The Financial Crisis: Who’s to blame?

Howard Davies

Director, LSE

HSE Cultural Centre, Moscow

14 December 2009

Rolling Stone described Goldman Sachs as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

Who is most to blame for the current financial crisis?

28

24

10

2

3

11

9

12

1

Bank executives

Governments

Financial regulators

The media

Central Banks

Thatcher and Reagan 1980s deregulatoryreforms

Consumers for borrowing too much

Everyone (democratic society for its collectivefailure to policy the above)

Other

%

Source: Thisismoney.co.uk, June 2009

•economists - “if anything needs fixing, it’s the sociology of the profession” – Dani Rodrik (Harvard)

• business schools – the Guardian

•testosterone – Scientific American: “risk-taking in an investment game with potential for real monetary pay-offs correlates positively with salivary testosterone levels and facial masculinity”

•video games – Professor Susan Greenfield of Oxford

• human greed – Rowan Williams

•Jews

Some suspects

Who blames “the Jews” for the financial crisis?

Source: N Malhotra, Y Margalit: State of the Nation. Boston Review, May/ June 2009.

% blaming

49 US banks

29 Investment banks

29 Credit Rating Agencies

28 US regulators

25 Hedge funds

23 EU banks

6 EU regulators

……and the answer?

Views of Members

of the European Parliament

…66% recommend deeper political union in Europe, as a key response

to the crisis

Russians trust their government more than the British do..What is your level of trust in the government to manage the financial situation?Average response, scale from 1.0 (no trust) to 10.0 (full trust).

Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.

But the social impact is large

Projected impact of the crisis on the poverty rate, percentage of people with income level below minimum subsistence, 2007-2009

Source: Russian Economic Report No. 19, World Bank.

The impact of the crisis on the long-term development objectives in Russia: dynamics of GDP level in Russia 2007-2020, (q1-2006=100)

Source: World Bank Projections, Strategy 2020.

Russians are more confident in banks

What is your level of trust in the stability of the banks?Average response, scale from 1.0 (no trust) to 10.0 (full trust).

Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.

Source: Worldwide Barometer of the Financial Crisis – August 2009, BVA.

Russia is one of the countries where level of optimism is above the average

“ Bank failures are caused by depositors who don’t deposit enough money to cover the losses due to mismanagement”.

Dan Quayle

Act One: Subprime

Act Two: Liquidity

Act Three: Unravelling

Act Four: Meltdown

Act Five: Pumping

The Credit Crisis: A Five-Act Shakespearian Tragedy

Real GDP % growth forecast, October 2008

Source: Financial Times European Economic Forecast.

Real GDP % growth forecast, July 2009

Source: Financial Times European Economic Forecast.

-6

-5

-4

-3

-2

-1

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014

France

Germany

Japan

UK

US

The IMF forecast a modest recovery next year

Source: IMF World Economic Outlook Database, October 2009.

Gross domestic product forecast (% change), constant prices, 2007-2014

But global unemployment is likely to continue to rise

Unemployment (Million) and unemployment rate (%), 1999 - 2009

Source: ILO, Trends Econometric Models, December 2008.

•global imbalances

•loose monetary policy, leading to•mispricing of risk•credit bubble

•‘excess’ leverage, facilitated by procyclical regulation, and regulatory arbitrage

•‘excess’ unmanaged growth of the financial sector, which magnified risks, rather than diversifying them

What are the underlying causes?

Global current account imbalances grew rapidly from 2003

Estimates of account balances for selected countries ($ Billion), 1993-2007

Source: Datastream, FSA Calculations.

Source: Bank of England, Speech of Charles Bean at the Annual Conference of the European Economic Association, 25th Aug 2009.

Monetary policy was loose, especially in the US

Deviation of policy rates from Taylor rule (%), 2000-2009

Household debt as % of GDP, 1987-2007

Source: FSA, ONS, Federal Reserve, Eurodata, Datastream

Household debt rose sharply

Case-Shiller Home Price Index (2000 Q1 = 100), Jan 1987 - 2005

Source: Silverlake, Case-Shiller Price Index.

US house prices doubled in five years

Source: ECB, National Statistical Offices, IMF, EMF, Italian Ministry of Infrastructure, Morgan Stanley Research.

House prices rose rapidly in much of Europe also

Real house price changes over the last ten years (%), 1996-2006

Bank Balance Sheets expanded

Source: Silverlake, Capital IQ.

Large-cap banks’ aggregate assets rose to 43x tangible book equity

UK banks leverage grew sharply from 2003 onwards

Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.

Major UK banks’ leverage ratio, %, 1998 - 2008

Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.

Source: The Turner Review, March 2009.

ABS – volumes outstanding, $ Billion, 1996 - 2007

As did the securitised credit market

Credit default swaps, $ Trillion, H2 2004 – H1 2008

And the outstanding credit default swaps

Source: The Turner Review, March 2009.

Resecuritisation magnified credit creation

BBB

A

AA

AAA

Residual/Equity

SUPER SENIOR

AAA

AAA

AA

A

BBB

Equity

Capital Structure Containing Subprime Loans

Subprime Mezzanine CDO Containing BBB Subprime Bonds

100%

28%

20%

11%

7%

0%

11%7%

11%

8.6%

7%

100%

40%

0%

CUMULATIVE LOSSES

Source: Morgan Stanley.

Private Equity Leverage Multiples grew

Source: Silverlake, Morgan Stanley, Capital IQ.

44.6 4.8

5.3 5.4

6.2

0

1

2

3

4

5

6

7

2002 2003 2004 2005 2006 2007

Debt/EBITDA, 2002 - 2007

X

Growth in Hedge Fund Assets & Leverage accelerated

Source: Silverlake, Through Q308 – HFR industry report; Q408 projections based on CS analysis.

This points to the need for monetary policy to focus more on

- credit growth- financial intermediation, and- asset prices

…with a stronger emphasis on the risk of financial instability

Weak regulation may not have been the main cause of the crisis, but it is important to reform it

• trust in markets, and in regulation, has been affected, which damages investment and economic growth

•the global system does not meet the needs of global markets

Trust

Source: The Financial Trust Index.

2.13 2.19 2.22 2.372.6

2.953.33

0

1

2

3

4

Average response on a scale from 1 to 5 to the question, “How much do you trust…”, where 1 means “I do not trust at all” and 5 means “ I trust completely.”

Trust in financial markets, and government, has fallen

-1.04

-0.69-0.63

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

Stock Market Banks The Government

Source: The Financial Trust Index.

Average response to the question, “How has your trust in some of these institutions changed in the last three months?” “Would you say your trust in…has 1) increased a lot; 2) increased a little; 3) decreased a little; 4) decreased a lot; or 5) has there been no change in your trust.”

The crisis revealed problems with the existing regulatory architecture:

• Hopelessly complex global structure

• Lacking a central authority to drive co-operation and make changes happen

• US system balkanised and ineffective

• European system a fudge – neither truly European nor truly national

• No two national systems the same

Global Committee Structure - A Regulator’s View

G-20(Gov’ts)

Financial Stability Board

WTOOECD

(Gov’ts)

FATF (Money Laundering) IASB

(Accounting IASC

Bank for International Settlements

(Central Banks)

G-10(Central Banks)

CGFS CPSS

Basel Committee(Banking)

IOSCO(Securities)

Joint Forum

IAIS

(Insurance)

Monitoring Group

IAASB(Audit)

PIOB

IMFWorld Bank

(Gov’ts)

IFIAR(Audit)

Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007.

IOSCO Structure

Presidents’ Committee

Executive Committee

Regional Committees• Asia-Pacific

• Europe• Interamerican

• Africa-Middle-East

EmergingMarkets

Committee

Working Groups• Disclosure and Accounting (WG1)

• Secondary Markets (WG2)• Market Intermediaries (WG3)

• Enforcement & Cooperation (WG4)• Investment Management (WG5)

Specific issue Task Forces

PrinciplesImplementation

Committee

SRO ConsultativeCommittee

Co-ordinationCommittee (with Basel

and IAIS)

Chairs’ TaskForce

TechnicalCommittee

Standing Committees•Multinational Disclosure and

Accounting (SC1)•Secondary Markets (SC2)

•Market Intermediaries (SC3)•Enforcement & Cooperation (SC4)

•Investment Management (SC5)

Specific issue Task ForcesE.g. CPSS-IOSCOInternet Task Force

Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007.

A new European Framework for Safeguarding Financial Stability

Macro-prudential supervision

Micro-prudential supervision

Source: De Larosière Report, February 2009.

Members of ECB/ESCB

General Council (with alternates

where necessary)

European Systemic Risk Council (ESRC)(Chaired by President ECB)

Chairs ofEBA, EIA

& ESA

European Commission

European System of Financial Supervision (ESFS)

European Banking Authority

(EBA)

EuropeanInsurance Authority

(EIA)

EuropeanSecuritiesAuthority

(ESA)

National BankingSupervisors

National InsuranceSupervisors

National SecuritiesSupervisors

+ +

Information on micro-prudential developments Early risk warning

National Regulatory Structures

Tripartite Dual 'Twin Peaks' Unified regulator

Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications.

57

35

2

493

54

28

739

10

Other bank regulators

Central banks as banking regulator

Central bank as one pillar

No Central Bank interest

Non-Central Bank

Central Bank

And there were a number of regulatory failures

US Financial markets regulation was uncoordinated and overlapping

- Promoted regulatory “competition”

European Regulation also at fault: complex mix of European and national rules

In the UK, weak FSA regulation of Northern Rock, and the Bank of England too distant from financial markets

More regulatory failures

Key markets were unregulated– Non-bank private mortgage industry– Credit Default Swaps

• No exchange, central clearing or capital requirements

Insurance industry in the US was lightly regulated– No federal regulator– Missed “one-sided” credit insurance & CDS risks taken on by

AIG and others

Basel II capital requirements were flawed– Allowed too much leverage, over-reliance on credit ratings, and

didn’t encompass liquidity– Pro-cyclical: as asset prices rose, banks seemed to need less

capital

G20 Summits

“Reshaping the global financial and regulatorySystem”

• Enhance corporate governance and risk management

• Strengthen prudential regulation, but with a ‘managed transition’ to avoid exacerbating the downturn

• Regulate financial activities according to their economic substance and ensure regulation is consistent in all jurisdictions

“Reshaping the global financial and regulatory system”

• Financial Stability Board with standing committees• Membership of FSB, Basel etc extended to BRICs and

others• Expanded coverage of regulation to include systemic

hedge funds• Tighter controls on offshore centres• Tighter regulation of credit rating agencies• More and better quality capital in the banking system• Macro-prudential mechanism to respond to asset price

bubbles• Regulatory controls on bank remuneration

G20 Summits

What about the bankers themselves?

• Poor risk management– excessive reliance on Value at Risk Models– herding behaviour– inadequate hedging

• Flawed capital allocation mechanisms– trading strategies under-capitalised

• Incentive structures which reward short-term risk-taking

• Weak corporate governance: boards ignorant of the risks management were taking on

Failures in the financial firms themselves may have been even more important

Much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst”

Prof. Paul Krugman, Princeton

“The unfortunate uselessness of most ‘state of the art’ academic monetary economics”

Prof. Willem Buiter, LSE

“The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year”

Alan Greenspan

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

The Global Financial Centres Index

Financial Centre GFCI Rank GFCI Rating

London 1 790

New York 2 774

Hong Kong 3 729

Singapore 4 719

Shenzen 5 695

Zurich 6 676

Tokyo 7 674

Chicago 8 661

Geneva 9 660

Shanghai 10 655

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

• Macro imbalances, loose monetary policy and financial innovation

• Rapid credit growth, asset price bubbles, overborrowing

• Global finance without global government

• Flawed assumptions about market efficiency and investor rationality

Such a complex failure has many parents

The Financial Crisis: Who’s to blame?

Howard Davies

Director, LSE

HSE Cultural Centre, Moscow

14 December 2009