from being able to agree on a burden sharing scheme?

• Deposit insurance: what for? – Also from Goodhart (March 2008): to protect some deposits from

bank default (making bank failures easier to manage) or to prevent systemic Diamond-Dibvig failures (to avoid failures)? Different features.

– From this crisis:• demand (and supply) for insurance goes much beyond traditionally

insured deposits• confidence-induced financial melting downs and contagion

(analogous to runs towards the D-D “bad equilibrium”) take place everywhere in the financial markets (bank-runs look even less important than other “runs”, TBTF mentality dominates)

• can we conclude that deposit insurance has lost importance and, in any case, that its only reasonable aim is the partial protection of “widows’ deposits”? → consequences for the EU deposit insurance directive.

Fundamentalisms• New “new deal”, back to Keynes, failure of Anglo-

American capitalism, end of dollar-US global leadership, back to “solid industry” away from fancy paper-based finance, proven superiority of relationship vs anonymous arm’s length finance, politicians must recapture control of market technicalities and bureaucracies, ethics must come back in business and greed be banished, etc.

• Anything worth-while taking seriously in this confused, imprecise, populist basket of rhetoric ravings?

• What about, for instance:– “BW II” or “Westfalia II”: some truly new feasible multilateralism?– Banks’ corporate governance: couldn’t we talk more about it, to

be concrete about ethics?– Shiller’s “financial democracy” and “financial literacy”, vs socially

disruptive circulation of irrational exuberance? – A new emphasis on authorities’ independence “from the

markets” and on arm’s length relationship between public servants and business?

Appendix

Financial Stability ForumApril 2008: directed to a wide range of actors, in the official and private sectors

Note: none of these categories of recommendations deals with crisis management but each of them can be considered in relation with it

• Raise capital requirements for structured credit products, trading book risks, liquid facilities for conduits, monoline insurers; additional capital buffers if needed; account for liquidity risks; check Basel’s cyclicality

• Improve OTC legal and operational infrastructure

• Enhance disclosure and transparency also in accounting, securitisation and rating

• Strengthen international cooperation and consistency in supervision

FSF (April 08) and disclosure

• Risk disclosure (Cebs work?)• Valuation practises• Rating: differentiated and transparent

rating scales; up to no rating for certain category of complex instruments

FSF (April 08) and international coordination

• International colleges of supervisors• Large banks’ liquidity contingency plans

shared with relevant central banks• Clarify procedures for crisis management

and its burden sharing• Deposit insurance: set international

principles and review national arrangements against them

FSF check October 08

• Timely progress all over the place (including work by the Basel committee and Ceps). But acceleration needed on:

• OTC: central counterparty clearing (for credit derivatives) and more robust operational processes

• Accounting standards: convergence!• CRA: comply with FSF recommendations!

Draghi’s account FT November 14• Strengthened Basel II, bank capital raised, supervision

more focused on liquidity, loopholes in bank capital and accounting rules closed

• Supervisory standards internationally enhanced• Convergent accounting guidance for illiquid markets • CRA: stronger requirements on conflicts of interests and

differentiated information on structured products• Progress on central counterparty clearing in CDS• Supervisory colleges nearly established• Progress in thoughts on cyclical rules, accounting and

provisions• FSF “enlargement” needed (?)

Towards Basel 2.5 (?)• To be disclosed around the turn of the year + three months of

public consultation + gradual phasing in towards 2010-2011• Major proposed change is in Pillar 1: a new “incremental risk

charge” (IRC) increasing very much capital requirements against the risks in the trading books, re-securitisations and short term facilities to asset-backed commercial paper conduits

• A reaction to the underestimation of potential illiquidity/insolvency of the trading book and to the excessive arbitrage shifting assets away from the banking book, also acting as an incentive towards an “originate and TRY to distribute” model

• Potential drawbacks of IRC:– Excessive shrinking of the marked to market trading book– Still based on complicated numerical calculations/models (with

analytical and probabilistic flaws and potential manipulations)– Excessive micromanaging of risk, artificially forcing banks away from

sound and efficient “originate and distribute” models , towards old-fashioned deposit-liability driven utilities

– Strong blocking reaction by the lobbies

EU’s High Level Group• Eight-members (de Larosière, Balcerowicz, McCarthy,

Masera, Nyberg, Issing, Ruding, Perez Fernandez): first report in spring 09

• To reform European supervisory architecture, also considering that 2/3 of total EU banking assets are held by 44 cross-banking groups, some operating in as many as 15 (EU) countries

• Home-host issues; supervisory colleges; re-start Solvency II; strengthen Lamfalussy committees

• Move towards a European System of Financial Supervisors ?

• Treaty change?• ECB role? In any case: which relationship between

monetary and prudential EU authorities?• A scenario of formidable political difficulties for the Group

… especially in case the crisis weakens a bit ….

Goodhart’s Regulatory Response, CESifo march 2008

• Deposit Insurance: clarify the purpose, harmonise in Eu and link to PCA

• Reorganise bank insolvency regimes• Money market operations and LoLR: tackle issues such

as the stigma effect, the facilities’ maturity, the quality of the collateral, etc.

• CAR and procyclicality (also: from levels of risk-weighted assets to their rates of growth)

• Boundaries and contingent commitments of the banking system (see over)

• Institutional issues for crisis management and burden sharing (in UK and cross border)

Goodhart’s Boundary ProblemNIER october 08

• “The combination of a boundary between the protected and the unprotected, with greater constraints on the business of the regulated sector, almost guarantees a cycle of flows into the unregulated part of the system during cycle expansions with sudden and dislocating reversals during crises”. This is also true for Goodhart-Persaud time-varying capital requirements

• Recognition that such a problem exists may help to mitigate it (cfr Sivs)

• “Set the boundary to include all those institutions whose SIZE and salience is such that their failure would endanger the continuing operation of key financial markets”

• Regulation should be set only to bite occasionally (in periods of optimism…), when additional restraint is really needed, so that the costs and benefits to the regulated are not too far out of line and trying to limit the potential extent of disintermediation

• Put more reliance on procedural rules, state publicly in advance that regulation will be tightened in certain specific conditions (fast increases in housing prices, overall or individual bank credit, …)

• Special relevance for hedge fund regulation