Journal of Financial Stability 4 (2008) 313–320

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Journal of Financial Stability

journal homepage: www.elsevier.com/locate/jfstabil

The sub-prime crisis: A central banker’s perspective�

Philipp M. Hildebrand ∗

Swiss National Bank, Börsenstrasse 15, P.O. Box, CH - 8022 Zurich, Switzerland

a r t i c l e i n f o

Article history:Received 7 April 2008Received in revised form 25 July 2008Accepted 1 September 2008Available online 5 October 2008

JEL classification:E32E61G28

Keywords:Sub-prime mortgageHousing marketLeverageCapital ratiosSwiss banks

a b s t r a c t

The crisis is not yet over; the housing market continues to dete-riorate and there are spill-overs into other markets. Growth isdeclining, with potentially self re-enforcing mechanisms betweenfinancial markets and the real economy coming into play. A localproblem became a global crisis because of poor risk management,lack of transparency and excessive leverage. Not only does thecapital base need re-building, but also incentive schemes needreconsideration.

© 2008 Elsevier B.V. All rights reserved.

1. Introduction

Billions of dollars of write-offs; Record losses. Banks have never before destroyed so much value inso short a time. But it is not just the dimensions of this crisis that are new. Another new feature of thiscrisis is the role that globalization of financial markets has played. Consider the problem from a Swissperspective. On the one hand, market developments abroad are clearly at the root of the problems inthe Swiss banking sector. On the other hand, at least one part of the solution to our problems is alsocoming from abroad, in the form of large capital injections from the Far East and the Middle East.

� Presented at London, 3 March 2008, LSE Financial Markets Group and Deutsche Bank, The strlation: Lessons from the crisisof 2007. The author thanks Jürg Blum for his contribution to this article.

∗ Tel.: +41 31 327 0103.E-mail address: philipp.hildebrand@snb.ch.

1572-3089/$ – see front matter © 2008 Elsevier B.V. All rights reserved.doi:10.1016/j.jfs.2008.09.012

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Globalisation of the financial sector is presenting enormous challenges to authorities around theworld. Put simply: Although many risks arise at a global level, the authorities are forced – to a largeextent – to act locally. It is within this context that I would like to review some of the initial lessonsfrom the current crisis. In many ways, we are learning by the seat of our pants.

The lessons that I draw from the current turmoil are, I believe, broadly in line with the considerationsthat have emerged from the discussions amongst my international colleagues in the Financial StabilityForum Working Group on Market and Institutional Resilience.

2. The US sub-prime crisis

The roots of the current credit crisis go back at least a decade. Since the beginning of the 1990s wehave been experiencing an unusually favourable macroeconomic environment.

In this situation, monetary conditions were for the most part accommodating. Liquidity in finan-cial markets was arguably plentiful and hence, not surprisingly, the appetite for risk buoyant. Oneconsequence of such conditions was that some markets developed in a manner that, at least in ret-rospect, was clearly excessive, as in the U.S. housing market. When housing in the U.S. finally cooledoff, defaults occurred amongst borrowers with the lowest credit ratings—the sub-prime segment.

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So much for the ex-post narrative of the crisis. By now, we are all aware of the consequences.Where do we now stand? Is the worst behind us? There are several indications that suggest that

we are clearly not yet out of the woods.

Most importantly, the U.S. housing market is likely to deteriorate further. At the very least, there is nocompelling evidence in the data that suggests an end to the price decline. Price expectations continueto point downwards. Second, there are now clear signs of spill-over effects into other markets. Asyou know, risk premia on commercial real estate and consumer credits have risen considerably in therecent past. You can see this very clearly in the next two graphs.

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Third, and not surprisingly, it has become necessary in many countries to make downward adjust-ments to growth forecasts. From the perspective of the banking system, a general economic slow-downwould obviously negatively impact those revenue sources that have, so far, remained relatively unaf-fected. In other words, the current credit crisis is now entering a phase where self-reinforcing feedbackmechanisms between financial market and the real economy constitute a genuine risk.

There is no apparent reason to be optimistic. While none of us can foretell where this crisis willultimately take us, conditions are likely to deteriorate further until US house prices begin to stabilize,the spill over effects into other credit market segments subside and the global growth correction hasrun its course. In reality, of course, financial markets aim to discount future developments. Therefore,we can be hopeful that global financial markets will stabilize and ultimately recover well before wecan be sure to detect these three developments in the hard data. If I had to point to something positive,it would be that first, at least so far, the macroeconomic data in Europe and in much of the emergingworld has held up reasonably well. Second, there are initial signs – albeit still very tentative – of there-emergence of a market for the particularly hard-hit securitized sub-prime holdings. Having said

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that, I find it particularly troubling that there is increasing evidence that we are entering a renewedperiod of tension in the major money markets. Indeed, the idea of a third wave hitting the moneymarkets is thoroughly unpleasant.

3. From local problems to a global financial crisis

How was it possible that a series of local US mortgage market problems could give rise to suchextensive disruption? After all, the sub-prime segment only accounts for just over 10% of the US mort-gage market. And this, in turn, amounts to significantly less than 10%, in value terms, of total bondsand shares traded worldwide.

As I have just pointed out, the crisis is clearly not behind us. Nonetheless, I believe that we arealready able to point to a number of reasons why problems in the U.S. sub-prime mortgage segmentwere able to lead to such dramatic turmoil:

First, the limitations of risk management practices and techniques have become clear. It has becomeevident that – with few exceptions – the world’s largest banks have failed to give sufficient consider-ation to the risks of extreme events. Events have now occurred that, based on the risk managementmodels that were commonly in use, should not have been possible. Many market participants ran intoliquidity problems because they simply had not anticipated such extraordinary market developments.Second, the lack of transparency turned out to be a handicap. For outsiders, the business conductedby international banks represents, in many respects, a black box. Generally speaking, banks havedifficulties in providing understandable assessments of their risks. Consequently, in the crisis, marketparticipants had great difficulty gauging the creditworthiness of their counterparties quickly and withsufficient accuracy.Third, the high leverage of international banks proved to be a problem. As a rule, these banks holdrelatively low levels of capital as compared to their total assets. This is particularly true of the bigSwiss banks, where the capital base has been receding for decades.

Meanwhile, trading has becoming increasingly important. The capital base appears very thin whenset in relation to these investments, some of which – such as the sub-prime exposures – are extremelyrisky. Consequently, in the current crisis, it took no more than losses in just one small part of businessactivities for various international banks to lose a significant part of their capital. The high leverageproved to be a dangerous cocktail when mixed with insufficient transparency and large exposures. Itwas a cocktail that at least temporarily cast doubt on the sustainability of the solvency of a number ofbanks and resulted in a sustained crisis of confidence on the interbank market such as I have certainlynever experienced before.

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An additional element that – in my opinion – must be addressed in these kinds of soul search-ing and fact-finding exercises is the matter of incentive schemes in the banking sector. At the riskof oversimplification, there is no doubt in my mind that asymmetrical compensation incentives havecontributed to the continuous increase in risk appetite in the global banking system. Put simply, com-pensation incentives are asymmetric because on the upside, bonuses are proportional to profits andthus virtually open ended. On the downside, however, they are limited by the zero bound. In otherwords, while employees participate in profits, losses have to be borne by the bank, the shareholdersor, in the extreme case, by taxpayers.

In a nutshell, heads I win, tails you lose. I understand that in reality things are more complicated.Nonetheless, the asymmetry is real and is ultimately an invitation to employees to take excessive risk.Perhaps, paradoxically, the hedge fund industry can serve as a useful reference point to inspire theinevitable and necessary discussion on compensation reform in the banking sector. It seems to methat concepts such as a minimum hurdle rate before performance fees kick in or the high watermarkprinciple are ideas worth exploring.

4. Initial lessons from the crisis

Allow me now to turn to the question of how we can prevent this kind of turmoil from occurringin the future?

Many of the imbalances and risks in financial markets arise globally. Yet the authorities are respon-sible for national banking and financial systems. In this field of potential conflict located betweenglobal risks and the limited influence of national authorities, international cooperation between theauthorities is becoming increasingly important.

In international bodies such as the Financial Stability Forum and the Basel Committee on BankingSupervision, we are working hard to find global answers to the problems we are facing. The focusis on further improving the existing regulatory and supervisory approaches. The idea is to refine andstrengthen further liquidity and capital adequacy regulations, thereby adjusting them to new productsand developments in the financial system. It is certainly necessary and sensible to introduce moredetailed regulations in some areas. However, fine-tuning already complicated regulations – whileprobably inevitable and perhaps necessary – will always amount to an imperfect response to theincreasing complexity in global financial markets.

The refinements not only make regulation and oversight more exact; they also make it increasinglycomplex. The effort and the costs are constantly increasing, both for the banks and for the authorities.At the same time, it is very difficult for the authorities to make adjustments in good time. It is a never-ending competition with market participants in which the authorities are bound to be always a stepbehind the latest market developments.

What is more, the current crisis has mercilessly laid bare the limitations of complex regulations andmodels. We must live with the fact that risk measurement will always be incomplete, despite a widerange of planned and widely discussed improvements. Even the most complex models will never beinfallible. It is therefore questionable, whether the current regulatory approach in and of itself, with itsincreasingly complex provisions that intervene at an ever deeper level in the daily business of banks,is the right one.

Moreover, we must be prepared to accept that international efforts – while necessary – will not besufficient to prevent future crises. Consequently, the question arises for national authorities whetherthey should not take additional precautions. This is particularly true for a country like Switzerlandwhere the banking system contributes greatly to economic prosperity. With that contribution to pros-perity comes a natural consequence. Compared to Swiss GDP, the Swiss banking sector is extremelylarge. The following graph illustrates that.

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Switzerland is in a unique position when it comes to the ratio of its banking sector to its GDP.Switzerland is therefore particularly dependent upon a robust financial centre with an impeccablereputation. This inevitably implies a particularly prudent and cautious approach in our regulatory andoversight framework.

Let me now broaden the horizon again. The quick detour to Switzerland was merely meant tounderline a broader principle by referring to an extreme case. Since the authorities cannot eliminatethe risks of financial crises occuring, and since ever more complex regulation is unlikely – ultimately –to achieve its goal, the financial system must be made more robust in order to withstand shocks whenthey occur. Gerry Corrigan talks about shock absorbers. I very much like that image. Our regulatoryefforts should focus on the shock absorbers or the buffers of the financial system. They need to bestrengthened.

In simple terms, what is ultimately needed are higher capital charges against the trading bookand larger liquidity buffers. To do this, the authorities should consider going beyond simply refiningthe regulations used so far. We need to examine to what extent these complex, risk-weighted andultimately model-based regulations can be supplemented by simpler and more robust indicators—suchas more effective concentration limits and an upper limit on leverage.

For their part, banks need to become more transparent. Otherwise, trust cannot be establishedbetween market participants and market discipline will remain impaired. Admittedly, it is difficultto value complex structured credit problems. But it is rarely impossible. In the current crisis, theinformation provided by many banks was too cautious over a long period. Banks claimed this wasbecause the value of their positions was unclear, given the lack of market prices. Yet some bankshave shown that there are ways around the problem. Early on, when valuing their positions, theyreferred to prices of related products, such as the ABX indices as proxies for non-existent marketprices. In this area, I expect the private sector itself to get organized and think hard about com-monly accepted valuation and disclosure standards. The Institute for International Finance (IIF), forinstance, would be very well placed to undertake such an exercise involving its broad member-ship.

Finally, banks should give consideration to more sustainable arrangements for their incentiveschemes. The asymmetrical structure, whereby profits are retained but losses borne by others, pro-motes short-term, risky behaviour. This asymmetry needs to be eliminated, or at least reduced. Thiswill be difficult and I am quite familiar with the arguments why compensation reform will not work.It is true that fierce competition for talent limits the banks’ room for manoeuvre. And yet, even duringthe past couple of boom years, some reforms have been implemented. One simple example is the

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principle that a part of a trader’s bonus is retained in any given year and only paid out if there are nolosses incurred in subsequent years.

5. Conclusion

I have attempted to provide a few thoughts and some tentative and simple lessons from the currentcrisis. They amount to a central bank’s perspective in so far as many of my central bank friends andcolleagues at the Bank of England, the ECB or at the Fed probably have similar thoughts. They amountto a personal reflection in so far as those same colleagues and friends would probably disagree withsome of the things I have alluded to. Such disagreement simply illustrates that the issues we are facingare hard. There are no easy solutions and deep reflection is needed. This has been an opportunity tostep away from the business of monetary policy and financial stability for a day and to review newideas and insights how to manage this crisis.