Lessons from the North Atlantic financial crisis

Willem Buiter 19 December 2007

a

A

The crisis is the product of a ‘perfect storm’ bringing together a number of microeconomic and macroeconomic pathologies. Among the microeconomic systemic failures were: wanton securitisation, fundamental flaws in the rating agencies’ business model, the procyclical behaviour both of leverage in much of the financial system and of the Basel II capital adequacy requirements, privately rational but socially inefficient disintermediation, and competitive international de-regulation. Reduced incentives for collecting and disseminating information about counterparty risk were a pervasive feature of the new financial world of securitisation and off-balance sheet vehicles – what Paul Tucker of the Bank of England has called ‘vehicular finance’. So was lack of transparency about who owned what and about who owed what and to whom.

Proximate local drivers of the specific way in which these problems manifested themselves were regulatory and supervisory failure in the US home loan market.

Solutions to the microeconomic pathologies will be partly market-driven, partly imposed by regulators. They include the following nice ‘do’s’:

  • Insists on simpler financial structures and products, instead of financial engineering masterpieces that cannot be priced even by their designers, let alone by buyers and sellers in the secondary markets.
  • Require the retention of the equity tranche (or first-loss tranche) by the originator of loans, to mitigate the adverse impact of Principal-Agent chains on the incentive for information-collecting and monitoring of ultimate borrowers.
  • Eliminate the quasi-regulatory role of the rating agencies in Basel II.
  • Require rating agencies to sell nothing but ratings, to reduce conflict of interest.
  • End the payment of individual rating agencies by the individual issuers of securities they rate.
  • Subject all off-balance sheet vehicles that act like banks to the same regulatory requirements and fiscal regime as banks (a principles-based ‘duck test’ for banks).
  • Encourage greater international cooperation between regulators.
  • Create a single EU-wide regulatory regime for banks, other financial intermediaries and financial markets. Have one European regulator for all European financial institutions and markets in a given class/category.
  • Have an international crackdown on ‘regulators of convenience’ and ‘regulatory havens’ (alongside a long-overdue crackdown on tax havens).

Among the macroeconomic pathologies that contributed to the crisis were, first, excessive global liquidity creation by key central banks and, second, an ex-ante global saving glut, brought about by the entry of a number of high-saving countries (notably China) into the global economy and by the global redistribution of wealth and income towards commodity exporters that also had, at least in the short run, high propensities to save.

Neither the Fed, nor the ECB, nor the Bank of England exactly covered themselves with glory in addressing the global shut-down of the financial wholesale markets and the continuing crunch and illiquidity in the interbank markets. The ECB probably did best, followed by the Fed, with the Bank of England coming in a well-beaten third.

All three central banks are now injecting fair amounts of liquidity not just in the overnight interbank markets, but also at longer maturities, especially at 1 and 3 months. The Bank of England was most reluctant to tackle the very large spreads between, say, 3-month Libor and the market’s expectation of the official policy rate over a three month horizon (as measured by the fixed leg of the overnight indexed rate swap or OIS). It believed (against the evidence and the odds) that this reflected largely market perceptions of counterparty default risk, rather than liquidity risk. The Bank also only recently widened its list of eligible collateral in 3-month repos (sale and repurchase operations) to assets beyond than the high-grade sovereign debt instruments it had insisted on before. For the December 2007 and January 2008 auctions it announced, it is also, for the first time, willing to do repos against this wider range of collateral at market-determined rates, rather than insisting on a penalty floor for the rate, as it did in September.

The ECB immediately threw very large amounts of liquidity at the longer-maturity interbank markets and the Fed pumped in moderate amounts. Interestingly, except in the very short-run, the effect on the interbank spread over the OIS rate did not respond very differently for sterling, the euro and the US dollar. Before one concludes from this that open market operations at these longer maturities have no influence on the spreads, one has to recognise that the need for liquidity may not have been the same in the three interbank markets. For starters, many UK banks with subsidiaries in the Eurozone (and some with subsidiaries in the US) obtained liquidity through these subsidiaries. Other indicators of liquidity of the interbank market, such as the volume of private transactions, suggest that, even with comparable spreads, UK banks continue to face especially tight liquidity conditions.

In the UK, failures of the Tripartite financial stability arrangement between the Treasury, the Bank of England and the FSA, weaknesses in the Bank of England’s liquidity management, regulatory failure of the FSA, an inadequate deposit insurance arrangement and deficient insolvency laws for the banking sector all contributed to the financial disarray.

Despite this, it may well be possible to contain the spillovers from the crisis beyond the financial sectors of the industrial countries and the housing sectors of the US and a few European countries. The reason is that the credit boom that came to an end in 2007 did not give rise to major excesses in physical capital formation (fixed investment), except in the financial sectors just about everywhere and in the residential construction sectors of a few countries, including the US, Spain, Ireland, the Baltic states and Bulgaria. The saving-investment balances and balance sheets of non-financial corporates remain healthy. The financial imbalances are mainly in the financial sector (excessive leverage, deficient liquidity, insufficient capital and the need for massive write-downs of assets – specialty CDOs and other complex securitised structures) and to a lesser extent in the household sector (financial deficits, excessive mortgage debt, unsecured consumer debt and the need to take large hits on the valuation of key assets, especially residential property). While a slowdown is unavoidable – and, in the case of the US, necessary and desirable because for the restauration of external balance – a recession is not.

CEPR Policy Insight No.18 'Lessons from the 2007 Financial Crisis'

a

A

Topics:  Financial markets

Tags:  subprime crisis, financial crises, spillovers