Financial Crises and Regulatory Responses

Financial Crises and Regulatory Responses Are Financial Crises Inevitable? Overview of Recent Financial Crises August 5, 2013 Patrick Bolton: Gerzen...
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Financial Crises and Regulatory Responses

Are Financial Crises Inevitable? Overview of Recent Financial Crises August 5, 2013

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1980s • • • •

Latin American Debt Crises. Failure of Continental Illinois in 1984. Crash of 1987. Rise and fall of Junk bond market -- Failure of Drexel, Burnham and Lambert.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s • • • • • • •

Savings & Loans Crisis in the U.S. Scandinavian Real estate and Banking crisis. Japanese asset price bubble and crash. Mexico and Argentina crisis of 1995. 1997 Asian Financial Crisis. 1998 Russian Financial Crisis. 1998 LTCM collapse.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s • Dot.com bubble. • Argentina crisis. • Enron, Worldcom, corporate governance scandals. • Subprime crisis.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1980s 1. Latin American Debt Crises: • Commodity prices fall + unexpectedly large spike in interest rates in the United States cause a widespread sovereign debt crisis. • Sovereign debt held by banks (syndicated loans). • Restructuring of sovereign debt required agreement of banks. • Solution: Brady Bonds, converting bank debts into collateralized tradable bonds Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1980s (2) 1. Failure of Continental Illinois in 1984: • (7th largest U.S. bank at the time). • Bank run by large depositors. • FDIC bailout (renamed Continental Bank) 2. Crash of 1987: • 1982, creation of futures market on S&P 500 index. • Portfolio insurance by Leland, O'Brien, Rubinstein Associates (LOR). • With a large fraction of insured portfolios there could be a risk of positive feedback effect through index arbitrage & put replication, which links futures and spot prices. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1980s (3) • Crash of 1987 continued.. – Friday, October 16th, Dow drops 4.6%, – Monday, Oct. 19th Dow drops 22.6% + breakdown of trading + drop of 29% of 2 months S&P 500 index futures, – Breakdown in index arbitrage & put replication. – What to do about portfolio insurance? Chicago Mercantile Exchange clearinghouse near collapse. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1980s (4) • Rise and Fall of Junk Bond Market – Michael Milken essentially kick-started the junk bond market which became an important source of financing of leveraged buyouts (LBOs), hostile takeovers in the mid-1980s. – Often buyers of junk bonds were Savings & Loans institutions. – Hostile takeovers were also facilitated by arbitrageurs (Ivan Boesky) who were later convicted of insider trading along with Michael Milken. Failure of Drexel, Burnham and Lambert. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s • •

Savings & Loans (S&L) Crisis in the US: failure of nearly 750 S&Ls. Cost to taxpayers exceed $300 billion. Economic causes: (based on Pyle, 1995) –

Asset-Liability mismatch. Long-term fixed interest loans (on average longer than 15 years) as assets and short-term variable interest deposit liabilities. – Deposits were insured (initially up to $40.000) but there was a ceiling on interest remuneration of deposits. ⇒ – S&L vulnerability to changes in interest rates; present value of liabilities remains constant but present value of assets highly volatile (Gordon growth formula: value of a perpetual coupon payment C is V(C)=C/r, where r is the short term interest rate; convex function). Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (2) •

Savings & Loans (S&L) Crisis continued.. –



inflation + competition from money market mutual funds (with unregulated interest rates) make it harder for S&Ls to retain and attract deposits

Regulatory Failures: –

Interest Rate Adjustment Act of 1966: establishes a positive spread between bank deposit rates and S&L deposit rates – Depositary Deregulation and Monetary Control Act of 1980: eliminates deposit rate ceilings, – Garn-St Germain Act of 1982: 1) mandates interest rates on deposit accounts equal to rates of money market funds. ⇒ solves liquidity crisis but creates an insolvency crisis. 2) allows S&Ls to diversify their asset base (up to 40% of commercial real estate and up to 30% consumer loans) ⇒ facilitates moral hazard in lending and gambling for resurrection. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (3) • Savings & Loans (S&L) Crisis continued.. – Political Failures: (based on Romer and Weingast, 1992) – Congress was the major source of regulatory forbearance during the period of 1985-1987. – It did not take action despite early warnings by economists and by regulators at the Federal Home Loan Bank Board (FHLBB). It intervened to stop regulatory actions to stop closures of insolvent S&Ls. – It intervened by facilitating S&L moral hazard and by weakening regulatory oversight. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (4) • Savings & Loans (S&L) Crisis continued.. – Politics of regulation: 1) Congress: i) multitask problem for congressmen: constituency service and national policy issues; ii) they are ombudsmen for their constituents before regulatory agencies; iii) role of congressional committees as gatekeepers (committee on Banking, Housing and Urban Affairs). – 2) Special interest politics: active and organized interests, trade associations (U.S. League of Savings Associations) vs. passive and unorganized interests (tax payers).

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (5) Savings & Loans (S&L) Crisis continued.. –

Main hypothesis: congressmen side with the active interests in their district. – 3) Regulatory Agencies: Regulatory capture → agencies respond to implicit and explicit political pressures mainly from the relevant congressional committees. – 4) The president: may have the power to mobilize the nation against narrow active interests. – political response to S&L crisis: Healthy S&Ls lobbied against tighter regulation and against higher deposit insurance contributions. – Failing S&Ls lobbied against closure. – Republicans were generally in favor of deregulation and wide support in Congress for encouraging access to home ownership (the American Dream). → Congress systematically turned down Thrift industry proposals to allow adjustable-rate mortgages (ARMs). Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (6)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (7) • Regulatory responses: 1. Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) 2. FHLBB and FSLIC abolished and creation of the Office of Thrift Supervision (OTS) 3. The Resolution Trust Corporation (RTC) is established to liquidate failed thrifts 4. Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) tightens bank and S&L closure rules, establishes risk-based deposit insurance and raises capital requirements, 5. Greater role for Freddie Mac and Fannie Mae and takeoff of mortgage backed securities (MBS) Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (8) •

Scandinavian Real estate and Banking crisis: – – – – – – –

Deregulation of the credit markets in 1985. Increase in real estate lending by non-bank entities financed with commercial paper guaranteed by banks. Real estate bubble. Collapse of one of these entities, Nyckeln, in 1990; freeze in the commercial paper market; banking crisis. Bank Bailout and Nationalizations: December 1992: Government guarantees all bank deposits and liabilities of the 114 Swedish banks. Creation of a Bank Supervisory Authority to supervise and manage insolvent banks. Cost estimate of bailout: 4% of GDP.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (9) •

Japanese asset price bubble and crash:

1. High post-war (export-led) growth + high savings rate + low interest rates 2. asset price bubble in the 1980s (real estate + stock prices) and lending boom. 3. Sharp increase in interest rates in late 1989 triggers a massive stock market and real-estate crash + a banking crisis.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (10) • Japanese asset price bubble and crash…. 4. Asset price crash + banking crisis was followed by a decade long stagnation (the lost decade). 5. Banks exposed to real estate crash through loans to jusen, non-bank entities specialized in real estate loans. 6. Also, deregulation in 1980s exposed the jusen to increased competition from banks; they responded in the same way as S&Ls by investing in riskier assets. 7. In 1995, 75% of loans by jusen were classified as nonperforming (see Hoshi and Kashyap, 2004 JEP). 8. Regulatory forbearance + zombie lending.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (11)

Nikkei 225 Index

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (12)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (13) • Mexican crisis and IMF (and US) bailout of 1995: 1. Fixed exchange rate + current account deficit + lax public finances and macroeconomic policy before important elections. 2. To finance the deficit Mexico issues Tesobonos, debt indexed to the dollar. Low foreign exchange reserves. 3. Self-fulfilling run on the peso and tesobonos devaluation and move to a floating exchange rate (4 to 7.2 pesos to a dollar in one week). 4. To avoid a sovereign debt crisis IMF and US intervene with a $50 billion bailout. Concerns with bailout and moral hazard in lending.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (14) 1997 Asian (Domino) Financial Crisis: 1) Thailand: • decade-long lending boom and real estate bubble financed with dollar-denominated loans. • Fixed exchange rate. • May 1997 run on the Thai Baht. • Central Bank has insufficient FX reserves and Thai Government applies for an IMF loan. • IMF grants a $17 billion package conditional on devaluation, more transparency on FX reserves and fiscal austerity.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (15) 1997 Asian (Domino) Financial Crisis: 2) Indonesia: • following devaluation of the Baht, Indonesia relaxes fixed exchange rate by widening band of the Rupiah. • Same scenario as in Mexico & Thailand: self-fulfilling run on the Rupiah in August. • Rupiah forced to float. • Banks who borrowed in dollars became insolvent. • IMF package of $33 billion conditional on fiscal austerity and bank closures. Response? Massive capital flight, system-wide bank run and stock-market collapse. • Indonesia's situation deteriorates again in January 1998 after the resolution of the Korean crisis and eventually leads to Suharto's downfall. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (16) 1997 Asian (Domino) Financial Crisis: 3) South Korea: • As in Thailand, South Korea had experienced a long lending boom. • Contagion from crisis in Indonesia and Thailand puts pressure on South Korea's currency the Won and the stock market. • Korea applies for an IMF package of $55 billion in December. • Capital flight continues and Won continues to fall. • Uncertainty over December 18 election outcome undermines financial confidence. • Speculation that Korea would run out of FX reserves despite the IMF package. • Risk of sovereign debt crisis as Korea had a lot of short-term bank loans that needed to be rolled over. • Fed convenes meeting with the six major US banks in NY to pressure them to roll over loans. (see Blustein, 2001). Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (17) 1997 Asian (Domino) Financial Crisis: 4) Other Asian Economies did not face foreign exchange and financial crashes: China, Hong Kong, Malaysia, Singapore, Taiwan. What do these economies have in common?

1998 Russian Financial Crisis: • The Asian financial crisis and the fall in oil and commodities prices weakened Russia's balance of payments and public finances, which were already fragile following the mass privatization and shock therapy reforms of the early 1990s. • Owing to IMF advice the Ruble exchange rate had been fixed so as to serve as a nominal anchor against inflation. • Russian Government recapitalized its Ruble-debt into dollardenominated bonds (Eurobonds) to reduce its debt. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (18) 1998 Russian Financial Crisis…. •

Russia receives another IMF package of $22.6 billion in July, having already received various IMF loans and technical assistance in 1992, 1993, 1994, 1995 and 1996.



But this new program does not forestall a run on the Ruble and Russian financial assets.



In mid-August Russia devalues the Ruble and defaults on its Ruble-denominated debt (GKO) thus precipitating a banking crisis and producing enormous inflation. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (19) 1998 LTCM collapse: • Financial markets were taken by surprise by the Russia default and the end of IMF bailouts. • News of the default triggered a massive flight to quality and resulted in a widening of spreads in bond markets. • LTCM, one of the largest hedge funds at the time was specialized in bond-arbitrage and convergence trades (combining a short position on a low risk and liquid bond with a long position in a comparable--somewhat higher risk and lower liquidity-bond). • They had huge, complex, and highly levered positions in bonds, derivatives and interest-rate swaps. • When it was founded LTCM was seen as the elite of the elite of statistical arbitrage and produced returns consistent with their reputation. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 1990s (20)

1998 LTCM collapse…. • Following in LTCM’s footsteps, other major funds and investment banks pursued similar strategies giving rise to what MacKenzie (2003) describes as a ‘superportfolio’ of partially overlapping arbitrage positions. • The simultaneous unwinding of those positions by several funds in effect created a run on the less liquid bond securities. • Eventually the NY Fed intervened to engineer a rescue of LTCM and letting the major lenders take over the fund to gradually unwind it. • The Fed also sharply cut interest rates to respond to fears of further contagion to Latin America and a Global Financial Crisis. • Speculative attacks abated after Brazil secured a massive IMF loan of $41 billion in October, and after Brazil let the Real float in January 1999, while containing inflation and avoiding a debt crisis. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s Argentina crisis: • •

• •

With the blessing of the IMF Argentina instituted a Currency Board, which locked in the Argentine peso with the dollar in oneto-one parity in 1991. While the fixed exchange rate helped Argentina fight hyperinflation it also made it especially vulnerable to the succession of crises, starting with the Mexican crisis of 1995, and ending the devaluation of the Brazilian Real combined with the slump in commodities prices. There was yet another wasted IMF program in the summer of 2001. Eventually Argentina was forced to devalue in January of 2002 and to default on its debt. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s (2) Argentina crisis… • • •

Inevitably this precipitated a major banking crisis and an unprecedented contraction in GDP (11%). Following the devaluation and default the IMF virtually stopped dealing with Argentina. While the crisis was unfolding the IMF initiated discussions on a major reform proposal to deal with sovereign debt crises: Anne Krueger's Sovereign Debt Restructuring Mechanism (SDRM).

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s (3) Dot.com bubble: •

The sharp reduction in interest rates by the Fed to fend off the Asian and Russia crises created ideal conditions for the onset of a new bubble: the technology bubble which started in late 1998 and burst in 2001.



New Economy implied higher productivity growth.



Outlandish predictions: Dow at 36000; Henry Blodget's predictions of Amazon stock price at $400 or higher (yesterday it closed at $247.88).



From Ofek and Richardson (2003) JF: Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s (4)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

The 2000s (6) Enron, Worldcom and other corporate governance scandals: • • • • •

Enron, an energy trading company, audited by Arthur Andersen revealed that it had reported false financial statements and that it was close to insolvent in October 2001. Eventually Enron was forced into bankruptcy and Arthur Andersen was dissolved. In June 2002 another accounting scandal involving Arthur Andersen, WorldCom, broke. Other major scandals around that time were Tyco International, Healthsouth, Adelphia, etc. Later in 2002, the Sarbanes-Oxley Act was passed to regulate the auditing industry and tighten corporate financial disclosure. Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? From Charles Kindleberger and Robert Aliber (2005) and other assigned readings:



Robert Solow: “large quantities of liquid capital sloshing around the world should raise the possibility that they will overflow the container.”



Bernanke et al. (2011): ‘global savings glut’ and the global demand for US originated fixed-income assets that were perceived to be safe



lax monetary policy, deregulation, facilitate the emergence of booms Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? •

Inherent fragility of banking system – Liquidity transformation role of banks and the risk of ‘bank runs’ – Interest rate risk – Contagion – Regulatory arbitrage and the growth in ‘shadow banking’



cycle of manias and panics → irrational behavior by investors: – from “hedge finance” to “speculative finance”… – get on the train before it leaves the station

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? (2) •

“chicken and egg problem”; more investment is profitable when the cost of capital goes down -- the cost of capital goes down as investors forecast a larger earnings growth option;



new economy illusion;



anticipation of short-term capital gains (speculative option value)



herd behavior; positive feedback and bandwagon effects; momentum traders; Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? (3) •

leveraged speculative positions, especially when the rate of growth in asset prices slows down (to get higher yields);



this produces a lending boom;



‘financial innovation’ and swindles are more likely in mania phases;



a boom in one market can spill over into other markets;



international contagion of manias and crashes; Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? (4) Crashes: turning points are very hard to predict: •

Signs that two and two don't add together:



Palm Inc.: post-IPO share price in 2000 reached $165, giving Palm a market capitalization of $53 billion--more than that of its parent company 3Com, which owned 94% of Palm shares and was valued at $28 billion.



Japan stock market bubble: at the end of the 1980s stock market capitalization of Japanese cos. was twice the stock market capitalization of US cos., but Japanese GDP was less than half of US GDP; Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Are financial crises inevitable? (4) Crashes: turning points are very hard to predict… •

flight to quality: race out of long-term assets into cash (gold, US treasuries);



panic feeds on itself, overshooting of prices;



sloshing money: when a bubble in one asset class bursts the money flows to other assets, setting the stage for another bubble in a new asset class…

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Manias, Panics and Crashes (5) policy responses: • intervention is called for ex post to provide stability; • creates moral hazard in speculation ex ante; • unlikely that manias can be stopped by official warning; • The trick is to “always come to the rescue...but always leave it uncertain whether rescue will arrive in time or at all...”; “We want to keep the markets calm and the Russians scared” Larry Summers



“The central question is whether a central bank can restrain the instability of credit and slow speculation...” Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms: Latin America and the World Gourinchas, Valdés and Landerretche (2001)

What is a lending boom? • An above trend increase in credit growth, accompanied by an above trend in output per capita •

How does a lending boom come about? – lower interest rates & financial liberalization; – financial accelerator (higher collateral value; house price appreciation); – Credit bubble

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (2) How does it end? • Smooth landing with gradually higher interest rates? • Debt Crisis and asset-price crash? • How is a lending boom identified? • Hodrick-Prescott filter: – take a time series yt – decompose it into: yt =  t + ct –

identify trend component

t

T

T−1

t1

t2

by minimizing:

∑ y t − t 2  ∑  t1− t  −  t −t−1  2 Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (6)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (7)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (3)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (4)

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Lending Booms (5)

Probability of observing a country episode in a given year in the geographic area.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Banking Crises: An Equal Opportunity Menace Reinhart and Rogoff (2008)



All parts of the world have been hit by banking crises, although most advanced economies have been spared post WW II until very recently.

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Banking Crises: An Equal Opportunity Menace (2) •

Financial integration and free capital mobility seems to facilitate the onset of banking crises:

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

Banking Crises: An Equal Opportunity Menace (3) •

One costly legacy of banking crises is the deterioration of public finances and the rise in public debt:

Patrick Bolton: Gerzensee, August 5-9, 2013

Financial Crises: Lecture 1

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