Financial Institutions and Markets

Financial Institutions and Markets

The Financial Crisis—An Early Retrospective

Edited by

Robert R. Bliss and George G. Kaufman

Palgravemacmillan

Softcover reprint of the hardcover 1st edition 2010 978-0-230-10835-6

FINANCIAL INSTITUTIONS AND MARKETS: THE FINANCIAL CRISIS—AN EARLY RETROSPECTIVE

Copyright © Robert R. Bliss and George G. Kaufman, 2010.

All rights reserved.

First published in 2010 byPALGRAVE MACMILLAN®in the United States – a division of St. Martin’s Press LLC,175 Fifth Avenue, New York, NY 10010.

Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.

Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

ISBN 978-1-349-29113-7 ISBN 978-0-230-11736-5 (eBook)DOI 10.1057/9780230117365

Library of Congress Cataloging-in-Publication Data is available from the Library of Congress.

A catalogue record of the book is available from the British Library.

Design by MPS Limited, A Macmillan Company

First edition: December 2010

10 9 8 7 6 5 4 3 2 1

Transferred to Digital Printing in 2012

Contents

List of Figures vii

List of Tables ix

About the Contributors xi

Part I Financial Crises across Countries

1 Banking from Riches to Rags: Ignoring the Supervisory Red Flags and Thwarting Prompt Corrective Action 3

Gillian G. H. Garcia

2 Too Much Right Can Make a Wrong: Setting the Stage for the US Financial Crisis 37

Richard J. Rosen

3 The U.K. Banking Crisis 71 Philip Molyneux

4 The Sub-Prime Crisis, the Credit Crunch, and Bank “Failure”: An Assessment of the U.K. Authorities’ Response 93

Maximilian J. B. Hall

5 Financial Crisis and Regulation: The Case of Spain 127 Santiago Carbó Valverde

6 Basel II Has Been a Costly Distraction on the Road to Minimizing the Societal Cost of Bank Failures and Financial Crises 147

George G. Kaufman

7 Fannie Mae and Freddie Mac: Creatures of Regulatory Privilege 157

David J. Reiss

Part II Other Issues in Financial Regulation

8 Uncertainty and Transparency of Monetary Policy 187 Giorgio Di Giorgio and Guido Traficante

9 Privatization and Governance Regulation in Frontier Emerging Markets: The Case of Romania 205

Gilles Chemla, Adrian Pop, and Diana Pop

10 Universal Access, Cost Recovery, and Payment Services 225 Sujit Chakravorti, Jeffery W. Gunther, and Robert R. Moore

11 Estimating the Volume of Counterfeit U.S. Currency in Circulation Worldwide: Data and Extrapolation 241

Ruth Judson and Richard Porter

vi CONTENTS

List of Figures

1.1 Number of bank and thrift failures by month: 2001–2009 5

2.1 Household debt servicing ratio, 1995–2008 38

2.2 Issuance of securitized bonds, 1990–2008 45

2.3 Subprime MBS issuance, 1995–2008 48

2.4 Share of MBS issued without a government or GSE guarantee, 1995–2008 49

2.5 Yield spreads for selected ABS, 2000–2008 50

2.6 Intermediation chain for the purchase of securities through a mutual fund 56

5.1 Nonlinear adjustments between lagged credit growth and current default 137

5.2 Nonlinear adjustments between lagged coverage ratio and current default 139

5.3 Sequence of the financial crisis in Spain 142

8.1 The effect of having different levels of informed agents on social loss (percent change relative to having full transparency for the entire private sector) 198

8.2 The effect of having different levels of informed agents on social loss with different perception of the potential output between the central bank and the private sector (percent change relative to having full transparency for the entire private sector) 200

11.1 Shares of counterfeits found in various countries, financial year 2002 255

List of Tables

1.1 Failures and material losses: 2007–2009 6

1.2 Causes of failure among banks supervised by the FDIC 9

1.3 FDIC supervision banks failing with material losses 13

1.4 Causes of failure among state member banks supervised by the Federal Reserve 19

1.5 Federal Reserve supervision of banks failing with material losses 20

1.6 Causes of failure among national banks supervised by the OCC 23

1.7 OCC supervision of banks failing with material losses 25

1.8 Causes of failure among federal thrifts supervisedby the OTS 28

1.9 OTS supervision of thrifts failing with material losses 30

3.1 Number of banks and building societies, 1985–2008 72

3.2 Number of banks in the United Kingdom 74

3.3 London’s share of investment banking and other international financial services (%) 76

3.4 Net interest margins—U.K. retail banks, 1990–2008 84

3.5 Net interest income / total assets—U.K., European, U.S., and Japanese banks, 1995–2007 85

3.6 Income of major British banking groups, 1985–2008(% of gross income) 86

3.7 Costs of major British banking groups, 1985–2008(% of gross income) 90

3.8 Profits of major British banking groups, 1985–2008(% of gross income) 91

4.1 The Northern Rock crisis: Key events 96

5.1 The revision of European financial regulation 135

8.1 Numerical simulation 195

8.2 Numerical simulation with the private sector having a more precise signal about potential output 200

9.1 Results from logistic and duration models 217

10.1 Check-processing fees for Federal Reserve cities and associated regional check-processing centers (RCPCs), cents per item 236

11.1 Data on counterfeit currency received by the U.S. Secret Service, fiscal years 1999–2005 (millions of dollars) 246

11.2 Counterfeiting rates in deposits at Federal Reserve banks, 2005 248

11.3 Counterfeit $100 notes detected in deposits processed at Federal Reserve Banks 1996–2005 249

11.4 Counterfeit $100 stocks implied by Federal Reserve processing data, assuming varying shares of currency held abroad 250

11.5 Counterfeit $50, $20, $10, $5, and $1 stocks implied by 2005 Federal Reserve processing data assuming all currency held within the United States 251

11.6 Counterfeits passed in the United States by denomination and method of production, fiscal year 2002 252

11.7 Stocks of $100 counterfeits for various longevity and share abroad assumptions 257

11.8 Stocks of $20 counterfeits for various longevity and share abroad assumptions 257

x LIST OF TABLES

About the Contributors

Sujit Chakravorti is a Senior Economist in the financial markets group at the Federal Reserve Bank of Chicago. Chakravorti’s research focuses on the economics of payments and the evolving structure of global financial markets. Before joining the Chicago Fed, Chakravorti worked at the Dallas Fed. Prior to joining the Federal Reserve System, he worked at KPMG as an international economist, advising foreign governments on financial market policy. In addition, he has been a visiting scholar at the De Nederlandsche Bank (Dutch central bank), European University Institute, the International Monetary Fund, and the University of Granada. Chakravorti received a BA degree in Economics and genetics from the University of California-Berkeley and MA and PhD degrees in Economics from Brown University.

Gilles Chemla is the Head of the finance group at Imperial College Business School, a Research Director at Centre National de la Recherche Scientifique at the University of Paris-Dauphine, and a Research Affiliate at the Centre for Economic Policy Research. He has taught at the London School of Economics and the University of British Columbia and has worked for BNP Paribas and as an independent consultant.

Gillian G. H. Garcia was an Assistant Professor at the University of California at Berkeley until she went to Washington to work on the U.S. banking and thrift crises of the 1980s and early 1990s. In Washington she worked for the U.S. General Accountability Office and the Senate Banking Committee, where she participated in the enactment of reform legisla-tion (the Financial Institutions Reform Recovery and Enforcement Act [FIRREA], and the FDIC Improvement Act [FDICIA]). She then went to the IMF to help resolve the financial crises in East Asia and advise the fund on issues relating to deposit insurance.

Dr. Garcia has also been a distinguished professorial lecturer at Georgetown University, a National Fellow at the Hoover Institute at Stanford University, a Visiting Scholar at the Office of the Comptroller of the Currency, the Congressional Research Service, the Federal Reserve Bank of Chicago, and De Nederlandsche Bank in Amsterdam. Now retired, she

currently teaches from time to time at the University of Maryland, consults for developing countries and the Financial Services Volunteer Corp, and writes and presents papers on financial-sector policy issues. She has pub-lished six books and a number of articles—especially on deposit insurance and banking reform for the United States and the European Union.

Giorgio Di Giorgio is Professor of Monetary Economics and Dean of the Faculty of Economics at Università LUISS Guido Carli, Rome. After a obtaining his BA at Università La Sapienza, Rome, he received a PhD in Economics at Columbia University. His research focuses on monetary policy, financial intermediation theory, and financial regulation. Professor Di Giorgio published several papers in academic journals and as chapters of edited books, and he is a former Editor of the Journal of Banking and Finance. He also served as an adviser to the Italian Ministry of the Treasury (1997–2002), as Deputy Rector for international relations (2003–2005), and is now an independent director of asset management and listed companies in Italy.

Jeffery W. Gunther is Vice President of the Federal Reserve Bank of Dallas, where he oversees analysis of financial institutions and their supervi-sory environment. His primary focus involves the detection of emerging risks to the banking system. Gunther received a PhD in Economics from Southern Methodist University in 1995.

Maximilian J. B. Hall graduated with a first class honors degree in Economics from Nottingham University in 1975. He received a PhD from the same university in 1978. He joined the staff of the Economics Department of Loughborough University in 1977 and is currently Professor of Banking and Financial Regulation in that department. Professor Hall has published nine books (one coauthored) in the areas of money, banking, and financial regulation and has contributed chapters to a further 12 books. He has three entries in the New Palgrave Dictionary of Money and Finance published by Macmillan in 1992; and he has also acted as Managing Editor for a further two books, including Regulation and Supervision of Banks (four volumes) published by Edward Elgar in July 2001.

Ruth Judson is an Economist in the Division of Monetary Affairs at the Federal Reserve Board. Her work covers a range of topics, including demand for broad money, the link between inflation and growth, and the implementation of monetary policy. Together with Richard Porter, she was a primary contributor to the joint U.S. Treasury-Federal Reserve program, examining the international use and counterfeiting of U.S. currency. In connection with the project, she has worked extensively on the measurement of currency flows using U.S. currency data as well as

xii ABOUT THE CONTRIBUTORS

other sources. She holds an AB in Russian Civilization from the University of Chicago and a PhD in Economics from MIT.

George G. Kaufman is the John F. Smith Professor of Economics and Finance at Loyola University Chicago and consultant to the Federal Reserve Bank of Chicago. He has published widely on financial markets and insti-tutions and authored and edited numerous books in the field including Global Financial Crises (Kluwer: 2000); Asset Price Bubbles (MIT Press: 2003); Systemic Financial Crises (World Scientific: 2005); and the annual Research in Financial Services (JAI/Elsevier Press: 1989–2003). Dr. Kaufman is coeditor of the Journal of Financial Stability and a founding editor of the Journal of Financial Services Research. He is the former President of the Western Finance Association, the Midwest Finance Association, and the North American Economic and Finance Association. He serves as cochair of the Shadow Financial Regulatory Committee. Kaufman holds a PhD in Economics from the University of Iowa.

Philip Molyneux is currently Professor in Banking and Finance and Head of Bangor Business School at Bangor University. Between 2002 and 2005 he has acted as a member of the ECON Financial Services expert panel for the European Parliament. His most recent coauthored texts are: Thirty Years of Islamic Banking (Palgrave Macmillan: 2005), Shareholder Value in Banking (Palgrave Macmillan: 2006), and Introduction to Banking (FT Prentice Hall: 2006). He recently coedited (with Berger and Wilson) the Oxford Handbook of Banking (Oxford University Press). His main research inter-ests focus on the structural features of banking systems, modeling bank performance, Islamic banking, and wealth management. He has recently held Visiting Professorships at Bocconi University, Erasmus University, and Bolzano Free University (Italy). He has acted as a consultant to New York Federal Reserve Bank, World Bank, European Commission, UK Treasury; Citibank Private Bank, Bermuda Commercial Bank, McKinsey’s, Credit Suisse, and various other international banks and consulting firms.

Robert R. Moore is a Research Officer in the Financial Industry Studies Department of the Federal Reserve Bank of Dallas. He has published various articles on banking and financial markets in academic, trade, and Federal Reserve publications. Dr. Moore joined the Federal Reserve Bank of Dallas in 1991. Before joining the Federal Reserve, he was an Assistant Professor of Economics at Tulane University. He received a BA in Economics from the University of Missouri, where he was elected to Phi Beta Kappa. He received a PhD in Economics from the University of Wisconsin.

Adrian Pop holds a PhD from the University of Orleans, France. In 2006, he obtained the prize for the “Best PhD Thesis 2006” in Banking & Monetary

ABOUT THE CONTRIBUTORS xiii

Economics awarded by Banque de France. He is currently Associate Professor of Banking and Finance at the University of Nantes and Research Consultant to the French Banking Commission (Banque de France). He is also the Head of the Executive Part-time MBA Program at the Institute of Banking & Finance. His main research interests include the role of market discipline in banking regulation and supervision, Basel II, capital standards, procyclicality, stress testing, financial crises, informational content of secu-rity prices, early warning systems, credit derivatives, Islamic banking, and Too Big To Fail issues in banking.

Diana Pop received a PhD from the University of Orleans, France. She is currently Associate Professor of Finance in the Economics Department of the University of Angers. Her main research interests are in the area of emerging markets finance and regulation, mergers and acquisitions and corporate restructuring, and corporate governance. She has a contributed chapter in Financial Development, Integration and Stability: Evidence from Central, Eastern and South-Eastern Europe, published by Edward Elgar in November 2006.

Richard Porter received a PhD in Economics from the University of Wisconsin at Madison. Currently, he is Vice President and Senior Policy Advisor in the financial markets group of the Federal Reserve Bank of Chicago. Before joining the Bank, Porter served as an economist at the Board of Governors of the Federal Reserve System for over three decades. He was the recipient of a special achievement award from the Board in 1982 and a certificate of appreciation in special recognition of efforts and superior contributions for the International Currency Audit Program to the law enforcement responsibilities of the USSS in 2000. In May 2004 he was privileged, along with Peter Tinsley and Dale Henderson, to have the Board of Governors sponsor a festschrift-type conference entitled in his honor.

David J. Reiss is Professor of Law at Brooklyn Law School and has also taught at Seton Hall Law School. His research focuses on the secondary mortgage market. Previously, he was an associate at Paul, Weiss, Rifkind, Wharton & Garrison in its Real Estate Department and an associate at Morrison & Foerster in its Land Use and Environmental Law Group. He was also a law clerk to Judge Timothy Lewis of the United States Court of Appeals for the Third Circuit. He received his BA from Williams College and his JD from the New York University School of Law.

Richard Rosen is an Economic Advisor and Senior Economist at the Federal Reserve Bank of Chicago. In that position, he focuses on financial intermediation including the future of banking, bank regulation, and the

xiv ABOUT THE CONTRIBUTORS

housing markets. Prior to coming to the Chicago Fed, Dr. Rosen taught in the Finance Departments at the Kelley School of Business at Indiana University, the Wharton School at the University of Pennsylvania and the School of Business at Georgetown University. He has also worked on the Board of Governors of the Federal Reserve System. He received a BA from Swarthmore College and a PhD in Economics from Princeton University.

Guido Traficante is an Economist at the Development and Strategy Department of Eni and a Research Fellow at Università LUISS Guido Carli, Rome. After a BA at Università LUISS Guido Carli, Rome, he got a PhD in Economics at Tor Vergata University in Rome. His research focuses on monetary and fiscal policy, International Macroeconomics and Finance. Dr. Traficante was Research Fellow at the University of California Santa Cruz during the academic year 2005–2006 and has been a teaching assistant since 2004.

Santiago Carbó has a BA in Economics (Universidad de Valencia, Spain), a PhD in Economics and an MS in Banking and Finance (University of Wales, Bangor, UK), and Full Professor of Economics at the University of Granada (Spain). He was Dean of the School of Economics and Business of the University of Granada during 2006–2008. He has been the Head of Financial System Research of the Spanish Savings Banks Research Foundation (Funcas) since 1996. He is also Consultant at the Federal Reserve Bank of Chicago since 2008. He has been (and in some cases still is) consultant for public institutions such as the European Central Bank, the European Commission, the Spanish Ministry of Science and Innovation, the Spanish Ministry of Labour, and the Institute of European Finance) and for leading economic consulting companies. He has published widely in peer-reviewed publications. He has given conferences, lectures, and seminars at international institutions (G-20, World Bank, World Savings Banks Institute), central banks and government bodies (European Central Bank, Federal Reserve Board, Bank of Spain, Spanish Antitrust Authority), several banks of the Federal Reserve System, and universities.

ABOUT THE CONTRIBUTORS xv